Financial Crisis 2008-2009, The Seeds of the Credit Crunch Part 2

By: Akhil_Khanna

Continued from Part 1

Effects on Corporates

The corporates had taken on huge debts during the boom times to expand their capacities to meet the huge quantum of orders they were receiving. They had retained manpower at very high employee costs to meet their targets and offered huge incentives and bonuses to the employees. They were caught unawares with the sudden drop in orders. Their capacity utilization began to drop substantially. They started to go back on or reduce their commitments to purchase the goods being manufactured in Asia.

As their earnings dropped they started on an aggressive cost cutting drive. They initially froze all recruitments and increments. They identified the employees or divisions they could do without and issued pink slips to the employees or shut down complete divisions in the organization they thought they could do without. They reduced the orders for raw materials which in turn induced cost cutting in the companies who were their suppliers. Advertisement and marketing budgets were slashed and the cost cutting disease spread to these industries too.

The demand for the most expensive product, housing almost dried up. The new houses being built found no buyers for them specially the ones under construction who were to be completed a couple of years down the line. The houses which were earlier booked on basis of say 10% down payment saw the consumers walking away from them forfeiting  the deposits. The change in spending habits saw falling demand for retail space available at the high prevailing rental rates. Due to the excess availability of retail space already vacant, the rental rates started to fall and the demand for new malls vanished.

In order to maintain their orders corporates started pricing their products/services aggressively taking hits on their margins and the rates of all products started dropping resulting in a major drop in inflation worldwide. A result of this led to substantial reduction in demand and hence sharp drop of the prices of commodities like oil, copper etc. The demand for cars and other luxury goods too dropped steeply leading to a glut of inventories.

Sensing the drop in profitability of companies all around the world, the stock markets started plunging and dropped more than 50% within a span of one year. This led to withdrawal of funds from the mutual funds, reduction in trading revenue of brokerages and major losses to companies holding stocks on their books as investments. The speculative element in all markets, use of derivatives and leverage, accelerated the fall in asset prices all around because the bets which had gone wrong had to be squared off at losses and fresh bets were placed on the current trend of the market i.e. downward. The spiral which led to the abnormal increase in prices of all assets was now working on the reverse side, aggravating the fall.

The Corporates were facing losses from a variety of areas. Their incomes were decreasing whereas their operating costs were high and the debt payable was increasing due to interest payable on loans. They had hedged their positions to protect themselves against the ever increasing prices of raw materials they used in making their final products. The exporters and importers had hedged themselves to protect themselves from the falling value of USD and increasing strength of their domestic countries. The commodity prices fell sharply, USD strengthened and the domestic currencies weakened, hence their hedged contracts bore major losses to their already reducing profitability.

Corporates started facing a major problem in raising funds to meet their normal day to day expenses. Fall in capital markets closed the door to raise funds by selling stocks through rights issue or fresh issue of shares. The banks themselves faced with increasing defaults and facing their own losses and hence were reluctant to lend to corporates in such uncertain times. The corporates who were reluctant to take risk had invested their surplus funds in the bond markets through the finance companies. These companies had further invested their funds in mortgage back securities, the market for which had evaporated due to rising default rates in the housing mortgage market. Hence they could not access their savings in times of need.

Many of the companies who could not bear the increased costs of financing and lower utilization went belly up and filed for bankruptcy. The spiral of debt and demand was unwinding resulting in large scale unemployment and in turn reduced demand for goods and services both domestically produced and imported. The evidence of this was directly visible in the U.S. trade deficit figures which dropped for straight seven months in a row to $25.97 billion in February 2009 from a high of $ 72.77 billion in August 2008.

The countries like China and India who had set up large manufacturing facilities and Back offices now started facing the prospects of reduced demand from their customers. The MNCs like Intel etc. who had set up manufacturing facilities in China began to shut them down and leave. China shut down thousands of factories in 2008 due to slowdown in demand of its products in Western Countries, its unemployment rate shot up and the GDP slowed down to about 7% from a peak of 12% p.a. Hit by the financial crises, India too faced reduced orders for their back office services and Call Centres.

The effects of the problems of the Corporates in the Developed countries spread to the developing countries. The reduced demand for exports led to the reduction in domestic consumption demand in the ratio of $1 to $4 - $5 in the reverse direction which initially had created the domestic demand for products when the export market was booming. The effects on the domestic consumers were same as those on the consumers in the Western Countries. They came to realize that good times don’t last for ever and specially the biggest credit and spending boom.

