The direct impact of Lehman Brothers going bankrupt and Bank of America taking over Merrill Lynch will not be significant on Indian capital markets, a senior Finance Ministry official said on Tuesday.
But indirect impact of the global financial crisis may be there in terms of FII capital inflow in both equity and debt, he added.
"In next six months, we may see continued volatility not only in equity but in debt markets as well, because of global uncertainty unless US resolves its housing market crisis," the official told PTI.
However, the recent reaction of stock markets is mostly driven by news reports emanating from the United States about Lehman Brothers' bankruptcy and Merrill Lynch's takeover by the Bank of America.
In 2006-07, the price-earning ratio of listed companies was as high as 35 to 36 per cent which was not sustainable as capital flow to equities were excessive. Now they have come down to around 20 per cent, the official said.
In a way, he said, it is good that prices are volatile as they act as a shock absorber in this kind of situation. "What we don't want is growth acting as a shock absorber," he added.
The benchmark equity index moved by 504.20 points intra-day before ending up at 13,548.70 points on Tuesday.
On the recent developments in the US financial markets, the official said,"The direct impact of Lehman Brothers going for bankruptcy and Bank of America taking over Merrill Lynch is not going to be much. But indirect impact of global financial crisis may be there in terms of FII capital inflow in both equity and debt."
The indirect impact could be much larger due to turbulence in global financial system, he said.
It will impact confidence of investors, both domestic and foreign, the official said. As such, there are concerns about capital flow from FIIs in both debt and equity segments, he said adding FDI is unlikely to be impacted.
The official said the direct impact of these events will be there to the extent that these entities reduce their exposure in Indian market and the Bank of America consolidates its operations after taking over Merrill Lynch.
However, their exposure to the Indian market was never enormous compared to their total global investments, he said.
Collectively, all the companies where Lehman invested in India had a market valuation of close to Rs 40,000 crores yesterday, which on Tuesday fell by more than Rs 2,000 crore.
Besides having a stake in listed companies, Lehman is understood to have invested in various projects of the Indian companies, especially in the real estate sector.
In India, Lehman recently acquired Brics Institutional Equities's division of research analysts, sales and trading professionals, and purchased a 26 per cent stake in Edelweiss Capital Finance, a non-banking financial company.
Rajya Sabha member C Rangarajan had said on Monday though the global financial crisis is a critical situation, one does not know whether the crisis has further deepened.
Recent reports about the Lehman Brothers filing for bankruptcy have created ripples across India’s real estate market. The rupee has weakened, and stock markets are on a down slide. The US-based investment banking firm had actively invested and partnered in several hospitality projects in India. However, due to the company’s latest move, its real estate investment arm has been put on hold, and it has stopped principal investments to companies.
Some prime development projects funded by the Lehman Brothers were with HDIL, Unitech and DLF Assets. Unitech’s projects will not be affected by the investment firm’s developments, as the project’s funds have already been received and are in a lock-in period of seven to ten years. HDIL funds will be diverted from the investment company’s Hong Kong subsidiary. DLF Assets had raised 200 million dollars (in 2007) from the Lehman Brothers. Besides, the company was also in talks with Future Capital for investments in its hotel development initiatives. When contacted, officials from Future Capital refused to comment.
A year ago, the subprime crisis blew up in the US. Policy makers in the US and elsewhere have been engaged in a grim battle to contain its fallout. Can we do anything to prevent such crises? One view is that boom-bust cycles are integral to the free market economy and that we should stand back and let institutions fail. But the immediate consequences of such a policy — a deep and long recession — are so serious that no government has the stomach for it.
Another view is that it is hard to call a bubble correctly — we know there is a bubble only after it has burst. Once the bubble bursts, policy-makers should step in to limit the damage, as they have done in the present crisis. The danger with this approach is that public intervention to limit the damage stores up worse problems for the future (‘moral hazard’) so that we end up facing even graver crises down the road.
A third school looks for preventive medicine. ‘Lessons from the subprime crisis’ promises to be as rich a field for researchers as the East Asian crisis of the nineties. Robert Shiller, professor at Yale, wades into the field with The sub-prime solution (Princeton). Shiller proposes three types of solutions. One, better information. Two, new markets for risks. Three, new retail risk management institutions.
Some of his proposals for better information are familiar enough — more disclosure from financial institutions; an improved database on individuals’ economic and medical history; a financial watchdog that will ensure consumer safety in financial products. Shiller has some new proposals as well. He wants low-income individuals to be provided advice on the basis of fixed hourly fees that will be eligible for tax benefits.
