In a Hole - The Honest Truth By Ajit Dayal
Investing in India - Honest Truth by Ajit Dayal
In a Hole A  A  A
30 AUGUST 2010

While the world economy continues to struggle to get out of a hole, the central bankers of 40 countries attended a conference in Jackson Hole, Wyoming in the USA this past week. And, based on the news reports of Bloomberg, it seems that the conference was also attended by the usual academics from the universities and the representatives from the financial firms.

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A few months ago, the Reserve Bank of India hosted a similar conference in Bombay with representatives from central banks of Australia, Canada, Europe, UK, and USA. The theme of that conference sounds pretty much like the theme of this symposium of intellectuals and men in grey suits: what the hell happened? How did we get into this hole? How do we get out - and make sure we don’t get back into this hell hole again?

Given that the Presidents and Prime Ministers of the G-20 have met at least twice since October 2008, and that central bankers have met more times than they can pray "recovery", and given that the global economy is still on the edge, it would be safe to assume that no one has a clue on what is going on.
Or when it will end.
And, when it does end, what will be looking at: a messy world or a more robust and sound global economy?

And will this have an impact on the growth rates - and stock markets - of the larger developing countries?

Is it capitalism, suckerism, or rescueism?
It sort of began with this assumption that financial engineering could produce money out of thin air and make everyone rich.

People believed that the creation of money by Fed Chairman Sir Alan Greenspan, dutifully shovelled around the world by the Wall Street firms and their dumber and poorer counterparts in the rating agencies - who happily stamped "AAA" on any scroll of toilet paper as long as they got a fee - was real wealth.

But printing a stack of dollar bills that could match the height of the Empire State building every few seconds is not the same as building the actual building. Investors got a wake-up call when they realised that what was really out there was one big bubble - and a fraudulent one at that. German banks were holding mortgages on properties in Florida and California that were 40% lower than what the papers said they were worth. And no one could pay their interest on the mortgages. What was rated as "AAA" low risk was actually a pile of fodder after it has been through a few chews of animal jaws.

The folks on Wall Street and the rating agencies were the capitalists - they maximised their returns and made full use of the opportunity. They did make money out of thin air. They were the ultimate alchemists.

The Germans, the Swedes, the retirees, the pension funds - and many others - were the suckers who were left holding the patsy.

The problem was that many of the Wall Street firms and banks were suckers, too. Having told the Germans how good the toilet paper really was - and repeating the story a million times - they bought their own lies and owned some of that toilet paper!

When it was discovered to be worthless, these Wall Street firms owned billions of dollars of the junk and, because they were worthless, the loss on these mortgages and derivative instruments pretty much wiped out the entire capital of the US banking and financial services industry.

But, hey, how could the smart MBAs be allowed to go bust like the German banks or the Swedish municipality?
And how could these glorified MBAs forgo the Great American Dream of owning a 5,000 square foot McMansion with 3 trophy cars in the garage.

And from that notion of "birthright" was born rescuisim - the new form of economic science which prevents the well connected from going bankrupt.
Or from going to jail.
You may have the worst business model out there, but if you have the connections you will always rake it in.

Change, it is
President Bush began the largest rescue of financial firms in the last few months of his 8-year Presidency.
President Obama, coming in to the White House on a promise of "change" did just that - he changed the Bush rescue plan by making it larger.

Some USD 1.2 trillion of direct new cash/liquidity has been created and another USD 2 trillion - or some such number - of guaranteed debt finds its way onto the US government’s balance sheet. And it is growing.
The numbers are so big, no one seems to care or count the actual number anymore.
The details that should frighten soon become concepts that enamour.
This conceptualising and ignoring the hard facts is manifested in a change in the way people have begun to think.
The change is from rational to irrational.

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Rational investors would demand more interest from the US government for buying more of the seemingly endless stream of new debt that the US government is willing to print. Ben Bernanke, the current chairman of the Fed - the central bank, reportedly made that very clear in his remarks at the Jackson Hole conference. Yet, investors today are willing to lend money to the US Government for 30 years at an interest rate of 3.69%. Bloomberg data indicates that in April 2010 the interest demanded from the US government was 4.84%.

The decline in interest rates (investors are getting paid 25% less interest in August than they were in April) and the strong demand for US Dollars is attributed to the fear over the very existence of the European currency - the only other major source of government bonds out there. The lower interest rates that investors are willing to accept from the US government reflects in the investors’ desire to stay in a "safe" place till the world climbs out of the economic mess. The US government paper is seen as safe - so investors are demanding less interest to own US government bonds.

But given the bail outs and continued rescueism policy of the US government towards its financial institutions, the buyers of US government bonds willing to accept lower interest may be behaving irrationally.

In the years 1999 and 2000, the irrational investors chased internet stocks for their ability to "attract eye balls". Rational investors focused on the lack of real earnings and cash flow. This ensured they stayed away from trouble.

