Dubai: KEL Session - The Impact of Subprime Crisis
by Deepak Machado
Daijiworld Media Network - Dubai
Dubai, Nov 27: Most of us have been the witnesses or have been hearing what the financial pundits’ term as “subprime crisis.” But a few had any clue as to what was going on around the globe and the local economy. Economic grapevine was that UAE was not affected by the crisis although the lenders were responding passively to the requests by customers. There was a mood of utter confusion and curiosity among the population.
What is this Subprime crisis? Who caused this? How is this going to affect my pockets? These and several other questions were looming in the minds of the investors and individuals as well. To address the doubts in the minds of the common man, KEL (Kanara Entrepreneurs Limited) had organized a session on The Impact of subprime crisis” at India Club on November 26, 2008 at 1830 hrs.
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Having a partial idea of what caused the financial crisis and what was in store for me, my rationale on attending was to do away with the doubts that were lingering in my mind.
The whole program was divided into 2 sessions. The speaker for the Session 1 was Mr. Suresh Kumar, Chief Mentor of Emirates NBD, who concentrated on the topic What is Credit crunch?, How it all started?, Where it started? etc.
In the Session 2 we had Sanjay Uppal-CFO Emirates NBD, who concentrated on “Global financial crisis and GCC”
I have substantiated what the speakers spoke on. Few points have been expanded and other paraphrased so as to make it easier for the readers to understand the basics.
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SESSION I- SURESH KUMAR
What is credit crunch?
It’s a sudden reduction in the general availability of loans or a sudden increase in the cost of obtaining loan from banks.
How it started and where it started?
Suresh Kumar mentioned that the ongoing financial crisis was triggered off by the subprime crisis. The fingers were pointed towards Allen Greenspan ex Federal Reserve chief who made the policies towards lending to the subprime category very liberal. An individual was termed ‘subprime’ if he had a late payment or defaults and the credit history was not satisfactory. Lending to this category was very risky since they were most likely not to repay and hence the interest rates were higher for them than a prime customer.
Background
The past 7 years have seen an unprecedented growth after the recovery since the previous crisis of 9/11 and resulting factors. Governments around the world had agreed to contain the inflation between 2-4%. Property prices were shooting up. Thanks to relaxed lending criteria and easy borrowings with lower interest rates.
Banks usually work on the premise of trust. The profit they make is the difference between lending and deposits. This is termed as the conservative form of banking. Investments banks on the other hand begged to differ from conventional banking. Investment banking was all about deal making, innovation and high risk taking. Behold the birth of modern banking. Investment banks removed 3 dramatic things from the conventional bank;
1) They removed the link from bank’s deposit base.
2) Buy and hold strategy for the lending was broken. Conventional banks usually hold the loans on their books until they are repaid. Investment banks said they need not do this. They could package these loans into new financial instruments that could be sold on.
3) The above 2 points resulted in the 3rd point that the banks have been able to lend more money on top of the same reserves of their own cash buffers.
This new model made banks grow much faster than their deposit bases. This made them much bigger and has allowed them to earn much higher profits.
At the same time banks were accessing their new found cash; large proportions of public had maxed out their credit cards and were taking out unsecured loans. When it became apparent that the debts were not affordable, it was suggested to them to roll these into mortgage, lowering interest rates through refinance or mortgage of their properties. As the house prices were high this seemed to be the perfect solution.
So what were people doing with this new found wealth? SPEND IT! They spent it on everything. This resulted in the rise of share prices of the suppliers. There were record profits generated. Investors showed interest in the companies making profits which drove the stock markets northwards. At the same time developing countries started to flex their muscles to become world’s manufacturing powerhouses. This resulted in the high requirement of raw materials in turn increasing the demand for oil, natural gas etc. The result was that prices of oil saw an all time high. Everything looked rosy. Dark clouds started looming and the question whether this unprecedented growth was sustainable.
First signs
It all began in early 2007 when the subprime started showing weakness. Bear Stearns was taken over, Northern Rock was bailed out, hedge funds started to liquidate. WaMu (Washington Mutual) was taken over by JPMorgan. In a bid to rescue the economies the Federal Reserve, ECB and BoE cut their benchmark rates and central banks infused fresh capital to the economies. It was realized that these subprime loans had been packaged into CDOs (Collateral Debt Obligation) and sold to other banks. Banks in turn broke these, repackaged sold until the underlying instrument became so muddled and people buying did not know what they were buying.
All was well till the time asset value increased. However, when economy slowed the house prices dropped and people realized their assets were worth much lower than they thought and the loan was unlikely to be repaid.
