Sudip Bandyopadhyay’s Blog

Finance needs regulation.  It has always been prone to panics, crashes and bubbles.  Because the rest of the economy cannot work without it, governments have always been heavily involved.  Without doubt, modern finance has been found seriously wanting.  Some banks seemed to assume that markets would be constantly liquid.  Risky behaviour garnered huge rewards; caution was punished.  Even the best bankers took crazy risks.  Financial innovation in derivatives soared ahead of the rule-setters.  Somehow the world ended up with $ 62 trillion-worth of credit-default swaps (CDSS), none of them traded on exchanges.  Not even the most liberal libertarian could imagine that was sensible. The crisis has brought complex structured financial products out of deep obscurity and exposed their weaknesses.  In particular, credit derivatives – which allow investors to make bets on the creditworthiness of baskets of corporate debt – stand accused as an accomplice in the meltdown.  Bad mortgage debt was at the heart of the credit crunch but, in the eyes of many observers, banks’ inability to quantify their exposure through credit default swaps (CDSs) the main kind of credit  derivatives, aggravated the crisis, while swings in the CDS market exacerbated the plunge in bank stocks.  CDSs allow investors either to bet on the chance of a debt default or to protect themselves from that risk.  One party pays an annual fee to another, in exchange for a promise that it will be compensated in a default.  The CDS market has experienced explosive growth, expanding by 81 percent last year to a value of $ 62,200 bn.  Although the sector has shrunk since then, it is so large that outstanding contracts are often 10 or more times larger than the underlying “cash” bonds.  Credit derivatives contracts are predominantly negotiated “over the counter”  - privately between traders in banks, rather than on a central exchange.  Because it is private, the decade-old sector has been largely unsupervised.  While CDSs have been hugely profitable for financial institutions, the lack of regulation and opacity have proved to be the market’s Achiles heel. The absence of a central clearer has made CDSs risky because there is no guarantee that parties will pay out.  As the Counterparty Risk Management Policy Group, a taskforce of specialist bankers, has noted, a Central Clearing Counterparty (CCP) would “create a shock absorber” that would reduce the impact of default by a big participant.  In North America, CME Group, the world’s largest futures exchange, looks likely to be first off the mark.

Indian Stock price were swept lower in a global wave of panic selling that pulled all the International markets down by 8-11 percent.  The dow futures were down by 6 percent which is the daily limit for this instrument.  It was the liquidity crunch and freezing of the debt markets that created the panic few weeks earlier, but once the liquidity eased, following trillion of dollars being injected into the banks to enable them to stay afloat, the fears of recession and slow down in global economies have taken over.  These are behind the rout in the stock prices, this week.  Though the fundamental worries triggering the meltdown in the stock price are many, it is de-leveraging that appears to be the prime reason behind this meltdown.  The fact that Investors worldwide are selling their assets in order to close their debt is apparent from the strength of Japanese Yen and US Dollar.  Investors are selling their assets to take money back to Japan and USA to repay their debts.  The fact that US and Japan investors, account for a major trunk of investments worldwide explains, to an extent, the worldwide crash in financial markets.

The primary problem today is not the financial but the real sector.  The danger, therefore, is not so much a further financial meltdown ( hoping that value buyers will emerge on the stock market before long), but the severity of a cyclical downturn.  The corporate results for the july-september quarter,point to this, with 40 percent of companies reporting an absolute drop in profits or a straight loss.  The policy makers’ attention has to be focused on steps to minimize the downturn.  Cheaper credit is one remedy, especially since inflation has more or less disappeared as a worry point.  Good macro-economic management ,fiscal control, followed by spending on infrastructure is even more important.  A combination of these  could lift spirits sufficiently to facilitate a recovery.

The current week is a truncated week with only three trading sessions and having expiry in F & O segment on Wednesday. FIIs continued to sell relentlessly all through the last week and were net sellers to the tune of Rs 3300 crs by Friday, (which includes provisional Sale of Rs 1431 crs in Fridays trading). FIIs net ‘sell-off’ during Oct 2008 totaled to Rs 11,736 crore so far till 22nd October 2008. This outflow of capital resulted in rupee touching a new low of Rs 50.15 against the U.S. Dollar. Panic has now clearly gripped the markets and the cascading effect of the meltdown now may be seen in the form of redemption pressures on mutual funds, portfolio unwinding by HNI’s, corporates and domestic treasuries.   Technically speaking the markets now are in an extremely oversold state and have a potential of bouncing back triggering ‘short covering’. Nevertheless all those recoveries will be bear markets pull backs.

( ** this is the transcript of the weekly column I write for Economic Times )