Capitalism Comes a Cropper!

Lehman Brothers, Bear Stearns, and Merrill Lynch have been swallowed by commercial banks, while Goldman Sachs and Morgan Stanley have become commercial banks with huge dollops of Federal equity injection from the U.S. Treasury’s USD 700 billion TARP (Troubled Asset Relief Program) bailout. Insane levels of leverage, both in housing and commerce, compounded by excesses of arcane financial derivatives and facilitated by an environment of scant supervision have decimated the much vaunted Capitalist system with its unchallenged mantras of “free trade�, “globalization�, and “privatization� that had kept the whole world enthralled for nearly two decades.

Starting in April 2007, what was initially perceived as a manageable problem with sub-prime mortgage lending in USA has metamorphosed into an international financial tsunami. European Schadenfreude at what was dubbed an American malady is now also an acute Continental embarrassment as a spate of banks and insurers have sought government help across Germany, France, Belgium, Holland, Spain, Switzerland and as far afield as Iceland. The Brits have poured nearly half a trillion dollars to shore up their credit markets as have the Germans and the French. No one can hazard a guess what the final bill will be.

Lessons of the Great Depression, though no way near its severity, are being relearned 70 years later; that in matters of finance, three things are paramount…Liquidity, Funding, and Capital. A crisis of confidence immediately impacts liquidity. This has happened on a global scale. From Tokyo to Buenos Aires, Stock and Commodity Futures markets have crashed. Record declines in valuation have been experienced everywhere as investors deserted all types of claims to financial assets in favor of Treasuries (Government Securities). The IMF estimates that global banking assets may shrink by as much as USD 10 trillion, the equivalent of 20% of world GDP. This has already cost USD 675 billion in banking delinquencies, to date forcing recapitalizations of USD 430 billion for the largest banks alone. Loss of confidence caused a seizure of market liquidity as Interbank lending evaporated.

Funding was the next domino. All financial institutions are leveraged, non-bank institutions much more than banks where capital is often a tenth of total assets. What’s more, among investment banks especially, a bulk of leveraged assets was funded by “hot-money�…overnight and short-dated funds. Over the past decade, to enhance earning yields, financial institutions purchased large amounts of dodgy mortgages, repackaged them as securitized assets and often sold them on to investors who in turn insured them with credit default swaps (CDS). This was a toxic brew.

In early 2007, valuations of asset backed securities whose volume had risen to USD 2.7 trillion tumbled, so did the value of their “Derivatives� like Credit Default Swaps (CDS). These had gone one better, peaking at USD 600 trillion in notional value…more than 11 times global GDP! When a whole slew of these obligations had to be redeemed, funding could not be obtained at any price. Hedge Funds and Investment Banks were denied wholesale credit by their bankers ('et tu Brute'). So, they fell!

In turn, having to take large write-downs on their dodgy portfolios, the largest banks soon ran out of capital. And, once that resource was exhausted, they fell into the arms of their central bankers. The American Federal Reserve’s initial optimism about containing the market funk via purchases of USD 200 billion worth of “sticky� banking assets was soon deemed inadequate. To save the day, the State had to step in. End of Laissez Faire. Hello nationalization!

That, in a nutshell, is the story of Capitalism’s failure being observed today.

Now to our domestic market. For the entire duration of the Musharraf years, our economy was held in thrall to the model of free trade, globalization, and privatization (the so-called Washington Consensus) with growth based on credit-fuelled consumption a la USA. Principal beneficiaries of the Musharraf regime have been a small coterie of investors that walked away with choice banking assets at throwaway prices, or promoted self-enriching mobile technology, or were the kingpins of brokerage at KSE. For all the USD 75 billion that reportedly poured into the country over this period in the form of workers’ remittances, debt rescheduling, FDI, and remunerations for being mercenaries in the American War on Terror, we have scant to show in terms of improvements to infrastructure, education, health, or poverty reduction.
While loose monetary policy, with money supply (M2) exploding at 18-20% per annum for the past five years has taken inflation from 4.5% in October 1999 to 25% today, over the same period, foreign debt has grown 50% from USD 32 billion to USD 47 billion. Meanwhile, given a free rein by SBP, our banking sector has literally raped its depositors. Over the past five years, by charging the highest loan-deposit spreads in the world, our banks have robbed the nation of over PKR 400 billion to boast current capital adequacy ratios in excess of 12%. Ironically, this ranks them among the best-capitalized in the world! Had they been equally conscientious about promoting investment, they would have proactively solicited interested entrepreneurs in energy and infrastructure. Unfortunately, their focus was auto-loans, and Badla-financing of punters on KSE.