At present, the advice they get is from people who sell products and who collect a fee from the providers of those products. Naturally, such advice tends to be biased. But how do we get people to opt for paid services when they can get free advice from sellers of products? How do we ensure that advice provided for a fee is of the right quality?
Shiller also wants financial contracts to have certain clauses that will protect consumers who cannot read between the fine print. A more interesting proposal is requiring asset prices to be quoted in inflation-adjusted terms. Shiller contends that if this had been done for housing, buyers in the US would not thought that homes would be spectacular investments. Note that both these proposals mean more stringent regulation.
Shiller advocates the creation of new markets for risks. Housing futures, he says, would help contain a speculative bubble by creating opportunities for short sellers. But such markets, which Shiller helped launch, have failed to take off in the US. Besides, this does seem a bad time to sing the virtues of short selling — we have seen the havoc this can create at American financial institutions.
Shiller’s third suggestion is the creation of new retail risk-management institutions. One is what he calls ‘continuous workout mortgages’ — mortgages on which terms are continuously adjusted in response to changes in borrowers’ incomes and conditions in the housing market. If the borrower’s ability to pay drops, the terms would be revised downwards accordingly.
Shiller contends that this is what happens in bankruptcy anyway, so he is only proposing a more orderly adjustment. He thinks there are ways to address the moral hazard implicit in such an arrangement — the borrower losing the incentive to earn or under-reporting his income. Another retail institution Shiller urges is home equity insurance. By putting a floor on home prices, it would prevent panic sales of homes and sharp collapses in home prices in a downturn.
These are ideas that would go some way towards making home ownership safer for large numbers of people. But one cannot resist the impression that Shiller takes too narrow a view of the subprime crisis. The crisis is not just about a collapse in housing prices and people losing their homes. In itself defaults on subprime loans would not have posed a problem for the US economy. The subprime crisis has ballooned into a financial crisis because it impacts financial institutions that have leveraged exposures to subprime contracts.
Another subprime crisis is as unlikely as a plane crashing into a tall building in the US — the problem will arise in some other form. We need to address the broader issue that underlies the subprime crisis: how to ensure that regulation keeps pace with innovation? This means the focus for reform has to be on financial institutions and the regulatory architecture, not just protection of the consumer.
Several factors have kept the world economy from keeling over. The Fed has bailed out large financial institutions and has been quick to provide liquidity even to investment banks. The US treasury has provided a large fiscal stimulus. Central banks have coordinated their actions well. Many banks in the western world have managed to raise capital from emerging economies to offset their losses. Emerging economies, whose weight in the global economy has increased over the years, have sustained growth thanks to strong domestic demand.
After the collapse of Lehman Brothers and Merrill Lynch's $50bn rescue takeover by Bank of America, investors had questioned the ability of stand-alone investment banks to fund themselves without access to retail deposits.
Yesterday, the Federal Reserve has allowed Goldman Sachs and Morgan Stanley to change their status to bank holding companies. This step will allow both investment banking firms to take deposits and shore up their resources. The Fed will also provide short-term loans for the two banks to transition as commercial banks.
As a result this move:
The merger talks between Wachovia and Morgan Stanley is on hold.
Both Morgan Stanley and Goldman will also come under the purview of the Federal Reserve (earlier they were regulated by only Securities and Exchange Commission). It means that, both Goldman Sachs and Morgan Stanley will be subject to bank capital requirements, which will be phased in over a transition period
Days of high leverage are gone:
Financial leverage at Goldman and Morgan Stanley, which both have roughly $1 trillion balance sheets, will have to come down, lowering returns. And it's going to be tougher to carry the illiquid assets, like private-equity stakes, that were a boon to Morgan Stanley and Goldman on the way up.
The change is likely to lead to less risk-taking by the companies. Both Goldman and Morgan Stanley held more than $20 of assets for every $1 of shareholder equity, making them dependent on market funding to operate.
Morgan Stanley said in a statement that it had sought the change in status in order to provide "maximum flexibility and stability to pursue new business opportunities as the financial marketplace undergoes rapid and profound changes."
As a part of Knowledge Series, please find attached a special report from Bloomberg.com on 'Crisis on Wall Street' which gives a summary of last weeks events that intensified the global credit crisis and the impact of actions taken by various Wall Street firms, US Banks and Federal Reserve.
