Tuesday, October 28, 2008

What is debt deflation?

Suppose asset value today is 100. Debt is 80. Equity is 20. So leverage = debt/equity = 80/20 = 4x

Suddenly, asset value falls by 10%. So new asset value = 90. Debt = 80. Equity = 10. So new leverage = 80/10 = 8x.

And suppose at the same, the system wants you to delever to 2x leverage.

When asset prices weren't falling, one would have needed another 20 of equity to bring leverage to 2x.

When asset prices fall by 10%, we need 30 of equity. Now because we cant get that much equity, a better idea would be to sell assets. We need to sell 60 of assets to go to 2x leverage.

But if everybody tries to do that at the same time. i.e. sell assets to reduce leverage, there is only one thing that will happen, which is that asset prices will fall. Which, can actually end up increasing the leverage, as we see from the small example above. Which increases the compulsion to sell even more assets, which pushes down asset prices even more. And we go into a huge negative feedback loop, which is where we are now.

Having falling asset prices and the compulsion of delever at the same time is thus very harmful for equity owners. Equity is the first loss tranche in the capital structure. Negative momentum can wipe equity to 0. Momentum is more important than valuation today.

Time to think of a new currency regime

One of the most intriguing aspects of the current crises has been the behavior of the currency markets. One can blame the Fed for keeping interest rates low and encouraging misallocation of resources to US housing. But the way currencies have moved over the last few years, one can argue that currency markets have misallocated resources across nations.

How should a cross-currency rate be determined? In a world where there are no capital flows across borders, it should be based on interest rate and inflation differential between two countries. One can argue it is the rate at which the current account deficit between two countries goes to zero.

Put the capital flows in, and the whole picture changes. As we see now, investors rush in when something is hot. So, when a country is hot, investors will rush in and the currency of that country can appreciate meaningfully above what its "fair-value" is. This will entice even more investors, which will push the currency even more above its fair-value. A positive feedback loop develops, and a currency bubble takes shape. This is what happened in emerging markets in the last few years.

Like all bubble, however, it bursts. And then, investors rush out. But when they leave, they cause absolute mayhem and destruction, particularly in smaller countries. A huge negative feedback loop develops - some investors leave pushing the currency down, which causes even more investors to pull out, which suddenly becomes a stampede.

Lets take the case of India. In 2007, as investors suddenly warmed up to the decoupling theory, they rushed into India. Suddenly Rupee appreciated from Rs 45 to Rs 40, and people started talking of the coming golden days when Rupee will touch Rs 35 and Rs 30. Probably it was this thinking that encouraged some Indian companies to go on expensive overseas acquisition binge (take dollar loan today, and repay it 5 years later when Rupee would have appreciated 20%).

And now suddenly, India finds itself staring into the barrel. Rupee has depreciated suddenly to Rs 50. Overnight, the capital allocation decisions made in 2007 by India Inc turn into demons. Suddenly, the currency derivative bets made by importers and exporters have backfired and caused some of them to go bankrupt.

What does the current currency regime expect? That the CFO of a small local company will be smart enough to figure out how currencies are moving and hedge appropriately? Even the most educated financiers and businessmen are unable to look through the currency movements and are carried away by the momentum. The probability of a emerging market currency bust in a decade is almost 100%, if I were to extrapolate the history of last 20 years. Is a young person setting up an export unit in India really making the right career choice from a 10 year perspective, considering that the biggest variable that will affect him - the currency - is outside his control.

So what is the solution? I dont know. A fixed exchange regime doesn't work either, as we know from Bretton Woods. Different countries grow at different rates and have differing inflation and interest rates. Over time, the fixed exchange regime becomes inflexible and a black market in currency develops.

One solution could be that countries become part of larger currency blocs. Like the Euro. But this means that countries need to give up their sovereignity, which is something not a lot of countries would like to do. One currency means a broad consensus on fiscal and political philosophy.

If the outcome of this crises is that more countries come together and better global institutions are created, it would all be worthwhile. It could also go the other away - like it did in the 1930s. So lets hope for the best.

Monday, October 27, 2008

Black Monday is here

There are a lot of people who think it is a technical situation, it is a liquidity situation. Don't believe them. It is a pure and simple solvency situation. Equity prices can go -ve.


There is a difference between enterprise value and equity value. It is called debt. So while EV can't go negative, equity value can, depending on the debt. That is why debt deflation is so dangerous.

But will never see negative prices on screen. So isn't my statement wrong?

