The Credit Bubble: 2002-2009AD

“It is interesting that the industry has invented new ways to lose money when the old ways seemed to work fine”
                                                            - John Stumpf, CEO, Wells Fargo

CNBC-TV18's research analyst, Haresh Soneji - Some time in the near future (read 2008/09): The credit bubble bursts. A few banks file for bankruptcy. Liquidity crunch hits equity market around the world. Equity indices retrace some 40-50% with no signs of bottoming. The US has a hard landing and Japan enters into a recession, again.

Circa February 2008: Equity market experts debate whether the credit bubble is all that bad. Will it have serious repercussions? And will emerging markets be affected with a US slowdown?

Just how big is this credit bubble? There are two theories that appear to carry decent weight amongst all other estimates and/or guestimates.

Theory 1:

• Subprime size in the world - $ 1tn ($ 700bn as of end 2006)  Source: Bank of England
• 20% of all sub prime is BAD – $ 200bn
• Multiplier (k) – 5
• Write downs – $ 1tn
• Write downs till date – $ 100bn
• Expected write downs – $ 900bn

Theory 2:

• US mortgage industry size – $ 10tn ($8tn as of 2005) Source: www.BIS.org
• 14% is subprime – $ 1.4tn (Source: Deutsche Bank, 2007)
• 20% of subprime are delinquent/BAD – $ 280bn
• Multiplier (k) – 5
• Write downs – $ 1400bn
• Write downs till date – $ 100bn
• Expected write downs – $ 1300bn

From the above two theories, the range for further write downs is anywhere between $ 900-1300bn. This is a big enough write down to wipe off 40-50% or may be more off the equity market. And the impact is not restricted to a few banks in the US and Europe. The impact is large. In such times, it’s always better to find sound advice.

I am a big fan of the legendary investor – Warren Buffett. But, then again – Who isn’t? If you’re an investor, even a small retail investor, then whatever Mr Buffett writes must be interpreted as a Commandment. Here’s why? Berkshire Hathway – Mr Buffett’s investment company – has delivered a return of 400,863% since 1964 as compared to S&P500 (including dividends) of 6,840% over the same period. A compounded annual return of 21.1% v/s S&P500’s compounded annual return of 10.3%. Now that’s out performing the market over 44 long years. So, one better take his words seriously.

In his annual note to shareholders for the previous year (released last week), Mr Buffett sounds critical like never before, using sentences like ‘The party is over’ and quotes from silicon valley, “Please, God, Just one more bubble”, apart from the above John Stumpf quote. His bullish though – but that’s for the long term. Mr Buffett has written European puts worth $ 4.7bn on S&P and 3 other global indices (doesn’t reveal the indices), but they start expiring 2019-2027. A perfect case of a short term bear and long term bull.

There is a good case to follow the ‘short term bear and long term bull’ strategy. And that’s true for any investor anywhere in the world. The reason is simple. The Big Daddy is about to sneeze and the world is all gearing up to catch cold. No matter where you are, the US led global slowdown will impact sentiments. And to my mind, perhaps the first signs of acceptance will sprout once the Presidential elections are over. So, we have a few months at hand. Exit till you can or face the consequences.

Back in India, the Union Budget is over. The populist budget seems to have inflationary impact. On the one hand, consumer durables, including vehicles will be cheaper and on the other hand disposable income will rise, once the bill is passed in the assembly. But, trading will suddenly become expensive with short term capital gains tax up from 10% to 15%. Keeping that in mind, the risk premiums are bound to decline. And no it’s not just that. Focus is back on valuations. With earnings downgrade risks rising over the quarter, things do look foggy in the absolute short term. Volatility is a given. Considering the global environment and India’s imperative stand, don’t expect too much. Remember to take advice from Mr Buffett. His wisdom is available free once a year. What are you waiting for?

Disclosure: The author is not permitted to trade and/or invest into the equity market directly or indirectly, apart from investing (long only) in mutual fund products.