The Hindu Business Line : Nightmare on Wall Street

Renowned global bankers, which served some of the largest corporations, governments and high net worth investors worldwide, have suffered deep wounds that will take time to heal. FIIs continue to dominate with sizeable holdings in many stocks.

Rajalakshmi Sivam

For those of us who had only a nodding acquaintance with Wall Street, news this week has been bafflingly littered with the big Wall Street names. Lehman Brothers filed for bankruptcy, the venerable Merrill Lynch was taken over by Bank of America and AIG, bailed out by the US Fed.

So, how has the housing crisis in the US impacted Wall Street? What were the repercussions on the Indian markets?

The (sub)prime crisis

Taking advantage of the housing boom in the US, mortgage banks disbursed loans to many sub-prime (less credit worthy) borrowers.

To compensate for the risk undertaken, these loans were given at higher interest rates. To raise more money, banks packaged these loans into securities and sold them to investment banks.

These highly leveraged positions paid off as long as the housing market continued its upward move, with rising property prices.

When recession set in, borrowers began to default. The banks seized properties and foreclosures rose. But, by then, the fall in the housing market was so steep that the foreclosed properties were difficult to sell.

The mortgage banks began to make huge losses on the outstanding loans and foreclosed assets. In the process, investment bankers who bought securities based on these loans too were hurt.

Bear Stearns flagged it off...

Bear Stearns, the US mortgage giant, was the first of the large investment institutions to fail on sub prime related issues, after it declared losses on mortgage lending in March 2008. Unable to sustain operations, the institution was sold to JP Morgan Chase.

Many other small and mid-sized firms in the US too declared losses on sub-prime mortgages. This triggered a lowering of interest rates by the US central bank- the Fed- to ease the credit crunch in the economy.

Following the Bear Stearns episode, there were similar problems at Fannie Mae and Freddie Mac, the two other mortgage giants of the country. This prompted the Fed to infuse $200 billion to shore up these institutions.

Just when the markets thought the worst was over, came the news of Lehman Brothers’ filing for bankruptcy on huge mortgage-related losses.

And even before the market could absorb this shock, came similar news from Merrill Lynch and AIG (US’ largest insurer). The stock markets plummeted. As the week drew to a close, the US Fed, with other central banks, assured the markets that the impact of the credit crunch would be contained.

Bailouts have been put together for the troubled banks with AIG taken over by the Fed and other investment banks in takeover talks with the stronger firms. The names that you just read are not of some neighbourhood bankers. All are renowned global bankers which served some of the largest corporations, governments and high net worth investors worldwide.

Also, several banks of other nations have invested in funds of these bankers.

Impact on the Indian market

FIIs, who are the key source of liquidity in Indian stock markets, continue to dominate , with sizeable holdings in many stocks. A weak stock market also makes foreign PE (private equity) funds hesitant to bring in money. In a scenario where the cost of borrowing is already high, poor foreign inflows (both FII and FDI) worsen the funding situation making fund availability tougher for corporates.

Given the size of FII holdings in stocks, bulk selling by foreign institutions has the potential to severely impact individual stocks as well broader markets. The Sensex lost 6 per cent off its value on the day the Bear Stearns collapse came to light.

But Lehman had already liquidated a significant part of its India holdings when its troubles came to light. However what worsened the initial falls this week were fears that other foreign institutions that run similar risks may also sell their holdings.Banking stocks were in the limelight, as they are most vulnerable to the credit crunch. A leading domestic bank that had exposure to the bonds of the Lehman Brothers faced tough times last week. Until reports clarifying that the bank expected recovery of the investments made came in, rumours had triggered huge selling in the stock.

The Banking Index too was in the red until the Finance Minister gave the assurance that the public sector banks had limited exposure to Lehman’s assets and that the Indian financial sector was well-placed to handle the crisis.

Lessons from Lehman

Are there lessons for Indian investors from the events on Wall Street? Here are a few. If the housing collapse in the US was triggered by ordinary borrowers being unable to repay loans, interest rates back home too have been rising. The Indian housing market has been showing signs of slowdown with property prices correcting in many markets. This should set the alarm bells ringing for borrowers, as also bankers. As banks become more cautious in offering credit to individuals, it is time for us to take stock of whether we have enough of a safety margin on our borrowings, be they home loans, credit cards or any other kind of credit. Stock market investors obviously should brace for choppy markets ahead!