The Hindu Business Line : US financial sector: A peep into the future

Despite severe credit losses due to sub-prime woes, long-time mortgage rates in the US have not gone up markedly, proving that risk aversion has not set in. The booming capital market shows that business confidence is still holding up. This is a difficult year to predict though, given the variance in the growth estimates for the US economy bets on the S&P figures, which predict a better show, banking on current jobs data, stock prices and interest rates.

Predicting the future is a risky business. Our desperation to know it keeps fortune-tellers and TV commentators in business; but given that we have so many ‘known unknowns’ and ‘unknown unknowns’ (thank you, Mr Donald Rumsfield) between the present and the future, soothsayers have a high propensity to eat their words.

Legend has it that a young Peter Drucker, on one of his first assignments, was asked to predict what the future looked like. On the basis of the prevailing economic environment, Mr Drucker predicted a period of benign economic growth in the next few years.

The year was 1929. So I am aware of the hazards. But, as many a Shakespearean play has proved, good soothsayers are bad at holding their tongues.

The US, being the world’s largest economy and India’s largest trading partner, is an important engine of global growth, in general, and our growth, in particular.

The US financial services sector is crucial because not only does it act as a barometer to measure the health of that country’s economy, its health is critical to the growth of other sectors also.

Bad news pouring in

There was a rush of bad news coming out from Wall Street’s biggies in the last couple of weeks on account of sub-prime woes. Citigroup said that it expected a 60 per cent fall in quarterly profits.

UBS said that it was taking a $3.1-billion hit; Merrill, a $ 5-billion hit; Bear Stearns reported a staggering 61 per cent decline in profits and Lehman a 3 per cent decline in profits).

The irony is that even as the Dow Jones touches historic heights, the financial firms that make a living out of it are going through a rather bad patch.

Even if we disregard the booming stock market as ‘irrational exuberance’, in the words of Alan Greenspan, not all news emerging from the Street is bad.

Goldman Sachs came out with record quarterly results that were the third best in its 138-year history, proving that the phrase ‘Age of Turbulence’ does not necessarily come with a negative connotation.

Still in the dumps

Well, now on to crystal ball-gazing. The obvious fact first: the mortgages market does not look very good.

Banks doing business in an unprecedented environment of low interest rates, benign inflation and uninterrupted growth — a ‘Goldilocks Economy’ — merrily went about lending to almost anyone who would ask for a loan, knowing that they would be able to sell at least part of these loans by securitising them.

As asset prices fell because of a slight fall in demand, some people who were struggling with their loans realised that they could not sell their assets to realise the loan amounts. So they defaulted.

This usually tends to have a snowball effect — the assets are repossessed by the lenders, so more houses are put out into the market and this reduces prices further, creating incentives for default.

From news posts emerging from that part of the world, it seems there are still many ‘For Sale’ signs posted on lawns across America.

Positive signals

However, since home prices are strongly related to overall economic performance, there may be reasons to be optimistic. The US economy grew at a fairly healthy clip of 3.8 per cent in the second quarter of 2007, after clocking a dismal 0.6 per cent in the first quarter of 2007 and 3.4 per cent in the whole of 2006.

The overall growth in 2007 was projected at 2.2 per cent by a pessimistic IMF World Economic Outlook report in April 2007. The same report estimated that the US economy would see better days in 2008, with 2.8 per cent growth. As per press reports, this has been downgraded to a projection of 1.9 per cent for 2008 by the IMF in its latest report.

As per estimates by the US Labour department, the economy created about 89,000 jobs in August (revised from the initial estimate of a loss of 4000 jobs). In September, the US economy created 110,000 jobs.

This was no isolated blip – it managed to create 1.6 million jobs in the past 12 months. So, fundamental data still holds promise, in spite of the liquidity crunch that hit the markets this summer as a result of the sub-prime crisis.

‘Global savings glut’

That apart, in spite of the rather severe credit losses, long-term mortgage interest rates have not gone up vis-À-vis last year. To some extent, this is because of the liquidity sloshing around in the economy, and the global savings glut (another expression from the Greenspan Dictionary of Words and Phrases); but to a large extent it proves that risk aversion has not set in.

The booming capital markets show that business confidence is still holding up. Moreover, central bankers have become more prescient now — the Fed has stepped in to stop financial contagion from spreading with liberal and timely dollops of liquidity and rate cuts.

Those who are talking of moral hazard have obviously not even begun to imagine the hazards that they will face if the world’s largest economy flounders.

The dollar is falling, so US exports — mostly high technology items and productised software — will get a fillip. That should help boost growth and reduce the yawning gap in their trade deficit too.

There is plenty of liquidity, and risk aversion seems to be contained, so credit creation will continue to happen.

Silver lining

Yes, there are big sub-prime losses, and these sins of the past will continue to hit profits. S&P estimates that ultimately these losses could add up to $150 billion. However, the silver lining is that part of the bad news is already out, and the big players have balance-sheets large enough to tide them through the crisis.

There is also a lot of buzz around a $80-billion consortium fund being formed by some of the big banks (branded as the ‘Master Liquidity Enhancement Conduit’) that will help tide over liquidity crises, like the one that seized the markets in August.

Recent news reports that a premier rating agency was planning to spin off its consulting arm into a separate company, and on rating agencies planning to introduce new rating codes on liquidity and volatility, prove that we have learnt at least some hard lessons from the sub-prime crisis.

Following the maxim ‘That which does not kill us makes us stronger’, recent experience will hopefully strengthen processes in risk management in financial services firms and rating agencies, and thereby help to improve investor confidence in this sector.

Variance in estimates

The fact that this is a difficult year to predict is obvious from the variance in the estimates — compared to the IMF’s 2.2. per cent for 2007 and 1.9 per cent for 2008, S&P has estimated a growth of 3.6 per cent for the US economy in 2007, and 3.5 per cent in 2008.

So all-in-all, though a consensus is building up that a slow-down is imminent, given current trends in jobs data, stock prices and interest rates, I am more inclined to bet on the S&P figures.

It does seem like that in this round of Goldilocks versus the Bears, Ms Goldilocks, after taking a few initial bruises, will win after all.

(The author is Senior Manager — Industry Research — with Gridstone Research, Mumbai. He can be reached on raghuvir.mukherji@gridstoneresearch.com. The views expressed are personal.)

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