Lifestyle And Wealth Management; The Wallstreet Meltdown And You

By the time this article will be printed, the $700 billion bailout funds would have been approved by the U.S. Gov’t, and the anxiety in the U.S. financial market and of the world would have subsided. While it will not totally solve the problem and the financial markets may take time to recover, the Bailout Fund is imperative to prevent further damage to the world financial system and economy.

The facts and the day to day developments of this debacle is well reported and is giving a good education to all those who read the newspapers, watch the TV news, and/or surf the internet. I think though, that the causes of the meltdown have been under explained and the short and long term effects of this meltdown to the other countries, especially the Philippines, need more elucidation.

The Wallstreet financial crisis actually started 15 months ago, when the valuation of the sub-prime mortgages started to tumble down, and the Rating Agencies downgraded the ratings of these securities and the banks holding them. It really blew up in September this year, when the hole had gotten so big it was wiping out the capitalization of the banks.

If I have to put in one paragraph the causes of this financial meltdown, it would be: the overleveraging of the banks, i.e. the banks over borrowing in relation to its Capital, and a failure of regulation by the authorities for having allowed this overleveraging. The Bank of International Settlements in Basle, Switzerland, which is the Bank of Central Banks, has a standing rule that banks should not borrow more than 10 times its capital. The Wall Street Investment Banks were leveraged 30 times or more if we include the contingent accounts which were off-books. With this kind of leverage, any substantial reduction in the value of the assets, e.g. sub-prime mortgages and derivatives, would wipe out their capital. Why nobody sounded the alarm when this was happening, was because everybody was making money. The borrower, as he believed that he can sell the house at a higher price, the mortgage broker as he was getting a commission for every mortgage loan that he passes to the bank, the banks as they were earning interest, and the investment banks as they were repackaging these loans as securities and selling them to the trust funds, insurance companies and other investors all over the world. In one word, the cause of the financial crisis is greed. 

The two balance sheet items that brought down these banks are: Sub-Prime Loans and Derivatives. Sub-prime loans are loans to unqualified borrowers but were given housing loans in the belief that even if they cannot pay, the mortgaged houses can be sold at higher prices to pay off the loan. This was fine as long as the economy was booming and housing prices was increasing; but disastrous, once housing prices are going down. Derivatives are financial instruments that are “derived” from an asset such as a loan, a forex (foreign exchange) position, an interest position, or an equity position. The instrument is a hedge or a bet on the movement of the position either up or down. So a “Credit Default Swap” is a hedge that if a loan defaults, it will be paid by the insurance company or the investment bank, because you have paid him a monthly payment based on the probability that the loan will default. A “forex swap”, is a hedge that the value of one currency against another will move in a certain direction, and if it does not, the other party will pay you the difference. Hedging is a legitimate transaction and makes business sense. This became dangerous when the banks and insurance companies, overloaded themselves with these transactions way beyond the capacity of their capital, even treated these as off-book transactions; in the same way that they offloaded the toxic mortgage loans to offshore Special Purpose Vehicle(SPV) companies. There is an estimate that there are $350 trillion Derivatives outstanding, and the World Gross Domestic Product(WGDP) is only $50 trillion.

So Bears Stern, Lehman Bros, Fannie Mae, Freddie Mac, AIG, Merrill Lynch, Washington Mutual, Wachovia, and other banks in Europe have to be saved by governments or bought cheaply, or filed bankruptcy. The decreased value of their loan assets and derivatives had eroded their capital and they did not have enough liquidity to continue business. They did not have the cash flow and they could not borrow anymore because of their eroded capital. The lenders, the other banks and the depositors, would not put money with them.

The immediate effect of this meltdown is the loss in part or all of the investments and earnings of those who had money invested in or lent to the Wallstreet banks that went under like Bear Stern and Lehman. These would be mostly the “high net worth individuals”, private equity companies, trust funds, retirement funds, and mutual funds. Some of these can absorb the losses but some cannot, especially the retirement funds(401K accts), and the mutual funds where the middle class investors put their money. This effect will spread from the U.S. to the rest of the world where the Wallstreet companies have presence or have investors.

The meltdown, if not properly addressed by the governments, will lead to a credit tightening as banks will be lending less, due to their lower liquidity and their aversion to risk. The Central Banks in the U.S., Europe, Japan and Asia have already addressed this problem by pumping liquidity into the system in releasing or lending Billions to their banks. The slowdown of the world economy due to this crisis is harder to address as consumer spending is sure to contract worldwide. The U.S. and some countries could go into a recession, and surely most countries will see their GDP growth rate lowered by 1 percent to 2 percent.

In the Philippines, the 5 percent of the Filipinos who have investible funds in the stock market, money market and mutual funds may see their earnings and the value of their investment lowered. It may not be as severe as in the U.S., but it will take some time to recover their values. The Philippine Stock Exchange (PSE) is P7 trillion in size and can absorb the hit even as it lost P800 billion in one day at the height of the crisis.

The Philippine banks, including those that reported exposure to Lehman, can also absorb the loss, as the P17 billion exposure of these banks is less than 1 percent of the P5 trillion assets of the Philippine banks. It is also fortunate that the Philippine banks had reduced their leverage ratios after the Asian Crisis, so that almost all Philippine banks have debt/equity ratios of less than 5 times. So bank deposits in the Philippines are safe even if the deposit rates are low.

The Philippine economy will grow slower at 4 percent, which is not so bad, but will surely affect those 40 percent below the poverty line as exports, remittances from OFWs, and certain industries and services will slow down. The lower consumer spending, with the consumers more cautious, will contract our consumer driven economy. Hopefully, government expenditures in infrastructure will offset the lower spending of the consumers. 

What do we do now? If you are one of those with funds in those in the stock market, mutual funds, UITF, and other trust funds, and your losses, so far, do not affect your lifestyle, my advice is stay the course. Nothing lasts forever. The market will go up in 2 to 3 years. If it does affect your lifestyle, then do liquidate some assets or earn somewhere else. On the other hand, if you are one of those with funds to invest, this could be the best time to go into the property market, the stock market, or the mutual funds.

There is very little probability (10 percent at best) of the U.S. or the world going into a depression, and a recession is always good to rid the excesses of the system, so this crisis will eventually be good for the “free market economic system”. Lessons were learned and greed will be moderated.

It is when our greed exceeds our fear that we get into trouble.