The US Congress finally passed the bill for the USD 700 billion bailout of the US financial system. Elsewhere, there have been many more high profile bailouts, in Europe - The major ones being the USD 50 billion bailout of Hypo Real Estate, Germany second largest mortgage lender; The Irish government's USD 572 billion blanket cover for liabilities in the banking system; and the USD 16 billion bailout of Fortis by Belgian, Dutch and Luxembourg governments. Call it bailout, or call it nationalizing, there is little disagreement that something needs to be done to clean up the mess that has been created globally. The era of easy credit, that drove business cycles and unprecedented profits is under grave threat.
The New economy was driven by globalization of markets, which led to a strong surge in job creation and profit maximization globally. However, the issue with any such opening up of economy is that it is always two-sided. So while benefits spread across the globe over the last 4-5 years, problems also broke national barriers. It was just to naive of all of us to think that globalization is only going to have a positive impact, wasn't it? But that was just all of us thought. When the news of the sub-prime mess first broke out, in the beginning of 2007, most global markets were yet to see the biggest boom of the decade. We saw the entire boom, always asserting the decoupling theory, thereby saying that while the benefits of globalizations will flow to Emerging economies, the problems will be for the developed world. What will happen to China when the US and Euro-zone slow down, was never on our minds. Alas, if we had gone back to basic economics and questioned this, maybe we would have been better off. But then, we are all human beings right, and we all have a short term memory.
I am a fan of classical economics, and believe in the demand supply equation. In the long run, that is the only truth that stays. So while prices can move anywhere during periods of boom and bust, it will finally be governed by demand and supply. This is particularly important when we think about the US bailout. The US government is supposed to be buying assets which are frozen up in the markets, or in simpler terms, no-one is buying these assets in the markets. Some of the assets are selling at 20% of the actual price. The question is - is the actual price correct? Is the risk pricing of the asset correct. When the asset was sold for say USD 100 million, was the risk underlying priced correctly. My guess is that this is unlikely, as evident from the current crash in asset prices. Today the same asset is trading in the markets at USD 20 million. Is this a correct price? Again my guess is as good as yours. The US government believes it is not. And hence they are willing to pay prices even slightly higher than these in order to save the holders of these assets. The success of this bailout depends on the actual defaults on the loans underlying these assets. If for some reason the defaults are higher than what the assets are pricing now, markets will be in serious trouble.
There is also an inherent belief regarding the astuteness of central banks when it comes to dealing with such crisis. This is even more pronounced in the case of the US, where it is virtually believed that the US Fed and the government will solve all problems and crisis. History is full of examples when central bank actions have not really helped in improving the economic scenario - in fact, some of these actions have aggravated the crisis. The equity markets till last week believed that the bailout plan will work. But these week, as the bill was being discussed in the US Senate, the markets first dipped, then jumped and finally when the bill was passed, ended lower. Maybe the markets are now uncertain about the bailout plan succeeding. Equity markets in the US are most likely headed down, and if the bailout does not work - substantially lower.
Whether this will work or not is anybody's guess. What is definitely going to happen is that markets will arrive at a mechanism of pricing these assets, as underlying economics prevails. Economics is also a mean reversion theory. Demand Supply dynamics work in this fashion. First we have periods of high demand and high profits and soaring inflation. This is preceded by higher supply coming up, falling prices, lower profits and hence lower demand, till the time supply starts to fall again, due to unviability of the business. There are price distortions in the short term, but economics ensures that larger the price distortions, longer the correction that follows. This may very well be the case this time. Sometimes, these corrections are very fast, and furious - difficult for even central banks to manage. The markets tend to realize this over a period of time, and hence the recovery of markets could be a painful and long-drawn process. In fact, after the 1929 crash in the US markets, the markets recovered a long way in the next year. It was only after that that they realized the magnitude of the mess, and ended nearly 80% lower from the top. Similar was the case with Japan, in 1990, where the initial crash was followed by a bounce. However, what followed has been a ruthless example of an asset price bubble bursting, and its aftermath (See chart below). This is not to say that we are in a similar situation, but just to assert, that not every dip is a buying opportunity. The underlying economics needs to be carefully monitored, and investment decisions need to be based on the same.