FAT Cat: I Own USAARCHIVES | EQUITYMASTER HOMEPAGE
22nd SEPTEMBER 2008
Addison Wiggin and Bill Bonner wrote the classic, must-read, "The Empire of Debt". The US Empire, the book surmised, had grown economically weak and unsustainable. It has burdened itself with too much debt. Its collapse is imminent.
From the roots of this book has emerged one of the most talked about documentaries: "I. O. U.S.A." (the "O" as in "owe") which highlights the extraordinary debt levels of the US government. A debt that is estimated at USD 410,000 per full-time worker in America – about 9x the average annual per capita income in USA. (Unfortunately, I missed the movie on a recent trip to USA but am hoping to get hold of the DVD.)
Well, the debt levels of the US government just got higher.
A lot higher.
In some shape or form the US government and the Fed (the central bank) have just taken on an estimated US 1,000 billion in debt. Thanks to the guarantees and loans given to Bear Stearns (an investment bank that got its gambling bets wrong); Freddie Mac and Fannie Mae (home loan companies that own 30% of all mortgages in USA and seemed to have mis-priced their risk); and AIG (the world's largest insurance company that used its AAA rating to borrow cheap and insure against the risk of company defaults – collecting premium income which looked like free money, till the defaults began).
ADVERTISEMENT Global Turmoil Sends Blue-Chip Prices Crashing.
Buy Now For 100% Returns. Opportunity Ends 30th September. Read On....
While many are mulling the higher costs of this action – just as I have done above - there are a few fundamental differences that lead to some interesting possibilities.
FAT Cat: The world's largest private equity and hedge fund
The most notable feature of this rescue is that the Fed and the US Treasury now own 90% of the equity of the home loan companies and 79.9% of AIG.
The Fed and the Treasury have become, overnight, the largest private equity fund in the world.
The new fund should be called FAT Cat denoting the partnership between the "Fed and Treasury".
And the "Cat" for their well entrenched and smooth political connections. (Origin: Bombay lingo: he is a cool "cat", a person who gets all the women mostly because of certain smoothness)
And the fund managers of FAT Cat are not even charging a "2/20" fee structure for it.
ADVERTISEMENT Gold Producers de-hedging. How will gold prices move?
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Blackstone, Carlyle, KKR, TPG, and the other luminaries of the private equity world may be having sleepless nights. (An irrelevant relevant fact: One of the main sponsors of the I.O.U.S.A. documentary is a foundation set up by Peter G. Peterson – the Chairman of Blackstone.)
The birth of FAT Cat is being labelled by many as the death of private business in the US. Critics have called the government rescues a mockery of the free market practices that the US has stood for. A country that always criticised governments around the world for interfering in the private sector has, with amazing speed, become an owner of the some of the world's largest businesses.
The "business of America is business" said President Calvin Coolidge in the 1920's.
Not any more, howl the critics of FAT Cat.
An insider, now playing from the inside
Maybe the critics are wrong?
Maybe they are jealous of the power, the financial muscle and political connections of FAT Cat.
Hank Paulson is a deal-maker by nature.
In his new role as the Secretary of the Treasury, he probably surveyed the landscape and figured out that the hedge funds who borrowed billions to make bets and charged their clients "2/20" were gamblers dressed up as gods.
That the private equity firms who used other people's money to make bets while they earned their "2/20" fees were people of average intelligence - but from well known universities with good political connections.
Table 1: The gamblers lose big time.
The hedge funds and the private equity firms could fool a person like Alan Greenspan into believing that they actually made a difference to life.
Greenspan gave them all the billions they needed to make them rich beyond imagination.
Greenspan gave them money for free. And was happy to be named as some sort of Advisor to Deutsche Bank.
But these folks could not fool Hank.
They could not offer him some Advisory role after his tenure.
Hank did not need it: he had come from their side of the business.
He was one of the architects of the success of Goldman, Sachs.
He was, in many ways, one of their own: An insider.
And Hank knew the true value of these Czars of Finance: zero. So Hank decided to be the fund manager, the CIO, the investment architect of FAT Cat.
So when Hank "rescued" AIG, he "allowed" AIG to borrow money from the US Treasury at 8% more than the US government's borrowing cost.
This man has put our Indian money lenders to shame.
When the Finance Minister in India rescues companies, he gives them cheap loans.
Not Hank. To be rescued by Hank is to be given what was called the "bear hug".
