»Straight from the hip by Jawahir Mulraj

QE 2 sails amidst stormy political waters

The popularity of President Obama lost some of its sheen as his Democratic party lost its majority to the Republicans in the US House of Representatives. The US economy is not doing well, with unemployment remaining high, home prices remaining subdued and consumer spending remaining low. The administration have few choices, actually. It is taking the route of pumping in more money by buying back its own bonds from banks, so that they have more money to lend to others, in a process called quantitative easing, or QE. The first QE was a trillion dollars, and QE2 is $600 b.

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That, though, is like trying to cure an alcoholic by giving him more to drink! One of the reasons unemployment remains high is because American's can't relocate to where the jobs are and the reason for that is that their mortgages are under water, which means that even if they sold their house in order to relocate, they would still be in debt, because the market value of the house is below the outstanding loan. And the reason for the low market value is because when the administration had pumped in money earlier, in circumstances similar, but not as bad, banks had become lax in their lending standards and had given mortgage loans to just about anybody. This is brilliantly brought out in the NYT article 'How Banks put the Economy Underwater' by Yves Smith in which he says the problem of appallingly poor documentation for mortgage loans. Now these poorly documented loans are being foreclosed in an equally poorly manner; banks use 'robo-signers' to sign affidavits on their behalf. The courts have taken notice and banks' foreclosures are being investigated in all 50 states.

The deeper malaise is in the way the financial sector has grown. Bank loans were 'securitised', a financial innovation that allows the originators of loans (banks) to bundle up loans, slice them into bits, and sell the bits to investors. Once they are off the bank books, the banks are not liable for recovery, thereby providing them an incentive to originate mortgages without worrying about the quality (or the documentation). Rather like parenthood without the responsibility of rearing the child! The sub prime mortgages proliferated only because banks had excess liquidity (similar to QE 2), had shareholders pressuring for ever improving quarterly performance, and had an exit by way of securitisation.

The other root cause is that corporate ownership has become highly institutionalised. It is financial institutions that now own over 70% of corporate equity and individuals the rest; the ratio was vice versa till the 70s, when mutual funds took off. Institutionalisation results in several things. One, the larger institutional holding allow them to exert pressure on corporate management; sadly the pressure applied is to improve quarterly (short term) profits, often sacrificing the long term, and not on improved governance. Institutions vote with their feet, preferring to exit a stock when issues of governance arise.

In fact, new research by David Erkens, Mingyi Hung and Pedro Matos, of the University of Southern California, quoted in the Economist of Oct 28, finds that "none of the tenets of good corporate governance stood up to close examination. Directors who were well informed about finance performed no better than know-nothings. Companies that separated CEOs and chairmen did no better. Far from helping companies to weather the crisis, powerful institutional shareholders and independent directors did worse in terms of shareholder value. Indeed, the proportion of independent directors on the boards was inversely related to companies' stock returns."

The reason for such findings is the structure of the finance world, as stated above, with greater institutionalisation of corporate ownership, putting pressure on short term performance (hence laxity in lending standards by banks, hence the mortgage crisis), combined with the financial innovation that, when combined with poor oversight, causes problems.

So the problems of unemployment and of falling realty prices and hence of low consumer spending, is not going to be solved with QE2. What QE2 will do is pump more money into the system, which will partially find its way into other countries and asset classes. The booming Indian stock market is a choice destination, for its manifold advantages. That will continue.

The RBI raised interest rates, both repo and reverse repo, by 25 basis points last week, with no impact on stockmarkets, which were expecting it. The highlight of the past week was the eminently successful listing of the IPO of Coal India which managed to get applications for $54b., second only to the recently concluded $70 b. IPO by Petrobras of Brazil. Both these successful IPOs suggest that there is an greater awareness of the need by financial institutions to increase their holding in emerging markets.

ONGC is in talks to buy a 25% stake from Exxon of n oilfield in Angola. The Prime Minister is exhorting oil companies to acquire energy assets abroad, to secure India's energy future, for without sources of energy to drive it, India will not achieve the 8%+ GDP growth it is capable of. But one of the big dampners to this is the subsidy burden that the Government is loading onto 6 of its public sector companies, ONGC, GAIL, Oil India Ltd., and the 3 oil marketing companies, IOC, BPCL and HPCL. A burden which really ought to go into the Union Budget, but doesn't, in order to show a better fiscal picture than really is.

The BSE sensex ended the week at 20893, up a whopping 861 points last week, and the Nifty at 6181, up 264. The new money being pumped in will also find its way to Indian markets, though at some stage the music will stop. When that will happen is anybody's guess.

Wishing all readers a happy Divali!

J Mulraj is a stockmarket columnist and observer of long standing. His weekly column on stockmarkets has run for over 17 years. An MBA from IIM Kolkata, he has been a member of the BSE. He is now India Representative for Institutional Investor. A keen observer of events and trends, he writes in a lucid yet readable style and takes up issues on behalf of the individual investor. Nothing pleases him more than a reader who confesses having no interest in stockmarkets yet being a reader of his columns. His other interests include reading, both fiction and non fiction, bridge, snooker and chess.

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 authors, Quantum AMC and Quantum Advisors do not claim it to be accurate nor accept any responsibility for the same.
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