Source: www.chartsrus.com (This is a good website that collates lots of historical charts, and is great for anyone who wants to draw inferences from history)
The New economy was driven by globalization of markets, which led to a strong surge in job creation and profit maximization globally. However, the issue with any such opening up of economy is that it is always two-sided. So while benefits spread across the globe over the last 4-5 years, problems also broke national barriers. It was just to naive of all of us to think that globalization is only going to have a positive impact, wasn't it? But that was just all of us thought. When the news of the sub-prime mess first broke out, in the beginning of 2007, most global markets were yet to see the biggest boom of the decade. We saw the entire boom, always asserting the decoupling theory, thereby saying that while the benefits of globalizations will flow to Emerging economies, the problems will be for the developed world. What will happen to China when the US and Euro-zone slow down, was never on our minds. Alas, if we had gone back to basic economics and questioned this, maybe we would have been better off. But then, we are all human beings right, and we all have a short term memory.
I am a fan of classical economics, and believe in the demand supply equation. In the long run, that is the only truth that stays. So while prices can move anywhere during periods of boom and bust, it will finally be governed by demand and supply. This is particularly important when we think about the US bailout. The US government is supposed to be buying assets which are frozen up in the markets, or in simpler terms, no-one is buying these assets in the markets. Some of the assets are selling at 20% of the actual price. The question is - is the actual price correct? Is the risk pricing of the asset correct. When the asset was sold for say USD 100 million, was the risk underlying priced correctly. My guess is that this is unlikely, as evident from the current crash in asset prices. Today the same asset is trading in the markets at USD 20 million. Is this a correct price? Again my guess is as good as yours. The US government believes it is not. And hence they are willing to pay prices even slightly higher than these in order to save the holders of these assets. The success of this bailout depends on the actual defaults on the loans underlying these assets. If for some reason the defaults are higher than what the assets are pricing now, markets will be in serious trouble.
There is also an inherent belief regarding the astuteness of central banks when it comes to dealing with such crisis. This is even more pronounced in the case of the US, where it is virtually believed that the US Fed and the government will solve all problems and crisis. History is full of examples when central bank actions have not really helped in improving the economic scenario - in fact, some of these actions have aggravated the crisis. The equity markets till last week believed that the bailout plan will work. But these week, as the bill was being discussed in the US Senate, the markets first dipped, then jumped and finally when the bill was passed, ended lower. Maybe the markets are now uncertain about the bailout plan succeeding. Equity markets in the US are most likely headed down, and if the bailout does not work - substantially lower.
Whether this will work or not is anybody's guess. What is definitely going to happen is that markets will arrive at a mechanism of pricing these assets, as underlying economics prevails. Economics is also a mean reversion theory. Demand Supply dynamics work in this fashion. First we have periods of high demand and high profits and soaring inflation. This is preceded by higher supply coming up, falling prices, lower profits and hence lower demand, till the time supply starts to fall again, due to unviability of the business. There are price distortions in the short term, but economics ensures that larger the price distortions, longer the correction that follows. This may very well be the case this time. Sometimes, these corrections are very fast, and furious - difficult for even central banks to manage. The markets tend to realize this over a period of time, and hence the recovery of markets could be a painful and long-drawn process. In fact, after the 1929 crash in the US markets, the markets recovered a long way in the next year. It was only after that that they realized the magnitude of the mess, and ended nearly 80% lower from the top. Similar was the case with Japan, in 1990, where the initial crash was followed by a bounce. However, what followed has been a ruthless example of an asset price bubble bursting, and its aftermath (See chart below). This is not to say that we are in a similar situation, but just to assert, that not every dip is a buying opportunity. The underlying economics needs to be carefully monitored, and investment decisions need to be based on the same.
Source: www.chartsrus.com (This is a good website that collates lots of historical charts, and is great for anyone who wants to draw inferences from history)
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