The US economy then started to pick up momentum in terms of ‘uncoiling’ which happens faster than the period of boom. All these events culminated into the investments banks Goldman Sachs and Morgan Stanley converting themselves to traditional banks. Many a banks which faced acute shortage of cash approached the SWF (Sovereign Wealth Funds) for funding purposes due to the freeze of interbank lending. Then came the high profile collapse of the financial world ‘accelerated’ by Lehman Brothers. There was an utter loss of trust and cash was considered the king. The trust is yet to be replaced. As months passed more and more bad news emerged and major banks declared record losses. AIG was bailed out, Lehman Brothers collapsed. Central banks came to the rescue by cutting interest rates and infusing capital into banks and guaranteeing customer deposits. Interbank lending stopped and banks struggled to keep up their obligations.
Effects on GDP
*IMF forecasts the GDP growth rate to be 3% on an average around the world.
*Worst hit economies are western developed economies.
*BRIC may achieve 6.1% growth rate.
Suresh also spoke on the business cycle of boom and bust along with recession and depression.
Looking ahead
What is in store for a common man in these times of crisis? Mr. Suresh gave few points on this question.
1) Interbank and lending interest rates will be high.
2) Leading economic indicators will be weak.
3) Public and private valuations now seem attractive with uncertainty looming over the outlook.
4) Businesses will need to re-adjust, control costs and explore M&A to grow.
SESSION II-SANJAY UPPAL
Sanjay, started off his session with the ‘lesson from history’ through a quote from Thomas Jefferson.
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I believe that banking institutions are more dangerous to our liberties than standing army. If the American people ever allow the private banks to control the issue of the currency, first by inflation, then by deflation, the bank and operations would grow up around the bank; will deprive the people of all the properties, until their children wake up homeless on the continent their fathers come from."
He said that the excess wealth was under major stress as the price of oil was lower. But a stronger US dollar would help offset reduced surpluses. Global banking assets bubble was imminent to burst but how loud would it burst would be the question of the hour. The policies of Allen Greenspan led ultimately to the subprime crisis which in turn had a domino effect on the financial sector and every other sector. There would be challenges in raising capital; lower Fed rate has not resulted in the lower cost of borrowing. The excesses would be long and fateful. The challenges faced at the moment are systemic, he said.
Sanjay shed light on the previous recent crises that have occurred and how long did these take to recover from the crisis. Black Monday for example took 2 years to recover and the longest was the 9/11 aftermath effect which took nearly 19 quarters to recover starting from 2001 up to 2005.
At the moment all the eyes are on the US. Since US is the biggest consumer in the world any negativity would have a bad repercussion on the other countries of the world. Humorously putting, if US sneezes, the whole world catches cold. Sanjay said, the US is under recession. US accounts for 25% of the world’s economy.73% of the US GDP is concentrated in consumer spending. If the spending of the consumers reduces even by 5%, the world GDP would contract by 3-4%. This implies that the US is important. The recession could spread to other economies. UK for example is already under recession which would put a heightened pressure on other economies.
We are, as mentioned by Sanjay in the ‘new era of transforming.’ There are multiple challenges that have to be faced by us. Common among them are housing led recession, falling asset prices, frozen credit markets, weak household balance sheet and forces of inflation and deflation are looming over our heads. He mentioned that low deflation would be more dangerous since it resets the entire economy to a lower level. And the recovery is harder. The governments in GCC are pumping money into the economy to keep the wheels of the economy running. Advertising revenues for start, are under stress, retail commerce is deteriorating, mobile markets are under stress. As per Sanjay, the resulting recovery or unwinding will be long term and might take 2011-12 to recover.
KEY THEMES
The key themes that we need to derive from the underlying crisis are that the crisis is global, this is not a normal crisis, the crisis is credit driven and not equity driven, there is significant risk to GDP growth and there is a potential for greater regulatory reforms and scrutiny.
As far as UAE is concerned, the trend will be above trend and will slowdown in 2009, there will be potential negative impact of oil price weakness, inflation pressures will ease off which is good for the population and so on.
Looking forward
There will be changes in the financial environment, Mr. Sanjay said. There are multiple increased challenges as M&A will decrease, prices will decrease, IPOs will continue to decrease and will take longer.
Sanjay mentioned that the extraordinary times call for extraordinary solutions. The attention is focused on Survival by preserving capital rather than grabbing market share.
Different businesses would be required to re-visit their fundamentals. For example for a sales and business development business will have to look at getting returns on the expenses incurred etc. The market condition would force the business to redefine their business models and this will lead to the ‘survival of the quickest.’ By redefining it is meant that the businesses would need to manage what they can control, their spending, growth assumptions, earning assumption, focus on quality, reduction in debt etc.
As Sanjay put, the year 2009 is the year of Risk and Mitigation for the businesses. What decision do you plan to make, what decisions you wish you had made, etc are the key questions that need to be addressed.
CONCLUSION
As conclusion Sanjay mentioned that there needs to be a situation analysis, adapt quickly to the new environment, use a zero based budget, review cost, employ a heavily commissioned sales structure, bolster the balance sheet, become cash flow positive as soon as possible, spend every Dirham as if that were your last.
Ivan Fernandes was the MC for the session and Michael proposed vote of thanks. Albert presented mementoes to the speakers on behalf of KEL.