What the Soviets did to much of Eastern Europe. What China has done to Tibet.
Hank makes offers they cannot refuse.
Shakespeare will have to re-write the description of Shylock.
The death of greed
The traditional private equity and buy-out firms may not have realised it as yet.
And this may be a breaking news article (maybe I can collect some McKinsey style consulting fee for outlining the new business environment?).
The Czars of Finance have a new competitor: the FAT Cat, a powerful combination of the US Treasury and the Fed.
And the "fund manager" of this largest private equity firm charges no fees.
There is no 2% annual management fee.
There is no extra performance fee of "20% of profits earned".
The "2/20" model has been discarded.
The fee is zero. Yes, you read this correctly: FAT Cat is not charging anyone any fees.
And FAT Cat can target any company they wish, and take over that company.
At any terms they deem fit.
With all the connections in the world to make that deal a success.
That is Hank over there on the left – representing the US Government. The man next to him is Ben Bernanke, the Fed Chairman. And on the right is Representative Nancy Pelosi – a Democrat from the state of California. That is the miracle of Hank – he could get the first elected lady Speaker of the House of Representatives, from the opposition Democrat party, to endorse the actions of FAT Cat.
For example, FAT Cat can ensure that the SEC imposes a rule that limits the short selling of the stock once FAT buys it: an immediate price floor is created for the company that they buy into.
The SEC just banned shorting in 799 finance companies.
FAT Cat has so far only invested in finance companies.
Coincidence?
If that does not work, FAT Cat has the ability to call central banks around the world and have them pump in money into the global financial system.
Just as they did this past week.
USD 247 billion of it.
Stock markets surged across the world on Friday – without any exception.
With those kinds of connections, any deal that the FAT Cat does can make them look smart from day one.
The naked fools
I think we are watching economic history unfold.
No, not the kind that most analysts are whining about: the excess debt that will make the prophecy of I.O.U.S.A. a reality sooner, rather than later.
Hank Paulson may go down in history as the man who took the world from its path of greed and destruction to a more "socialist" path. And he may help reduce the US debt by selling the companies he is buying at a huge profit.
Hundreds of billions of dollars of profit.
Enough money to stay another 436 days in Iraq and Afghanistan.
Enough profit to cover - for 269 days – the oil required to fill all those 50 million cars driving across USA.
Hank's deals may not save the USA but it will postpone the inevitable.
The Secretary of the Treasury, Hank Paulson, is not a typical government bureaucrat and a "do-gooder".
Nor is he an academic that made it to the top job because of some theoretical paper on "inflation targeting" or "interest rates and cost of money" or "public ownership of private goods".
Oh, no.
No, no.
Remember: Mr. Paulson has worked with Goldman, Sachs.
He was a key member responsible for the firm's global success.
This man is a walking power-point on building businesses – successfully.
He is a turn-around artist.
I think he knows what he is doing: there is method in this madness.
Many years ago, President John F. Kennedy was asked why he was keen to send an expedition to the moon.
To which President Kennedy replied: "because it's there."
It was the height of the Cold War. Kennedy made the Soviets look like fools.
Like losers.
And so it must be with Hank.
"But, Hank", a reporter may ask, "why build the world's largest private equity fund and hedge fund and charge zero fees for it?"
And I can picture Hank saying, "because I can".
The Czars of Finance just got a new Emperor.
And Hank makes them all look so foolish.
And so naked.
Suggested allocation in Quantum Mutual Funds
Quantum Long Term Equity FundQuantum Gold Fund
(NSE symbol: QGOLDHALF)Quantum Liquid Fund
Why you should own it:An investment for the future and an opportunity to profit from the long term economic growth in IndiaA hedge against a global financial crisis and an "insurance" for your portfolioCash in hand for any emergency uses but should get better returns than a savings account in a bank
Suggested allocation80%15%5%
Disclaimer: Past performance may or may not be sustained in the future. Mutual Fund investments are subject to market risks, fluctuation in NAV's and uncertainty of dividend distributions. Please read offer documents of the relevant schemes carefully before making any investments. Click here for the detailed risk factors and statutory information"
Note: Ajit Dayal, the author is a Director in Quantum Information Services Private Limited and Quantum Asset Management Company Private Limited. Views expressed in this article are entirely those of the author and may not be regarded as views of the Quantum Mutual Fund or Quantum Asset Management Company Private Limited or Quantum Information Services Private Limited.