In the years 2005 through 2007, irrational investors chased the "AAA-rated" mortgaged back securities in the belief that home prices could only increase. Rational investors focused on the fact that salaries and incomes were not rising fast enough to sustain the rapid increases in home prices: the affordability ratio. This, coupled with the facts of increasing supply, allowed them to stay away from trouble.

Today, irrational investors are chasing US government bonds. But the government does not have the ability to repay all that new debt given its lower tax collections and other revenue streams which have suffered from a slump in the economy. The biggest buyers of the government debt are foreign governments (about 25% of the total) but also the banks and the insurance companies. When this bubble bursts - there will be a bigger hole out there to dig the world out of as these financial firms holding US debt will again need to be rescued.

Fund flows - and confidence - will again be hit and emerging market stocks will initially be "hit" but, once rationality sets in, the emerging markets in general and India in particular, will recover.

So, while the central banks of the world shuttle from city to city trying to analyse the causes of the world’s economic problems and concocting new solutions, the only surety seems to be that we have discovered a new economic system: welcome to the world of rescuism.

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Disclaimer: The Honest Truth is authored by Ajit Dayal. Ajit is a Director at Quantum Advisors Pvt. Ltd and Quantum Asset Management Company Pvt. Ltd. The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and has not been authenticated by any statutory authority. The author, Equitymaster, Quantum AMC and Quantum Advisors do not claim it to be accurate nor accept any responsibility for the same. Please read the detailed Terms of Use of the web site. To write to Ajit, please click here.

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11 Responses to "In a Hole"


Sep 4, 2010

Agree that commenting & justifying in hindsight about the affordability ratio is easy. The real estate prices in India have also been rising steeply for so many years now, particularly cities like Mumbai. Are these also sustainable and are salaries & incomes rising in line with rise in property prices i.e. is the affordability ratio suggesting a continued increase or a fall is imminent.


K.G. Rao

Sep 2, 2010

Can we have your comments on Paul Krugman's views as expressed in his NYT column. He seems to feel that more of the US stimulus plan (not to be confused with rescuing the big boys) is the only way to revive employment and thereby the US economy. He says the possibility of inflation, currently not hi enough in the US to be a big worry, is in any case the lesser evil as compared to prolonged hi unemployment. Sounds rational. What's your take?



Sep 1, 2010

I had read Dr. Ravi Batra's pathbreaking book "Great depression of 1990".in 90s.He was made a pariah by the community of economists in the US, but everything he mentioned in the book came true;albeit 18 years later. But one of his observation has stuck in my mind. More the intervention by Governments, later the depession but greater the depression. Let us see what's going to happen..



Aug 31, 2010

It is easy let our prose flow with the benefit of hindsight. Rescues happen world-wide and not limited to the US. We have had similar episodes, albeit in smaller scale, in India too where institutions are 'merged' into larger, messier ones. No one is going to stop trading with the US because for many countries including India, a large part of revenues accrue from there. In a nutshell, we should try to be positive rather than lamenting about others' mistakes!


Sriraman V.Chari

Aug 31, 2010

Ajit, while your views make eminent sense and I always enjoy reading them, why do you call him Sir Allen Greenspan? He is not a British subject and cannot be knighted, you know. I shall stand corrected if you know something more to justify giving him that title.



Chaitanya Jha

Aug 30, 2010

Well the Sukerism or rescuism, as u call it, is more towards providing ground to the already traded bubbled transactions.Yes , what we see today is resultant of irrarionality, but i guess , when the stakes of Govt is involved, in a bet, it would be Irrational on our part to outright reject it as another irrational behaviot.Amit i do not have numbers but my gut say....Let the fallen giant get up again, who knows, there will be new Economic setup.being gung ho about India, sounds glamorous, but we r still irrationally unkwon what makes India always get such liners in you authors rightings : India Safe and shining.Show the numbers to public man.


patient investor

Aug 30, 2010

Enjoyed reading this piece. For a more detailed yet enjoyable reading of the subprime mortgage bond crisis - I recommend this book: "The Big Short" by Michael Lewis.

Question for Ajit Dayal: Would you advise investors to immediately get out of US bonds ? Do you suspect the "bond bubble" will burst soon? It would be very interesting to understand what timeline you had in mind.

Thanks for your insights.



Aug 30, 2010

Very nice read Ajit ... I always enjoy reading through your text. I too believe that India in many ways is a country that will survive all odds because of its intrinsic nature.



Aug 30, 2010

All are soft Hearth.


Nandkishore Toraskar

Aug 30, 2010

Without any hesitation, let me admit that I enjoy reading your "Honest Truth". But one thing I always notice that you repeatadely using word "Bombay" instead of "Mumbai". Are you alergic to "Mumbai" or being using word "Bombay" proud of? When globally it has recognized the city of "Mumbai" which they always used in their communication, you should be more careful when using word "Bombay". Personally I dont know whether this is by mistake or not. But certainly it dose not seems so. Hope you take note of it & change your way of using "Bombay" to Mumbai.

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