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Habits die hard: TBTF - Ajit Dayal - Views on News from Equitymaster
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  • Aug 13, 2007

    Habits die hard: TBTF - Ajit Dayal

    The alcoholic has a bad habit: he cannot give up alcohol. Every day, as the bells on every stock market floor and bond market screen starting from Australia in the East, to Tokyo to Hong Kong to Singapore to Bombay and moving on westwards to Dubai to Zurich to London and then to New York, chime their sweet musical opening buzzers, the alcoholics are there: lined up with their swagger and their new, heady thoughts waiting to smell another day of sweet and easy money.

  • What to make of this global crisis - Ajit Dayal

    The bartender, alas, seems to have developed a bad habit: that of pouring drinks and moving his hands and elbows in that spontaneous motion that throws up free money to those drunks around the bar.

    The man with the addiction to alcohol is as addicted as the man who serves up the alcohol.

    The alcoholic and the bartender are on two different sides of the table, but they both have one goal, it would seem: to keep the party going.

    The party goes on - fuelled by the bartenders
    How else would you explain the actions of the central banks in Australia, Japan, Europe, Canada, and USA to add a reported US$ 138 billion in 72 hours into the global financial system to avert a global financial crisis? The bartenders just gave the drunks some more money.

    They have done it before.
    In 1998 when the Long Term Capital Management hedge fund blew up and reportedly put to risk such stalwarts as Goldman Sachs, J. P. Morgan, and UBS, what did the central banks do? They pumped in money to save these large financial giants.

    In 2000 and 2001 when the tech bubble was imploding and the 9/11 attacks tipped the balance towards potential financial chaos because insurance companies - already suffering from huge investment losses in their portfolios (they bought a lot of tech shares at the peak) and large underwriting losses due to claims from frauds and bankruptcies (like Enron and Worldcom) - were now likely to get soaked by losses from terrorist attacks; the central banks again stepped in to save the day.

    When SARS spread like a viral wildfire in 2003, again the central bank stepped in to ease the pain and keep the global economy humming along.

    The days of the bartender, leaning over the counter, covering the glass of the customer with one hand and saying: "No more, my friend" are destined to stay in the archives of the black and white movies.

    The bartenders earlier were the friends who let you run a bit loose but reined you in if you were going crazy.

    Today's bartenders switch the lights on, announce the bar is closing and then - when the first drunk breaks down and cries - they shut the lights again and bring out the bottles!

    The bartenders want a goldilocks economy: a fairy tale ending where everyone ends up happy.

    And the drunks know it.
    They are already proclaiming that the worst is over.
    The bar tenders have turned on the taps, the booze is flowing.
    USD 138 billion of it pumped into the global financial system to keep the wheels of liquidity going.
    To keep the froth from turning into a flat, tasteless beer that no one will like.

    The drunks have won previous battles in 1998, 2001 and 2003. Why should they lose in 2007? They are still the same animals they were. They are "T B T F".

    Yes, understand these words carefully. TBTF = Too Big To Fail.

    In banking terminology, there is a saying: "If your customer owes the bank a little money, that is fine because the customer will always be in trouble since he owes you (the bank) money. However, if the customer owes the bank a lot of money, then the bank is in trouble!" If that large customer fails to pay back the large loan from the bank, the bank may be bankrupt!

    The same equation applies to the size of the financial institution or bank: the bigger the bank, the less likely it will be allowed to die a natural death and "fail". Because of its sheer size the closure of such a financial institution is likely to have a larger impact on the economy and the financial system in general.

    It is quite simple, really, and we have seen the examples of this even in India.

    IFCI, ICICI, and IDBI were all developmental financial institutions that lent good money to bad projects. By 1999 many of these financial institutions were in trouble. Why? Because there were a few larger business houses that owed them a lot of money and, since industry was in bad shape, no one could pay so these financial institutions were in trouble and needed to be rescued by a combination of money, change in management, or change in business strategy. Today, all 3 institutions stand alive - some prospering, some tottering. But they stand.