Mutual Fund Investments are subject to market risks. Please read the offer documents of the respective schemes before making any investments.
Other Views on News:
» Debt Funds: Liquid vs Liquid Plus
Being financial planners, we regularly interact with investors to understand their needs and the problems they face while investing. Read on...
» Casino capitalism?
The US$ 700 bn financial rescue plan announced by the US government and Federal Reserve last weekend is probably the most extensive intervention Read on...
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©Equitynaster Agora Research Private Limited 2007-08
But indirect impact of the global financial crisis may be there in terms of FII capital inflow in both equity and debt, he added.
"In next six months, we may see continued volatility not only in equity but in debt markets as well, because of global uncertainty unless US resolves its housing market crisis," the official told PTI.
However, the recent reaction of stock markets is mostly driven by news reports emanating from the United States about Lehman Brothers' bankruptcy and Merrill Lynch's takeover by the Bank of America.
In 2006-07, the price-earning ratio of listed companies was as high as 35 to 36 per cent which was not sustainable as capital flow to equities were excessive. Now they have come down to around 20 per cent, the official said.
In a way, he said, it is good that prices are volatile as they act as a shock absorber in this kind of situation. "What we don't want is growth acting as a shock absorber," he added.
The benchmark equity index moved by 504.20 points intra-day before ending up at 13,548.70 points on Tuesday.
On the recent developments in the US financial markets, the official said,"The direct impact of Lehman Brothers going for bankruptcy and Bank of America taking over Merrill Lynch is not going to be much. But indirect impact of global financial crisis may be there in terms of FII capital inflow in both equity and debt."
The indirect impact could be much larger due to turbulence in global financial system, he said.
It will impact confidence of investors, both domestic and foreign, the official said. As such, there are concerns about capital flow from FIIs in both debt and equity segments, he said adding FDI is unlikely to be impacted.
The official said the direct impact of these events will be there to the extent that these entities reduce their exposure in Indian market and the Bank of America consolidates its operations after taking over Merrill Lynch.
However, their exposure to the Indian market was never enormous compared to their total global investments, he said.
Collectively, all the companies where Lehman invested in India had a market valuation of close to Rs 40,000 crores yesterday, which on Tuesday fell by more than Rs 2,000 crore.
Besides having a stake in listed companies, Lehman is understood to have invested in various projects of the Indian companies, especially in the real estate sector.
In India, Lehman recently acquired Brics Institutional Equities's division of research analysts, sales and trading professionals, and purchased a 26 per cent stake in Edelweiss Capital Finance, a non-banking financial company.
Rajya Sabha member C Rangarajan had said on Monday though the global financial crisis is a critical situation, one does not know whether the crisis has further deepened.
Recent reports about the Lehman Brothers filing for bankruptcy have created ripples across India’s real estate market. The rupee has weakened, and stock markets are on a down slide. The US-based investment banking firm had actively invested and partnered in several hospitality projects in India. However, due to the company’s latest move, its real estate investment arm has been put on hold, and it has stopped principal investments to companies.
Some prime development projects funded by the Lehman Brothers were with HDIL, Unitech and DLF Assets. Unitech’s projects will not be affected by the investment firm’s developments, as the project’s funds have already been received and are in a lock-in period of seven to ten years. HDIL funds will be diverted from the investment company’s Hong Kong subsidiary. DLF Assets had raised 200 million dollars (in 2007) from the Lehman Brothers. Besides, the company was also in talks with Future Capital for investments in its hotel development initiatives. When contacted, officials from Future Capital refused to comment.
A year ago, the subprime crisis blew up in the US. Policy makers in the US and elsewhere have been engaged in a grim battle to contain its fallout. Can we do anything to prevent such crises? One view is that boom-bust cycles are integral to the free market economy and that we should stand back and let institutions fail. But the immediate consequences of such a policy — a deep and long recession — are so serious that no government has the stomach for it.
Another view is that it is hard to call a bubble correctly — we know there is a bubble only after it has burst. Once the bubble bursts, policy-makers should step in to limit the damage, as they have done in the present crisis. The danger with this approach is that public intervention to limit the damage stores up worse problems for the future (‘moral hazard’) so that we end up facing even graver crises down the road.
A third school looks for preventive medicine. ‘Lessons from the subprime crisis’ promises to be as rich a field for researchers as the East Asian crisis of the nineties. Robert Shiller, professor at Yale, wades into the field with The sub-prime solution (Princeton). Shiller proposes three types of solutions. One, better information. Two, new markets for risks. Three, new retail risk management institutions.