To which I will say, look at UBS. Its market cap is $37bn. It has raised close to $32bn in equity so far over the last year. And then they just moved $60bn of assets to the Swiss govt. So last year, before this crises began, UBS's equity value was negative. The only reason we didnt see it negative was because of repeated capital injections in the bank.

This is also going to happen in a lot of other industries and companies. Repeated capital injections.

We have gone into a huge -ve feedback loop.

Saturday, October 25, 2008

What is Long Term Investing..

I am now seeing a lot of earning downgrades and rating downgrades notes. What happened to looking out 5-yr growth stories? Oops. Sorry investors. We lost you 70%, and now we realize that we can't see where the world is going next week, let alone five years. Unfortunately, the world is not linear, it accelerates and decelerates, and right now it has gone off a cliff.

As Buffett said in his last letter, "When the tide goes out, we see who is swimming naked. We find Wall Street was a nudist beach." He can add the entire Indian sell side and buy side community to the list. They have been happily ensconsced in their 8% growth rate assumption and not even once tried to figure out what is happening around in the world. It was all too macroeconomic, India was decoupled and they wanted to go to company specific detail. 90% of them wouldn't have still heard of CDO and CDS.

Long-term investing doesn't mean that we need to project 5 years out and do a DCF etc. It is all hogwash. Who knows what the right discount rate is? What we need to figure out is

(a) What is the history of the company?
(b) What did the company do when faced with similarly tumultous times - remember 1997 and 2001?
(c) What is the capital allocation policy of the company - the most important decision that long term investors should care about. How does the company raise capital? Does the company use excess free cash to do stupid acquisitions, hoard cash on balance sheet, or return to shareholders?
(d) Is the company reasonably valued on cyclical adjusted EPS and ROE's?

And in these times, I will also add
(e) What is the debt maturity profile of the company. What is its capital structure?

It is widely known that Buffett spends less than 15 min to figure out whether he wants to invest or not. The reason is simple - he knows the history well, and he bets on his knowledge of history. History might not repeat itself, but it is the best guide to the future. The only way to look forward is to look behind.

Kamal Nath and Chidambaram are doing a great disservice right now by insisting that everything is fine and the rupee movement is an aberration. It is not. Currency movements are self-fulfilling prophecies. They need to get together with other Asian countries, particularly Japan and China asap, to intervene in the currency markets. Developed countries are intervening in banks, emerging markets need to intervene in currencies.

Friday, October 24, 2008

Will Fed cut to 0% next week

If we are going into a deep recession and inflation is not a problem particularly with dollar rallying, why not cut to 0%. Till asset prices stabilize, there is no bottom to this mess.

This is deflation. And we now see the terrifying impact of it.

Sep and Oct have lived up to their reputation of being the worst months of the year. Will Nov and Dec now live up to their reputation of being better. You never know. Nothing ever goes down in a straight line, even though there is a lot of pain left. The giant Ponzi scheme of ever increasing asset prices has blown up spectacularly.

This is what Greenspan says

It was a four hour testimony, so I only have some snippets from WSJ. Here are the best ones:

a) Mr. Greenspan was asked when he knew there was a housing bubble and when he told the public about it. He answered that he never anticipated home prices could fall so much. "I did not forecast a significant decline because we had never had a significant decline in prices," he said. -

Now we are talking!! A bet on ever increasing prices - also called gambling in Vegas. There have probably been more real estate bubbles than commodity price bubbles in this world.

b) If the best experts were not able to foresee the development, "I think we have to ask ourselves, 'Why is that?'" Mr. Greenspan said. "And the answer is that we're not smart enough as people. We just cannot see events that far in advance."

Thats not true. There were a lot of people who saw what was happening, and have made billions shorting the real estate market in US. I got the feeling after reading Greenspan's book that he started thinking of himself as God. So probably he closed his mind to positions and beliefs that conflicted with his belief and ideology.

People in democracies keep criticizing their politicians saying that they are all corrupt etc. Why are technocrats better? Probably the biggest problem is not Greenspan's philosophy, but that he was Fed Chairman for 17 years - thats a very long duration in a position of enormous power, and would make any human being think that he/she is a God. It was Bill Clinton's mistake.

There is one thing in all this that makes me respect the US - people are after the right person (Greenspan), even though he left 2-1/2 years ago. If it had happened in India, they would be after the current incumbent. Congress will blame the next govt for the mess that is going to happen in 2010, even though the seeds have been sown under their watch.

Thursday, October 23, 2008

Greenspan says he was wrong

Just got a snippet of live testimony of Greenspan in front of US Congress on BBC. He said that there is a basic flaw in the model of the world that he has used for the last 40 years. It is a very profound statement and is probably a big setback for the entire Republican establishment. I am looking forward to read the entire testimony tomorrow.