Effects on Banks /  Financial Institutions

The Banks had been making abnormal profits lending money to consumers and corporates who, in slightly adverse circumstances, could in no way pay up their monthly obligations as far as their loans were concerned. There was a drastic change in the operating environment due to the reasons explained above, both for consumers and corporates.

The default rates on loans given to both consumers and corporates began to rise. The banks had sold off these loans to other banks and financial institutions / hedge funds as securities. This enabled them to additional funds which they kept on lending and earning commissions on them. These hedge funds who bought these securities leveraged them to the extent of 30 – 50 times and invested the proceeds in derivative trading. This enabled them to get abnormal returns on the money invested by their clients and they raked in high fees and commissions.

As the bonds started being defaulted upon, the market for these vanished. The banks, hedge funds etc were not able to sell them and they were stuck with them. Banks were unwilling to lend even to each other as they were not sure as to the quatum of non saleable assets on each others balance sheets. Then began the process of unwinding and due to the high leverage the selling process accelerated. This led to massive correction in all the asset classes, namely stocks, commodities, bonds etc. around the world. As the risks increased the bond yields rose substantially compared to the U.S. Treasury yields.

Banks started selling all the investments they could sell domestically and abroad and started bringing the money back to the U.S. They began to call in their loans to other banks and reduce the borrowing limits of their customers to repair their balance sheets. This led the strengthening of USD and weakening of other currencies around the world. Indian Re. moved from an all time high of Rs. 39/- per $ to Rs. 50/- per $ within a year. Similar moves were seen Euro, U.K. Pound, Other Asian currencies etc. Euro weakened from 1.60 to a $ to 1.30, the U.K. Pound weakened from 2.10 to a $ to 1.40 to a $. Money was moving out of the rest of the world and flowing back to the U.S. because cash had become a rare commodity.

This process created a massive credit freeze in the world where by the banks were unwilling to lend and this started effecting the normal functioning of businesses and the availability of funds to the consumers. The banks are saddled with homes and commercial properties which they have acquired in foreclosure and are not able to sell them because of lack of demand for them. They have acquired assets against which the loans are higher than the amount they can get by selling them, if they actually can sell them. This is leading to heavy losses to banks. This further led the banks to curtail lending in these times of high risks of rising unemployment and reduction in profitability of corporates.

Effect on Government

The first major effect the bursting of the credit bubble had on the govt. was a steep drop in tax revenues. The govt. had expanded its expenses in infrastructure based on the revenues they were earning during the boom times and this fall in revenues created heavy deficits. Many of the life insurance companies, public fund management companies had invested in the, presumed safe, mortgage backed securities were facing heavy losses and were holding assets which they could not sell. A major liquidity problem had arisen.

 Apart from this, the banks faced with heavy losses and on the verge of bankruptcies asked the govt. for bailouts without which they could not survive. The failure of a major finance co. or bank, like Lehman Bros, set off a chain  reaction whereby the liquidity problem accelerated multifold. This led to the decision by the govt. to provide trillions of dollars of bailout to banks to keep them functioning even though by traditional parameters all the banks were bankrupt. Companies like General Motors and other car manufacturers, hard hit by the drop in demand for cars, too started approaching govt. for bailout packages.

The CEOs of the large banks and financial institutions who had created this credit crises by excessive leverage and speculation for their own personal gains continued to enjoy millions of dollars of bonuses despite the state of affairs of their companies and that they were still in business only because of bailout packages of the taxpayers money.  This created a backlash from the common citizens who were faced with massive job losses, reduced earnings and lack of credit they had become so accustomed to.

The govt. is now announcing Trillions of Dollars of Govt. spending with an aim to compensate for the drop in private spending and fall in investment expenditure by the private sector. They believe this will revive the economy by creating more jobs and reviving the credit market and consumer spending. They are also slashing interest rates in lines with reduced inflation assuming that a cheaper cost of loan will lure the consumers to take on more loans. The Govt. is using all the means it has to kick start the economy and to avoid the onset of deflation which is marked by falling prices of all products and assets like in Japan since almost last two decades.

The actions of the Govt. / Central Banks are not having the desired effect that they presumed. The excess funds available with the banks are not being lent out to corporates or consumers. The banks are investing them in Govt. Bonds or Govt. Treasury keeping in mind the safety of the funds first. The consumers are using the tax cuts given by the govt. to either increase their savings or pay back existing debts. The demand for all products is still falling.

Where to from here??