Some of his proposals for better information are familiar enough — more disclosure from financial institutions; an improved database on individuals’ economic and medical history; a financial watchdog that will ensure consumer safety in financial products. Shiller has some new proposals as well. He wants low-income individuals to be provided advice on the basis of fixed hourly fees that will be eligible for tax benefits.
At present, the advice they get is from people who sell products and who collect a fee from the providers of those products. Naturally, such advice tends to be biased. But how do we get people to opt for paid services when they can get free advice from sellers of products? How do we ensure that advice provided for a fee is of the right quality?
Shiller also wants financial contracts to have certain clauses that will protect consumers who cannot read between the fine print. A more interesting proposal is requiring asset prices to be quoted in inflation-adjusted terms. Shiller contends that if this had been done for housing, buyers in the US would not thought that homes would be spectacular investments. Note that both these proposals mean more stringent regulation.
Shiller advocates the creation of new markets for risks. Housing futures, he says, would help contain a speculative bubble by creating opportunities for short sellers. But such markets, which Shiller helped launch, have failed to take off in the US. Besides, this does seem a bad time to sing the virtues of short selling — we have seen the havoc this can create at American financial institutions.
Shiller’s third suggestion is the creation of new retail risk-management institutions. One is what he calls ‘continuous workout mortgages’ — mortgages on which terms are continuously adjusted in response to changes in borrowers’ incomes and conditions in the housing market. If the borrower’s ability to pay drops, the terms would be revised downwards accordingly.
Shiller contends that this is what happens in bankruptcy anyway, so he is only proposing a more orderly adjustment. He thinks there are ways to address the moral hazard implicit in such an arrangement — the borrower losing the incentive to earn or under-reporting his income. Another retail institution Shiller urges is home equity insurance. By putting a floor on home prices, it would prevent panic sales of homes and sharp collapses in home prices in a downturn.
These are ideas that would go some way towards making home ownership safer for large numbers of people. But one cannot resist the impression that Shiller takes too narrow a view of the subprime crisis. The crisis is not just about a collapse in housing prices and people losing their homes. In itself defaults on subprime loans would not have posed a problem for the US economy. The subprime crisis has ballooned into a financial crisis because it impacts financial institutions that have leveraged exposures to subprime contracts.
Another subprime crisis is as unlikely as a plane crashing into a tall building in the US — the problem will arise in some other form. We need to address the broader issue that underlies the subprime crisis: how to ensure that regulation keeps pace with innovation? This means the focus for reform has to be on financial institutions and the regulatory architecture, not just protection of the consumer.
Several factors have kept the world economy from keeling over. The Fed has bailed out large financial institutions and has been quick to provide liquidity even to investment banks. The US treasury has provided a large fiscal stimulus. Central banks have coordinated their actions well. Many banks in the western world have managed to raise capital from emerging economies to offset their losses. Emerging economies, whose weight in the global economy has increased over the years, have sustained growth thanks to strong domestic demand.
After the collapse of Lehman Brothers and Merrill Lynch's $50bn rescue takeover by Bank of America, investors had questioned the ability of stand-alone investment banks to fund themselves without access to retail deposits.
Yesterday, the Federal Reserve has allowed Goldman Sachs and Morgan Stanley to change their status to bank holding companies. This step will allow both investment banking firms to take deposits and shore up their resources. The Fed will also provide short-term loans for the two banks to transition as commercial banks.
As a result this move:
The merger talks between Wachovia and Morgan Stanley is on hold.
Both Morgan Stanley and Goldman will also come under the purview of the Federal Reserve (earlier they were regulated by only Securities and Exchange Commission). It means that, both Goldman Sachs and Morgan Stanley will be subject to bank capital requirements, which will be phased in over a transition period
Days of high leverage are gone:
Financial leverage at Goldman and Morgan Stanley, which both have roughly $1 trillion balance sheets, will have to come down, lowering returns. And it's going to be tougher to carry the illiquid assets, like private-equity stakes, that were a boon to Morgan Stanley and Goldman on the way up.
The change is likely to lead to less risk-taking by the companies. Both Goldman and Morgan Stanley held more than $20 of assets for every $1 of shareholder equity, making them dependent on market funding to operate.
Morgan Stanley said in a statement that it had sought the change in status in order to provide "maximum flexibility and stability to pursue new business opportunities as the financial marketplace undergoes rapid and profound changes."
