Fall of 2008

I finally decided to write down my thoughts on market falling in 2008. This problem actually started building back in late nineties. With internet arriving on the scene and a few successes with internet companies, investors thought sky is the limit. Given the lack of data and visibility, no one wanted to miss this golden boat to riches. For a while, there was a never-ending party. Investors were willing to pour in money without thinking through and so arrived the time of easy credit. Companies without any profits were able to get money. Everyone was thinking big and willing to put in money for future returns. As the credit eased, money supply increased. Companies were spending big so in return, their vendors started to make big money. In turn, they increased their spending and so an upward cycle was created leading to the famous dot com boom until 2000. Y2k issue might itself have contributed partly to this since every business needed to make sure this issue didn't arise. Of course, this also led to increasing home prices since people had easy money and credit was easy. Of course, there were more forces at work like the financial institutions trying to come up with innovative ways to make more money available (like credit swaps) to fulfill the money demand.

As with every party, people get drunk, get high and go to sleep. And next day they wake up with a big hang-over questioning what happened. So, did the investors finally wake up. They had given enough time for companies to be profitable. But for a lot of companies, profits were nowhere to be found. And finally, investors got real. They started demanding profits before putting in money. And the credit tightened. Easy money was no longer available. This created a vaccuum (or a hangover).

To explain this, let's say you have $1000 of real assets. When the credit was easy, let's say you were able to borrow $2000 on this money. (I am being simplistic but you could actually borrow a whole lot, even 10 or 20 times or even more.) So now you have $3000 of money to put to work. But when the credit tightens, your borrowing capacity reduces. Let's say it goes to $500. Well, you only have $1500 to work with now. So, from $3000, you go to $1500. $1500 of your money capacity has simply disappeared. If you had invested those $3000, you would now have to cough up those $1500. This would mean you would have to liquidate some of your investments. If everyone is liquidating these investments, market would fall because there are more sellers than buyers around.

This is precisely what started happening in 2000. Credit started tightening and slowly the money supply dried up. This resulted in businesses cutting spending. When one business cuts spending, this means less income for its vendors. As the vendors have lesser business, they in turn cut their expenses. Some may even go under. As a result, a downward spiral formed and slowly squeezed all the wealth generated in dot com bubble. 9/11 was the final nail in the coffin. As a result of 9/11, we stepped into a war time leading to lot more uncertainty and hence further tightening of credit.

Things got pretty ugly until Fed pushed by Govt decided to step in by lowering interest rates. This led to another bubble. This time in housing. Prior to 2001, 30 year mortgage interest rates were above 7%. But, now the interest rates started falling. 30 year mortgage interest rates fell to 5% by 2003. Short term interest rates were even lower. Needless to say, housing prices that have been rising in late nineties because of increased wealth but slowed in 2000, 2001, started rising again because people could afford a lot more at low interest rates (see 3rd para). So house prices started rising. People could leverage their money 10 to 20 times using a house as collateral i.e. you would take a 90% or 95% loan and only pay 10-20% collateral. And then there were no-doc loans and only-interest loans which made people's afforadability many times more. Again, there was a party. This party was to get rid of the hangover from earlier party. 

In 2004, interest rates finally fell to their lowest. Most of the people looking to buy houses in future simply moved their schedule ahead. But by this time, house prices were hitting the peak. In the party of low interest, people forgot that the interest rates could move up, making their afforadability lower. Most people were imagining that the house prices wouldn't move down. Their reasoning was clouded by a decade of rising house prices.

