Are You left holding the baby? Hindustan Times, 22nd August 2007

When I was a student in college, there was a lecturer who devised a scheme wherein a list was prepared with her name to begin with. It was sold to 20 people, who paid Rs 100 for the same. Rs 100 in 1983 meant a lot of money. Each of them sold the list to another 20 and so on. The rule was that whoever bought the list had to send Rs 100 each to all those on the list and then strike out the first name and include their own as the last. In the next round, they would be receiving money from a multiple of 20 persons and so on. This was a fool proof scheme as only like-minded people would join and the rules would be obeyed. The problem would arise when someone at the end could not find another 20 to sell to. Those people would be the losers and the scheme would crumble.

This is a kind of a Ponzi scheme which is fine as long as the direction is maintained. A break would mean a fall for lots of people with the early entries making the money and those holding the stock of lists being the losers. The stock market is similar to a regulated and organized Ponzi scheme where everything is good as long as all are buying and making money without any effort. But, when some big guys sells, then those left holding the stock suffer losses and there is a crash. Should one grieve for these losses? The answer is really no.

The stock market has been falling since the sub-prime specter has afflicted global markets. What happened was quite plain and simple. In the USA, when interest rates were low, people bought property and banks financed them at low interest rates (sub prime lending rates). The idea was that as real estate prices were rising, low rates were good enough and even if there were defaults, that would not matter since the property could be sold and the amount recovered. Now, the world of finance is a crazy one. Fancy models guide you as to how the future will be. To top it all there are new instruments such as securitization which made banks reorganize such assets and issue securities to others, including hedge funds. The risks are passed on or rather scattered among more risk-takers. These funds bought them for a song and knew that they were backed by rising real estate assets.

Now as we come to 2006, interest rates move up and the price of property comes down. This means that those holding on the estate backed securities realize that their collateral value has diminished. The borrowers are unable to repay their mortgages when rates rise, and the banks have sold these securities to hedge funds, which after a point of time cannot be identified. The result is mounting losses for these funds. Nobody wanted to lend to anyone and the commercial paper and call rates rose, which finally got the Fed and ECB to intervene.

The result was a collapse of global stock markets. After all if the financial sector is in jeopardy, the share market must reflect them and therefore share prices started tumbling. Funds are answerable to investors and need to sell assets elsewhere to pay the returns that are expected. So they start selling in overseas markets such as India which caused the Sensex and NIFTY to take a beating.

When the Bear Sterns crisis erupted and the Nifty and Sensex slid, it was called a correction waiting to happen. But, now it looks more serious even though there is nothing incorrect about our fundamentals. Our banking system is strong and has not been lending recklessly to real estate. It is an externality, which Thomas Friedman would be proud of, that has caused these travails.

There are irrational cycles in markets which are waiting to collapse - stock markets as well as sub-prime lending market. There is a perception to begin with which starts from positive things about the future leading to rising prices. It happened in the real estate sector and stock markets world over with credit pouring in. Fortunately our banking regulation ensures that prudence supersedes animal spirits. Then there is over-trading wherein everyone seems to be in the market. In case of the USA, people were borrowing money to buy property to sell it to others to make a quick buck. This euphoria is often cautioned as being a bubble, but is disparaged by the market moghuls – after all India is shining. And then there is the inevitable fall, and the experts are already predicting doomsday.

Now, stock market movements are always governed by ‘herding’ where everyone follows everyone in which ever direction the herd moves. There is little rationale or logic. The economy has always been strong in the last 3 years and has displayed no exceptional trait. But, this state of existentialism was used to justify the booming market, when funds poured in. But, such exuberance is not always rational as the words of Mr Alan Greenspan have been resonating for a few years now.

It is anecdotal that the legendary tennis star Arthur Ashe when detected with AIDS had a fan pleading with the Almighty as to why did he choose Sir Arthur Ashe for this punishment. Ashe’s reply was quite soul touching. There were thousands of people who played tennis, of which hundreds played in the Grand Slam tournaments. Of them some 60 odd played the Wimbledon while 4 made it to the semi finals and 2 to the finals. And ultimately only 1 won the tournament. When he won the Wimbledon in 1975, he never looked up to ask the Heavens as to why be he the chosen one. So it was the same with the AIDS attack.

Take this analogy to Dalal Street. When the Sensex zoomed, we never stopped to ask “but why”. Now that it is falling, just sit back and ruminate over your losses without; but don’t complain.