As a part of Knowledge Series, please find attached a special report from Bloomberg.com on 'Crisis on Wall Street' which gives a summary of last weeks events that intensified the global credit crisis and the impact of actions taken by various Wall Street firms, US Banks and Federal Reserve.
FAT Cat: I Own USAARCHIVES | EQUITYMASTER HOMEPAGE
22nd SEPTEMBER 2008
Addison Wiggin and Bill Bonner wrote the classic, must-read, "The Empire of Debt". The US Empire, the book surmised, had grown economically weak and unsustainable. It has burdened itself with too much debt. Its collapse is imminent.
From the roots of this book has emerged one of the most talked about documentaries: "I. O. U.S.A." (the "O" as in "owe") which highlights the extraordinary debt levels of the US government. A debt that is estimated at USD 410,000 per full-time worker in America – about 9x the average annual per capita income in USA. (Unfortunately, I missed the movie on a recent trip to USA but am hoping to get hold of the DVD.)
Well, the debt levels of the US government just got higher.
A lot higher.
In some shape or form the US government and the Fed (the central bank) have just taken on an estimated US 1,000 billion in debt. Thanks to the guarantees and loans given to Bear Stearns (an investment bank that got its gambling bets wrong); Freddie Mac and Fannie Mae (home loan companies that own 30% of all mortgages in USA and seemed to have mis-priced their risk); and AIG (the world's largest insurance company that used its AAA rating to borrow cheap and insure against the risk of company defaults – collecting premium income which looked like free money, till the defaults began).
ADVERTISEMENT Global Turmoil Sends Blue-Chip Prices Crashing.
Buy Now For 100% Returns. Opportunity Ends 30th September. Read On....
While many are mulling the higher costs of this action – just as I have done above - there are a few fundamental differences that lead to some interesting possibilities.
FAT Cat: The world's largest private equity and hedge fund
The most notable feature of this rescue is that the Fed and the US Treasury now own 90% of the equity of the home loan companies and 79.9% of AIG.
The Fed and the Treasury have become, overnight, the largest private equity fund in the world.
The new fund should be called FAT Cat denoting the partnership between the "Fed and Treasury".
And the "Cat" for their well entrenched and smooth political connections. (Origin: Bombay lingo: he is a cool "cat", a person who gets all the women mostly because of certain smoothness)
And the fund managers of FAT Cat are not even charging a "2/20" fee structure for it.
ADVERTISEMENT Gold Producers de-hedging. How will gold prices move?
Click here to know more
Blackstone, Carlyle, KKR, TPG, and the other luminaries of the private equity world may be having sleepless nights. (An irrelevant relevant fact: One of the main sponsors of the I.O.U.S.A. documentary is a foundation set up by Peter G. Peterson – the Chairman of Blackstone.)
The birth of FAT Cat is being labelled by many as the death of private business in the US. Critics have called the government rescues a mockery of the free market practices that the US has stood for. A country that always criticised governments around the world for interfering in the private sector has, with amazing speed, become an owner of the some of the world's largest businesses.
The "business of America is business" said President Calvin Coolidge in the 1920's.
Not any more, howl the critics of FAT Cat.
An insider, now playing from the inside
Maybe the critics are wrong?
Maybe they are jealous of the power, the financial muscle and political connections of FAT Cat.
Hank Paulson is a deal-maker by nature.
In his new role as the Secretary of the Treasury, he probably surveyed the landscape and figured out that the hedge funds who borrowed billions to make bets and charged their clients "2/20" were gamblers dressed up as gods.
That the private equity firms who used other people's money to make bets while they earned their "2/20" fees were people of average intelligence - but from well known universities with good political connections.
Table 1: The gamblers lose big time.
The hedge funds and the private equity firms could fool a person like Alan Greenspan into believing that they actually made a difference to life.
Greenspan gave them all the billions they needed to make them rich beyond imagination.
Greenspan gave them money for free. And was happy to be named as some sort of Advisor to Deutsche Bank.
But these folks could not fool Hank.
They could not offer him some Advisory role after his tenure.
Hank did not need it: he had come from their side of the business.
He was one of the architects of the success of Goldman, Sachs.
He was, in many ways, one of their own: An insider.
And Hank knew the true value of these Czars of Finance: zero. So Hank decided to be the fund manager, the CIO, the investment architect of FAT Cat.
