Why bubbles matter to even a cautious investor?

The creation and bursting of bubbles can have direct or indirect impact on the finances of even a very cautious investor.

If the investor is aggressive and has invested borrowed money during a bubble, the results could be disastrous. However, even for a conservative investor, there could be major impact if a large number of big investors have invested borrowed money. Such a situation can lead to severe economic consequences in the aftermath of the bursting of the bubble.

Less than a decade ago, we witnessed such an event, popularly known as the sub-prime crisis. Large banks, institutions, hedge funds and even some Sovereign funds borrowed heavily and invested the money in risky assets. The after effects were felt across the world and by all investors – aggressive or conservative.

I have written the following in the beginning of the Chapter 2.9 – The Sub-prime Crisis:

In early 2014, while referring to the global meltdown of 2008-09, an IFA asked, “How does one explain to a school teacher in rural India that her portfolio value dropped by around 50% because someone on the other side of the world defaulted on his housing loan?”

Think about it. The investor thought that she was conservative and taking least risk. What she did not know was that it was someone else’s action that impacted her.

Read and learn from history. It is a good protection against the stupidity of others and of your own.

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Why nobody saw it coming?

During a visit to the London School of Economics in October 2008, Queen Elizabeth II, British Queen of the United Kingdom wondered: “Why did no one see it coming?”

It is not that no one saw it coming, just that probably no one knew the exact date. This repeats in every market cycle – whenever the rising markets start falling or whenever the falling markets start rising – it is not possible to know well in advance when exactly something is likely to happen.

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First forecasting … and then denial

Ben Bernanke was asked in 2005 about the possibility of fall in housing prices in America. He said: “It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis.”

We know what happened later.

When the house prices started falling in 2007, he further added, “The impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.”

First came a forecast, which went horribly wrong and then came a denial that this is not e problem.

As Lao Tzu has said, “Those who have knowledge, don’t predict. Those who predict, don’t have knowledge.”

#RidingTheRollerCoaster – 188

 

AIG – Was it overconfidence?

“It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”

— Joseph J. Cassano, a former A.I.G. executive, August 2007

AIG was  bailed out by the US Government roughly a year later.

AIG, then one of the largest insurers in the world, was expert at insuring what are known as the insurable risks – life insurance, property insurance, etc. These risks are such that history is a good indicator of what to expect since most risks do not manifest together. Not all insured would die simultaneously. History suggests that even in case of wars, natural calamities or disease outbreaks, the number of deaths are not unusually high. This turns out to be  astable business for the insurers.

During the great liquidity rush, practiced by the US Federal Reserve Bank under the chairmanship of Alan Greenspan, the financial intermediaries found a very lucrative opportunity to make money – insuring against the default risks of borrowers. Thus came the CDS or the Credit Default Swaps. These risks were very different from the insurable risks we discussed earlier. There is a higher possibility that an unusually large number of borrowers may default together, if the economic conditions change, e.g. interests rise – thus making the floating-rate home loans costlier to service or if the house prices fall – thus reducing the value of the house collateral less than the outstanding loans.

This was (probably) not understood by AIG FP or to respect their financial acumen, one may say that they preferred to ignore the risks. Was it overconfidence in their abilities?

Be careful of the overconfidence. It can lead one to make very costly mistakes.

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Tata Steel to evaluate divestment of Tata Steel UK, in whole or in part

Tata Steel has informed the stock exchanges about the decision taken in their board meeting. In the meeting, the issue discussed was related to the European operations of Tata Steel. The company is struggling due to various global factors, including falling commodity prices.

At this stage, it is important to take a look at when the acquisition was made.

In the period prior to the crisis of 2008-09, the global economy was booming and rising stock prices exhibited the confidence of global investors in the risk assets.

It was around this time, when India was one of the fastest growing economies, there was a lot happening. Indian companies also went on an acquisition spree. One of those multi-billion dollar acquisition was that of Corus by Tata Steel.

Well, I am not going to analyse whether the decision was right or wrong. I am also not going to analyse if the current decision of getting out of the business is right or wrong.

What I want to highlight is something we keep witnessing in the market cycles. It is in the boom times that large-ticket acquisitions become commonplace. We see many announcements of big acquisitions – the amounts are large not just because the companies acquired are large, but also due to the valuations they fetch.

As I have written in my book “Riding The Roller Coaster – Lessons from financial market cycles we repeatedly forget” in the chapter on Valuation: “If one happens to buy at the top of the respective market, the time to recovery was quite long.”

In case of the Tatas, they waited for almost a decade before they decided in the board meeting to consider the exit option.

Some things do not change.

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Liar loans

Do you know that during the boom before the sub-prime crisis, in there US there was a category of loans that was known as “liar loans”?

Apparently, this was a brilliant innovation (!) to give away loans to people who may not have supporting financial strength. These borrowers could take loans by simply stating that they had enough income and/or assets to qualify for the loans. No documents were checked.

As we have written elsewhere, “… seeds of disasters are sown in boom times …”

Well, if this sounds familiar to the current situation in India, remember Bishop Desmond Tutu’s words, “What we learn from history is that we don’t learn from history”.

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“Why did no one see it coming?”

“Why did no one see it coming?” Queen Elizabeth on the financial crash of 2008, during her visit to London School of Economics

Queen Elizabeth was among the most popular personalities to have asked this question that bothered many.

However, it is not that everyone had ignored the possibility of an oncoming crisis. It is just that majority preferred to ignore those who talked about the possibility. Or there were some who chose to continue playing the game.

 

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