I think one should feel privileged just to be living today. All the obscure philosophies of the past few centuries are going to get a new life as people try to figure out the best way to organize man and machines. The longer the crises, the more incentive there will be to change the entire system. So while materially we will all end up poor - whether you put money in cash/stocks/real estate you will end up worse two years down than today - we are entering a very different period philosophically. By a quirk of fate, it is possible Obama is the best guy to lead US at this time.

Tuesday, October 21, 2008

Bears - take a bow

The ultra-bears of this world should take a bow - they took substantial risks with their careers and have been thoroughly vindicated. It requires guts to argue that stock x will fall 90% from its peak when the "smart money" of the world is investing expecting it to double.

We approach the golden age of long-term investing. Competition is about to thin out as hedge funds/PE funds are taken to cleaners.

Monday, October 13, 2008

Global Coordinated Action Happens

One good thing about freely falling markets is that they make policy makers act quickly. The bad thing is that they are forced to act without thinking things through. By intervening in the markets, govt can limit the downside, but it will also limit the upside. This is going to be a very slow drawn out affair.

It will be interesting to see how big a hole the US Social Security and pension plans have at the end of this year. Equity markets have delivered 0% return in 10 years, when they are budgeted to deliver 8% return.

Friday, October 10, 2008

Climate Change and Stock Markets

If this is how Mr. Climate plays out - i.e perceived stability and equilibrium over a long time despite pressures building into the system, and then the system cant take it any more and it collapses - then I am scared. It is time to pay more attention to the climate doomsdayers. At least the stock markets are not killing us physically - not so far that is.

The big game right now is in the currency markets - the more a currnecy collapses, the more toast it is. India should be scared about rupee..

Monday, October 06, 2008

Use $700bn to buy 3.5mn homes

October is supposed to be the month when the big blowups happen. Oct 1929, Oct 1987, Oct 1998 spring to mind. Add Oct 2008 to the list.

There is one way in which $700 bn can be used to just stop all this in its track. The average price of a US home is about $200,000. So, $700 bn can buy 3.5mn homes. There is an inventory of 4.7mn homes in the US currently - a 11 month supply at current sale pace. If I remember correctly, 5-6 months of inventory is considered more normal. So, if the US Treasury were to indeed take 3.5mn homes off the market, in one fell swoop it would have taken care of the inventory overhang depressing house prices. As US house price stabilize, investors can then better calculate the value of a mortgage backed security and all the other alphabet soups (CDO etc). You might indeed have a rush to buy these distressed securities.

Now this is going to massively distort the markets in unforeseen ways for sure. But who knows what the current plan ends up doing? The job is to use $700bn to stabilize the financial system, and I can't figure out how buying MBS and CDO's will encourage banks to lend, if real estate prices keep falling because of the inventory overhang.

People are talking about nationalizing banking - why not nationalize housing?

The entire problem lies in the way inflation is defined. If one were to include asset price inflation in calculating inflation, Fed would have been forced to raise rates much earlier in 2003-2004, which would have prevented this huge housing boom.

China has US by its balls

In the mid 1940's, Britain was a spent force. Following the two wars, it had a huge debt problem. US helped it out, but made sure that it occupied the centre-stage thereafter.

US needs external capital to finance its bailout and many more future bailout proposals. It needs Japan and China. Can the Chinese govt say, for ex, take those ships away from East Asia, calm down on Taiwan etc.? It is at these times that the geo-political situation of the next 50 years is written. Can the Chinese exploit the situation to their advantage? I will bet they do. Chinese are far more ambitious than Japanese.

Saturday, October 04, 2008

Global Central Bank Coordinated action

Central banks globally need to step into the money markets and act as counterparty to all transactions to get the money flowing again. If money markets don't unfreeze in the next 7 days, I think we will see multiple bankruptcies beginning this month. It needs to happen this weekend. A globally coordinated interest rate cut might help too, but I am not sure that will really unblock the money markets. The issue is counterparty solvency, not liquidity. An interest rate cut cannot solve the counterparty solvency issue.

The problem with this action is - if some bank fails, its central bank, and by extension its govt, will be on hook for billions. So this is a fiscal decision, which a govt should take, not a central bank.But considering that the Treasury now has $700 bn, it can surely spend some money here.

We need some luck now to avert a catastrophe. Otherwise, there is nationalization of a host of industries on the horizon.

Is it that there is a supercycle of regulation-deregulation, capitalism-socialism that overlays the smaller business cycle?