The crux of the problem here has been speculation and living beyond ones means. The U.S. consumer who has been the driving force of the World economy have already spent years of their future income by taking on unprecedented debt. The bursting of the Biggest Credit Bubble in history has led to fall in incomes and rise in unemployment. The debts payable stand rock solid against the falling prices of all asset classes. There are three final outcomes to debt :

• Repayment
• Default
• Part repayment part default (Lender books losses)

The falling incomes and rising unemployment with increasing debt indicates that it will take years for the consumers to pay back their debts. The corporates too have got excessive capacities set up which will be under utilized for the foreseeable future resulting in lower profitability. The loans they took to increase their capacities will be paid on the back of lower profits. Hence they too will take a no. of years to pay back their debts.

The real estate sector has built much more houses and commercial space than is currently required. This excess inventory with reduced affordability is going to take a no. of years to catch up with demand. The hot industries like Finance and Real Estate will see large no. of lay offs or reduction in pay due to the reduced profitability. The excess capacities created in manufacturing, mining etc to cater to the demand in the boom period too will take years to work itself out. There are no quick fixes to the massive problem of overcapacity we are facing in almost all the industries. They can only be utilized over time as the recovery takes shape in the long run. The recovery will be very slow whenever it starts and going to take years to pick up pace. Till then there is a lot of financial pain to go through. The trigger that led to the bursting of the bubble is behind us but the a large portion of effects are still ahead of us.

The banks having burnt their fingers due to reckless lending will now be operating under stricter rules laid by the Govt. They are not going to be creating a new credit bubble in the near future by lending to consumers or corporates who are unlikely to pay them back. The unemployment and lower profitability will curb the attitude of the borrowers towards loans / debt and reduce the demand for credit substantially. The bankers, after years, will be actually doing what they are supposed to do, lend to borrowers who use the funds for productive purposes and their cash flow allows them to service the debt.

The size of the derivatives markets is so big that the unwinding is still taking place and is likely to continue till it is totally unwound. An idea of the size of unwinding can be understood from the fact that the Derivatives Market size currently is more than 20 times the World GDP. The bailout packages announced so far are approx. $15 Trillion against the derivative market size of more than $500 trillion which is a conservative estimate. Its like throwing match sticks at a Hurricane. Have you given a thought to the reason why stock and commodity markets around the world are moving in synchronization since 2003 irrespective of what happens in any country? The most recent move is the 25% - 30% rise in world stock markets within a span of six weeks. Derivatives controlled by the biggest financial players in the world to maximize their own profits.

We cannot assign a time frame as to when this crises  and its effects will be over. We are confident that this is not going away in a hurry or even in a couple of years. Just as the boom prevailed much longer than the most optimistic estimate the effects of its bust most likely will outlive the most pessimistic estimates till date. There should be stabilization when the debts have reduced to such levels that the consumers / corporates can comfortably keep on paying them back. To arrive at this level the banks will have to reduce the loans recoverable and book the balance as losses in their books.

The Trillions of dollars worth of incentives, bailout packages announced by the govts. are not going to make much of a difference as far as the health of the world economy is concerned. It is just postponing the day of reckoning. Govts. are not a very efficient users of capital and the announcement of their plans and their actual implementations and the positive effects have a very large gestation periods.

Japan faced a similar crises in the 1990 and they have yet to come out of the effects of their biggest credit bubble bursting even after almost 20 years. They have been dealing with the problems of deflation since then and have kept their interest rates near zero for all these years. Japan’s stock index was at 40,000 at the peak of the bubble and it is currently at 8,000. Japan had the privilege of reducing its pain to some extent by exporting its way out to Western Countries as the rest of the world was booming.  This time the whole world has entered in period of deflation simultaneously so you won’t have one economy helping the other to get out of deflation. As far as we know, the financial world has no known cure for deflation and that too a global one.

The prime reason why the boom is not coming back in a hurry is that the attitudes of people and companies towards debt has changed.. They will be reluctant to take on more debt having seen the ill effects of living beyond their means. What would you think will the attitude of children be towards debt who are seeing their parents face the hardship of foreclosure or mental torture on not being able to meet their living expenses? The quantum of losses incurred by a majority of population by the time the economy bottoms out will be enough to discourage anyone from speculating. This will take its toll on all asset classes ie, real estate, stocks, commodities etc. in the foreseeable future. Till then CASH is KING.

By Akhil Khanna

© 2009 Copyright Akhil Khanna - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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