Butterfly Effect and Butterflies in my stomach

Chaos in the Markets – How a home loan default in America hurts investors in India

The recent crisis in global equity markets as a result of the sub prime mortgage meltdown in the United States has caught many investors by surprise. Economic fundamentals of most global markets had no major changes yet the disturbances were severe enough to erode and nullify recent rallies in the market. The subsequent panic caused in world currency and equity markets were severe enough to raise multiple levels of concerns in central banks, governments and the investors. What analysts worldwide called a re-rating of risk appetite has led to severe loss of appetite for many investors.

While on one hand it points to the increasingly close knit network of the world financial economy with all its subsequent gains in efficiency and capital investment, it also points to a new area in evaluating equity valuations in varying times of global risk. It is thus necessary for the Indian investor to understand not only those markets in the world are now strongly co related but also the macro economic drivers that affect various markets including hedge funds , sub prime markets, and the US federal bank’s unparallel influence beyond its borders.

Introducing the Butterfly Effect- The butterfly effect is a concept in chaos theory. It refers to the idea that a butterfly’s wings might create tiny changes in the atmosphere which could lead to a tornado appearing somewhere else. Thus changes which apparently seem random are actually caused by small changes in the initial system. The flapping of wings represents a small change in the initial condition of the systems.

Similarly the loosening of credit in the United States sub-prime mortgage system partly due to the increased liquidity in the system and collateralization of loan based collaterals to financial intermediaries has caused the widespread chaos in the worldwide financial systems. Simply put, there was too much money in the market that mortgage companies could easily borrow, and transferring risk was also easy due to securitization of these loans. As a result, while financial discipline was lost while lending to a booming real estate market, the risk was systematically transferred and in fact hidden during the collateralization process to the whole financial system.

Quite notably, the about turn by the United States Federal Bank also caught the market by surprise. By cutting the inter –bank lending rateand the later the key Fed rate, the Fed ,led by Bernanke in it’s first crisis since the post Alan Greenspan era, effectively did a volte-face on it’s previous stand of waiting and watching. Indeed markets in Alan Greenspan’s time used to talk of the Greenspan put – basically a concept that is asset prices tumbled too far the Federal bank would step in to take control.

Note: This has important lessons for even Indian lender. In the United States median house prices almost doubled from 1993 to 2005, while incomes rose just 49 percent. In India, the real estate boom has been even faster and thus the increased danger of the bubble bursting.

The recent crisis also pointed to the fact that Indian Markets continue to be sensitive to downward global cues, to the point of ignoring value investing. The concept of value investing was created by Graham –Dodd and most successfully used by Warren Buffet. It said that it was better to concentrate on the fundamentals of the company and expected cash flows rather than try and anticipate its future price. The metric used was the long term rice to earnings ration of a particular stock. Thus the ups and downs of the market have actually taught both the retail and the institutional investor the fundamentals of investing on actual value rather than be caught up in bearish or bullish swings.

At this point, the recent record fund raising by mutual funds is also an increased area of concern. The regulators led by AMFI, SEBI and the RBI should focus that mutual funds are sold transparently with easy to understand tables of disclosures, and adequate amounts of effort is spent on educating the common man, who is the worst affected in any stock market bust.

Author: Ajay Ohri


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