Apologists never tired of pointing to the phenomenal growth of the KSE index. Yes, it did grow astronomically…from a level of 1,200 to 15,600 over a span of 8 years. That is a 13-fold growth at an annualized compound rate of 150%! And yes, a handful of investors of this casino and its principal brokers became fabulously rich and powerful. While they prospered no end during the Musharraf years, the change of Government in February 2008 did not faze them a whit. To keep their casino rolling along merrily, on the eve of the budget for 2008-09 they were able to “persuade� Mr. Asif Zardari to extend the tax holiday on capital gains for another 2 years.

But, the shock wave in global finance that began a year ago seems to have finally caught up with the KSE casino. A market decline that began early this year became a rout in July-August. The 100-Index fell from its mid-May peak of 15,600 to 9,144. It induced an ill-thought action. Disallowing sale below this “floor-level�, KSE painted itself into a corner that is becoming all too untenable by the day. With trading practically suspended, in the first week of October, KSE sought to close the exchange!

Unfortunately for KSE management, the Ministry of Finance has a new boss in Shaukat Tareen, the recently appointed Advisor to PM. A highly successful international banker who scripted the revised Badla mechanism (called CFS) and recently served as Chairman of the Exchange, he is a savvy operator who appears determined not to let the KSE coterie have their way. And, unless higher authorities intervene, he has vowed to keep the market open. But, keeping it open without removing the floor under trading is meaningless. We all know what will happen on October 27th when the floor is yanked…the market is likely to go into free fall till all wishing to exit have done so. The first in queue will be the reportedly USD 2 billion investment of foreign funds. Given current market capitalization of around USD 25 billion, the 100-Index artificially pegged at 9,144 should fall by at least 10%-15% taking it down to a level of plus/minus 8,000…more if local investors join the party!

To forestall this impending doom, the KSE fraternity along with some large banks that have biggish equity, Badla-financing, and mutual fund investments have been frantically engineering various schemes to keep themselves whole. The largest Mutual Funds outside the PKR 80 billion in NIT are operated by these self-same brokerages. While well-capitalized banks may weather the storm, coming on top of the 40% meltdown in equities over the past 9 months, the renewed collapse indicated above is likely to decimate the portfolios of the broker-owned funds. Consequently, they have been pleading for some form of rescue. They have been predicating market re-opening on a PKR 20 billion federal bail-out fund. And according to them, Government’s failure to assist will seriously gum up the works, i.e. cause mass redemption delinquencies and defaults.

Let them face the music. Heaven will not fall if a handful of brokerages are liquidated. However, since a lot of small investors will suffer in the bargain for no fault of their own, prudence would favor some form of bail-out. But, it can and should be so structured that relief is first provided to small investors before helping the large brokerages. A simple and uncomplicated methodology would be to redeem small savers’ investments at current levels before removing the floor under the 100-Index. Thereafter, the floor should be removed to let market forces determine the fate of the rest (the institutional investors).

Thereafter, exit should be provided by redemption via GOP’s above-mentioned Fund at a reasonable discount…say 25% off the day’s price of scrip being redeemed. If the resultant liquidity enables the target brokerage/institutional investor to survive, well and good. If not, too bad for them. They ought to be liquidated.

For those brokerages/institutional investors wishing to hold on to their portfolios, an alternate relief option could be temporary funding against pledge of their “sticky� portfolios. They could be funded up to 60% of the post-floor-removal value of these portfolios, which they could later redeem over a period of 3-6 months at a steep interest penalty. In other words, they could be given a “Call Option� on their pledged portfolios at current (post floor-removal) market prices with a 10% option premium. This mechanism would ensure that the federal government does not end up using tax-payers money for cradling a few fat cats (pun intended). Because when the bow breaks, the cradle will fall.