So when Hank "rescued" AIG, he "allowed" AIG to borrow money from the US Treasury at 8% more than the US government's borrowing cost.
This man has put our Indian money lenders to shame.
When the Finance Minister in India rescues companies, he gives them cheap loans.
Not Hank. To be rescued by Hank is to be given what was called the "bear hug".
What the Soviets did to much of Eastern Europe. What China has done to Tibet.
Hank makes offers they cannot refuse.
Shakespeare will have to re-write the description of Shylock.
The death of greed
The traditional private equity and buy-out firms may not have realised it as yet.
And this may be a breaking news article (maybe I can collect some McKinsey style consulting fee for outlining the new business environment?).
The Czars of Finance have a new competitor: the FAT Cat, a powerful combination of the US Treasury and the Fed.
And the "fund manager" of this largest private equity firm charges no fees.
There is no 2% annual management fee.
There is no extra performance fee of "20% of profits earned".
The "2/20" model has been discarded.
The fee is zero. Yes, you read this correctly: FAT Cat is not charging anyone any fees.
And FAT Cat can target any company they wish, and take over that company.
At any terms they deem fit.
With all the connections in the world to make that deal a success.
That is Hank over there on the left – representing the US Government. The man next to him is Ben Bernanke, the Fed Chairman. And on the right is Representative Nancy Pelosi – a Democrat from the state of California. That is the miracle of Hank – he could get the first elected lady Speaker of the House of Representatives, from the opposition Democrat party, to endorse the actions of FAT Cat.
For example, FAT Cat can ensure that the SEC imposes a rule that limits the short selling of the stock once FAT buys it: an immediate price floor is created for the company that they buy into.
The SEC just banned shorting in 799 finance companies.
FAT Cat has so far only invested in finance companies.
Coincidence?
If that does not work, FAT Cat has the ability to call central banks around the world and have them pump in money into the global financial system.
Just as they did this past week.
USD 247 billion of it.
Stock markets surged across the world on Friday – without any exception.
With those kinds of connections, any deal that the FAT Cat does can make them look smart from day one.
The naked fools
I think we are watching economic history unfold.
No, not the kind that most analysts are whining about: the excess debt that will make the prophecy of I.O.U.S.A. a reality sooner, rather than later.
Hank Paulson may go down in history as the man who took the world from its path of greed and destruction to a more "socialist" path. And he may help reduce the US debt by selling the companies he is buying at a huge profit.
Hundreds of billions of dollars of profit.
Enough money to stay another 436 days in Iraq and Afghanistan.
Enough profit to cover - for 269 days – the oil required to fill all those 50 million cars driving across USA.
Hank's deals may not save the USA but it will postpone the inevitable.
The Secretary of the Treasury, Hank Paulson, is not a typical government bureaucrat and a "do-gooder".
Nor is he an academic that made it to the top job because of some theoretical paper on "inflation targeting" or "interest rates and cost of money" or "public ownership of private goods".
Oh, no.
No, no.
Remember: Mr. Paulson has worked with Goldman, Sachs.
He was a key member responsible for the firm's global success.
This man is a walking power-point on building businesses – successfully.
He is a turn-around artist.
I think he knows what he is doing: there is method in this madness.
Many years ago, President John F. Kennedy was asked why he was keen to send an expedition to the moon.
To which President Kennedy replied: "because it's there."
It was the height of the Cold War. Kennedy made the Soviets look like fools.
Like losers.
And so it must be with Hank.
"But, Hank", a reporter may ask, "why build the world's largest private equity fund and hedge fund and charge zero fees for it?"
And I can picture Hank saying, "because I can".
The Czars of Finance just got a new Emperor.
And Hank makes them all look so foolish.
And so naked.
Suggested allocation in Quantum Mutual Funds
Quantum Long Term Equity FundQuantum Gold Fund
(NSE symbol: QGOLDHALF)Quantum Liquid Fund
Why you should own it:An investment for the future and an opportunity to profit from the long term economic growth in IndiaA hedge against a global financial crisis and an "insurance" for your portfolioCash in hand for any emergency uses but should get better returns than a savings account in a bank
Suggested allocation80%15%5%
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Note: Ajit Dayal, the author is a Director in Quantum Information Services Private Limited and Quantum Asset Management Company Private Limited. Views expressed in this article are entirely those of the author and may not be regarded as views of the Quantum Mutual Fund or Quantum Asset Management Company Private Limited or Quantum Information Services Private Limited.
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