Sub-prime lending now, private equity next?

Sub-prime mortgage troubles in the US are reverberating in stock markets across the world. The emerging markets have seen a flight of the Foreign Institutional Investors (FII) in the past two weeks, and our own BSE Sensex fell over 600 points yesterday, closing below 15000. What is even more worrisome is that the worst may be yet to come!

The issue under scrutiny, sub-prime mortgage loans, were given on the increased value of houses, during the recent real estate bubble in the US and elsewhere, and to those with bad credit histories. With the real estate market booming and interest rates at all time low, the American banks went on a lending spree in the first half of the decade. But now, with the real estate bubble having burst and interest rates on their way up, sub-prime mortgage loans are starting to show up, as borrowers start defaulting and the value of collaterals start falling alarmingly.

The last two decades have seen inflation (we even had theories proclaiming "the end of inflation"!) and bond yields remaining at low levels, leading to historically low interest rates across the globe. Low interest rates have impacted the saving and spending behaviours of both consumers and companies in many ways. Companies have massively leveraged their balance sheets for takeovers and inorganic growth. Many public listed companies have borrowed heavily for buying back their own shares, so as to boost their earnings per share. Consumers have been borrowing and spending merrily, in one of the biggest consumption booms ever. They have also been borrowing heavily to purchase houses, thereby generating a real estate boom. Thanks to all these, personal borrowings have long since crossed sustainable levels.

Low interest rates, which made borrowing for purchasing houses easier and also the spectacular growth in mortgage loan lending, fuelled the real estate bubble. This bubble in turn generated a positive income effect, which first lifted to the consumption boom in the US to a new trajectory and then sustained it. The wealth effect and the resultant consumption boom in the US, coupled with robust economic growth in China and India led emerging economies, resulted in sharp rises in commodity prices, with prices of metals like copper reaching historic highs. Further, global stock markets, especially in the emerging economies, breached their highest levels.

The period also saw the emergence of private equity firms as major players in the global financial markets, with far reaching consequences. From less than $10 bn in 1991, private equity funds have gone on to raise more $459 bn in 2006, and is expected to raise more than $500 bn this year. In fact, private equity fund's share of global Mergers and Acquisitions (M&As) has grown from 2% in 1998 and just 4% in 2001, to over 25% in 2006. More than a third of the S1 trillion in M&A activity in 2007 has been funded by private equity.

The massive private equity led M&As and Leveraged Buyout (LBO) boom in the US and Europe has been driven mainly by the prevailing low interest rate regime and the massive growth of the credit markets and credit instruments. With global interest rates at historically low levels, banks have gone overboard in lending to these private equity firms. They have also borrowed money heavily from the capital market, and purchased under valued companies or have taken a large number of public companies private. The credit markets have given these banks and other lenders the ideal platform for transferring credit risks from their balance sheet, thereby enhancing liquidity. The low rates have also meant that investors, especially the high net worth ones, are forced to lookout for more remunerative investment options. This hunger for more attractive alternate investment options has in turn spawned the development of many exotic financial instruments.

The corporate sector too has not stayed away from the party, and have been running up unprecedented profits for the past five years. In fact, but for the rising surpluses of corporate America, the American current account deficit would have been even worse. This is the dividend from the massive capital investment, especially in technology, by American corporate sector in the nineties and the corporate restructuring in the aftermath of the late nineties tech bubble. As part of the restructuring there were massive layoffs and outsourcing of activities, and companies hived off unprofitable segments of their business.

But unfortunately, while corporate profits have soared in the first decade of the new millennium, it has not been accompanied by proportionate increase in capital investment. Instead of using the low interest rates and the rising surpluses to make capital investments for future growth, the US corporates have been living off the excess capacity generated during the tech boom of nineties. Taking advantage of low interest rates, the private sector has borrowed heavily and also used a substantial portion of their profits, to buy back shares and invest in M&As and takeovers, which in turn have contributed to further rise in share values. This means that the private sector, especially in the US, is badly positioned to face any climb down from the peak of the business cycle.

All this good news from the global financial markets generated a virtuous cycle, that lifted the business cycle into its peak. In fact, in many ways this business cycle can be interpreted as the climax of a process that saw the emergence of financial markets as the critical determinant in the fortunes of the global economy. It is also the ultimate evidence of the fact that the manufacturing sector has eclipsed the financial sector in the pecking order.

Now dark clouds have started gathering on the horizon. The business cycle appears to have passed its peak and corporate profits in the US are already showing signs of slackening. The real estate bubble has burst and the sub-prime mortgage lending market has started unravelling and is beginning to show its effects on the global financial markets. If inflation concerns and the weak dollar pushes up the interest rates further, it could spark off massive mortgage defaults and could hit the financial markets even more.

It could also affect the over-leveraged private equity firms and hedge funds, and the banks who have lent them, thereby setting off ripples in the global financial markets. The over-leveraged takeovers and mergers by private equity firms and others, once hailed as testimony to the genius of modern financial engineering, could start looking silly and foolish. Stephen Schwarzman could become the Michael Miliken of our era! This could have a 'contagion' effect on the financial sector, especially the banks which have financed this boom and also purchased risky credit instruments like Collateralised Debt Obligations. Witness the recent collapse of funds floated by investment banking major Bear Stearns. (as somebody famously said, "If I borrow Rs 1000, I have a problem. But if I borrow Rs 1 million, the bank has a problem!")

The investor and consumer expectations are also not encouraging. Interest rates are expected to go up, as the inflation pressures become stronger. Anticipating this, the bond markets have already fallen sharply, raising yields and the cost of borrowing. The rising interest rates and the consequent higher interest repayments, coupled with the lower real estate asset values, will definitely slacken the capital gains based consumption growth in the US, as the reverse of income effect begins to exert itself. The high interest rates could squeeze the much needed investment in manufacturing sector where capacity utilization is at its peak. Finally economic growth will be affected with the prospects of a recession, which in turn could drag the global economy down.

Therefore the sub-prime bubble may only be the tip of the iceberg. The private equity and the general mortgage lending bubbles could also be on the way to getting deflated. The multiple effects of weakening dollar, rising current account deficit, rising bond yields (or increasing spreads), will increase the pressure on interest rates. The cheap debt that fuelled the LBO and M&A boom will be more difficult to come. Already there are enough signs of investors shunning corporate debt market, and this could seriously affect investment.

Given that the massive investments by private equity firms and debt financed share buy backs by corporates, have played significant role in propping up share prices, the equity markets will also get adversely affected. With higher interest rates and collapse of the housing market, home equity borrowing, a major source of funding for domestic consumption, could fall sharply and even collapse. In any case, we are looking at interesting and tumultuous times ahead!