    Over the same time period, many smaller banks and cooperatives have been shut down. These smaller banks made the same mistakes as the larger banks and institutions but they were not likely to have such a large impact outside a specific geographical area. So they were allowed to "fail".

    Moral of the story: if you get a banking license in India, open 500 branches nationally in one year and announce plans for another 500 by year two.
    Think big, Talk big, and Grow big.
    TBTF = Too big to fail.

    Once you are big and a part of the national footprint, the TBTF policy works in your favour.

    How you run your bank may have little meaning: you may be the bank with the narrowest profit margin and the riskiest loan book, but if you keep that large footprint, you are safe.

    It is this same TBTF phenomena that has likely kept the central banks around the world busy running their printing presses.

    Can any central bank allow its larger banks to fail or be in trouble? Well, under Paul Volcker, the Fed Chairman in 1980 it was possible.

    Citibank nearly sank and its stock price was US$ 1 and priced for bankruptcy before the famous Saudi investor (Prince Alwaleed bin Talal) rescued it. But Paul Volcker was a bartender from the days of the black and white movies. Like our own V P Singh, he did not care for the might or reputation of anyone. If you made some silly financial bets and you were wrong, Mr Volcker let you suffer for it. When the US was going through a housing boom in 1980, Mr Volcker did what all central banks should do - he cut that boom to size by raising interest rates to 21% (yes, 21%) in USA. That killed the demand for housing, hurt the US economy big time, killed any inflationary pressures but probably laid the ground for the next, largest and most sustainable expansion in the US economy. By raising interest rates, banks went bust, home building companies went bust, Wall Street was dead. Mr Volcker kept on chewing his cigar and kept on throwing the drunks out of the bar.

    But Mr Greenspan, a recent head of the US central bank, who coined the term "irrational exuberance" seems to have done everything in his power to allow it to flourish or, at the very least, not done much to kill this irrational behaviour of the drunks at the bar. When there was any sign of trouble with any TBTF category group out there, the taps were turned on.

    Each time the tap is turned on, it gets harder to break the habit. The costs to society increase. A man with one extra drink in his belly will, at worst, stumble out and fall on the floor. A drunk with 4 extra drinks under the belly is likely to beat someone, insult someone, start a brawl and leave a lot of mess around to clean up.

    Investors and bankers who don't understand risk and don't understand business cycles because they are TBTF will crank up the level of economic activity by fuelling and funneling that extra cash to take it to some exaggerated level. So housing demand jumps because "sub-prime" people start buying homes they cannot afford. And because they buy those homes they cannot afford with real money but can afford on free money, they start buying furniture from China, cement from Mexico, steel from Brazil. And all those economies start pumping up their capacities to build more furniture, more cement, and more steel. Everyone is living on, and planning for, some unreal demand.

    Imagine what will happen when that demand does not come and the number of homes being sold declines! Chaos.

    We saw it in the tech boom and bust seven (long) years ago. Everyone expected computers to be bought by every person in the world, every business would have a web site, would need servers, would need routers, would need optic fibre. Yes, one day the world would need all that but the business folks and bankers expected all that to happen in CY 2001. Well, it did not. And there was a bust.

    Boom and bust cycles are part of economic development. The central bankers' job is generally defined as trying to create an environment which allows this economic cycle to be smoother - less of a decline and less of a sudden rise. Recent history and situations show a disturbing trend. The peaks are getting riskier, fuelled by cheap money. The painful declines in economic activity are being fended off with a huge dose of cheap money to revive economic activity and risk-taking.

    The bartenders have been challenged by some very smart and sophisticated TBTF drunks who understand their power of size. And, if the USD 138 billion that was pumped in last week is any indication, the bartenders have a bad habit and are as addicted as their customers.

    Ajit Dayal is Director, Quantum Advisors Private Limited. Ajit is the founder of Quantum Asset Management Company Pvt. Ltd. and also Quantum Information Services Pvt. Ltd., which owns Equitymaster & Personalfn.



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