But, Fed didn't plan to keep the interest rates lower. As they pushed the interest rates slowly up in late 2004, things changed. With already increased prices, and increasing interest rates, buyers started shying away because the houses were already priced out of their affordability range. e.g. If you had an interest rate of 4% and the interest rate now moves to 5%, it means you now have to pay 25% more money as interest. Most of the people had a 3year or 5year term loans so they were safe until 2007 or 2009. In the period between 2004 and 2007, not much happened since not many people needed to sell the house. But in the meantime, the buyers dried out and so the house prices started moving down. Finally when the 3 year term started closing in on some home buyers, an avalanche started. By this time, the interest rates had moved way up so re-financing got many of these buyers out of their affordability limit. On top of it, house prices hadn't increased. Neither were the home owners able to sell as there weren't any buyers around. So, bankruptcies started happening. And that further led to home price declines, a little sharper this time. As the prices fell, more buyers shied away, people with interest only payments suddenly found out that they had paid more money for the house than it was now worth for. So, those people started to walk away from their houses. As the house prices went further down, people who had paid 5% or 10% down suddenly found that the pending balance is still more than the house is worth. So, the string of bankruptcies just kept becoming bigger. People who had multiple houses got burnt. Overall, the avalanche started and with that it brought down the mortgage companies that had given such loans because they couldn't recover money and had to write it off. There were many more houses in foreclosures, more than the buyers for those foreclosed homes. Without government intervention, it would just become worse. It was better for banks to re-work the loan terms because they would lose more money on foreclosed homes. There wasn't much option for government than to reduce the interest rates or ask banks to re-work the mortgage payments. 

But, there were other consequences of this. People used home to lever the amount of money they had. Some people took loans and put it in stock markets or other investments near and far. It made sense since home loans were far too cheap compared to the interest earned in stock market or bond market. You could get much better returns if you invested in India, China or other such countries. So, people took out mortgage loans to the full when things look good. But, now they needed to get that money out to pay for the mortgage. Lot of businesses specially the mortgage businesses needed to break their investments to meet the loan requirements (loan to asset ratio). Some that foreclosed led to breaking the investments any way. In nutshell, everything fell around the world.

Boom in countries such as China and India was essentially because of all the leveraged money that found way into these markets as foreign investments. But, when the foreign investors started taking out their money, the result was obvious - a fall in these markets. Since India and China rely heavily on exports, the fall was much more pronounced there. In fact, lot of countries had invested in US home mortgages as a safe hedge against their economies ironically. Well, it turns out there is no hedge. So, all the economies fell worldwide. Lot of US money that was invested worldwide was taken out to pay for the housing debacle. But, the money the foreigners invested in the housing market didn't get returned to them because lot of such companies went bust. So net result was that dollar became stronger. In future, however, foreign investors may shy away as they have been bitten once. Still, their economies are not going to provide a better return either. So, strong dollar is here to stay.

Now, when unemployment is increasing in US, people are insecure and going to start saving. Because of the housing debacle, credit is much tighter. Businesses are unsure who is going to survive or live. In turn, they are afraid to work on credit, they are starting to cut spending, look at everything they can save. Investors overall will be very afraid to lend. All this means a big credit crunch. All this in turn leads to a downward spiral until it comes down to bare minimum.

One problem with current US business practices is that they are too focussed on quarterly results. Focus on quarterly results means that moment the executives see a downturn, they start cutting spending, and employment. Cut in employment in turn leads to insecurity which in turn contracts the spending and hence lack of money turn-over which is the grease of economic wheel. When money turnover dries up, economy becomes squeaky.

It has now become the job of governments to grease this wheel by easing credit. This in turn means that tax-payers have to fund the easing of the credit e.g. through government spending, making it easier to get a loan when the banks have become paranoid to lend. Yes, this also means that lending practices will have to loosen up somewhat (from paranoid to practical). However, as with any government plans, it is only a matter of time before the focus shifts away. But for now, hopefully the lesson is learnt.

In coming years, credit would still stay tight as long as the memory of 2008 is a around (I am sure it will for a long while). People worldwide will get into the habit of living within their budget and saving enough. This also means that heady days of double digit growth may be over. But this may be the only time to ensure of such returns. There is still no certainty on how the government plans will work so it is not certain (it never is) that market will start recovering. I am expecting fits and starts. My strategy is to look for companies with nice returns, with strong balance sheets that can weather the storm. That way, you can get good dividend at cheap price.