Chart Fun | The Ponzi Gambit
Financial bubbles lie hidden in our heads.
Until some catalyst —a new-new thing—ignites dormant tendencies; pushing us to indulge in a speculative orgy.
The story of affable swindler Charles Ponzi, of Ponzi Scheme fame, is illustrative of bubbles; and human behaviour.
The sharp eyed Ponzi identified an arbitrage opportunity in postal reply stamps sold in America and Europe. The values of these stamps were at fixed exchange rates between America and Europe. Post World War I, inflation ravaged currency values of European nations. When European currencies swooned relative to the US dollar, Ponzi hit upon the idea of buying stamps in Europe and reselling them in the USA. At a markup, of course.
Ponzi touted net returns in excess of 400%. To raise the initial sum required to initiate the arbitrage, Ponzi floated a joint stock company — the Securities Exchange Company — to raise capital. In the roaring ‘20s, enthusiasm was in abundance, and Ponzi soon managed to entice a large investor base.
There was, however, a tiny problem. The total value of available stamps was $1 million. Ponzi’s entreaties lured over 40,000 excited ‘investors’, who sent $15 million, wanting a piece of the opportunity.
No one paused to question the absurdity of downing $15 million for a profit pool of $1 million.
Long before such trivialities pricked the bubble, Ponzi kept the cult going by paying old investors with money raised from new believers. Many mortgaged their homes and reinvested past profits into the scheme. The old and the new returned with gusto.
…and became beta testers for The Ponzi Scheme.
The treadmill of pyramiding came to a stop eventually. Leaving a long line of the hopeful with little hope of ever seeing their money.
Everyone blamed Ponzi.
No one could face up to the prospect that the bubble was, perhaps, all in their heads.
The decade since Lehman
Ten years ago in September, Lehman Brothers collapsed, setting off a global economic and financial markets contagion.
Lehman’s collapse brought to the fore the high degree of linkages in global markets. The primary lubricant of economies — credit flow — froze in the immediate aftermath, and financial markets wilted the world over.
As the full effects of the contagion became apparent, central banks launched into coordinated monetary easing that dampened the impact of the financial crisis.
US banks, the epicentre of the crisis, are far larger today by market value compared to a decade ago. US banks have also grown larger than European counterparts. Commercial banks have led this growth in size at the expense of investment banks.
Banking is alive and well. Very likely, always will be. Boring, and too-big-to-fail, have been rewarded.
The lure of leverage
Pre-Lehman era was characterised by high financial leverage, both in the US and Europe.
A 30x leverage implies that a little over 3% fall in asset values would suffice to wipe out the equity base. Europe, relatively, was the more leveraged geography leading up to the Lehman collapse. At the peak of euphoria (2007/08), some European financials carried over 40x leverage. When the tide turned, these institutions were hit badly.
Leverage has fallen in the post-Lehman era to ~10x in US and under 20x in Europe. Regulatory requirements mandating greater capital buffers have pushed down leverage levels.
What’s changed since Lehman?
Financials have two ways to achieve a target Return on Equity:
1) Assemble a pool of assets that deliver a hurdle rate return (return on assets).
2) Juice up (1) with as much leverage as permissible (use as little equity capital as allowed by regulation, or as determined by the financials’ nature of operations).
When assets offering high rates of return are readily available, low levels of leverage is enough to deliver a reasonable return on equity. This usually attracts competition that drives down the high rates of return. More leverage is then needed to maintain/grow return on equity.
The crisis changed equations considerably.
Increased regulatory oversight post-Lehman has coincided with an era of historically low interest rates. Europe has witnessed negative interest rates. Falling interest rates have pushed down return on assets. Leverage has fallen. Delivering a double whammy on return on equity.
Responding to changed realities, financials’ valuations have dropped dramatically since the crisis.
Indian financials
India sidestepped the worst of the financial crisis by virtue of being fairly insulated from contagion effects. Indian financials have exhibited higher correlation to the domestic environment.
Ground zero in the domestic bad loan crisis — public sector banks — have historically carried high leverage levels; on absolute basis and relative to private banks. Indian public banks resemble European counterparts on leverage.
Banks have historically enjoyed high regulator-imposed entry barriers. Competitive intensity has gradually increased over the past two decades. Non-bank financials (NBFC), with lower entry barriers have become a major financial force in recent years.
A Two Decade History
After bottoming at the turn of the century, Indian financials enjoyed a stellar run fuelled by the global liquidity glut. This run peaked with the Lehman collapse. Industry valuations topped in 2008, then declined in the aftermath, in line with global financials.
Beset by legacy bad debt issues, public banks have had a woeful run over the past few years. High leverage and coordinated defaults have wiped out some public banks’ equity capital bases. This has necessitated capital infusions, and has resulted in public banks ceding ground to private banks and NBFCs.
IL&FS’ Lehman moment. The valuation conundrum
A large financial institution, IL&FS, defaulted on certain debt obligations recently. This set off a bout of financial contagion, much like Lehman ten years ago. The default by a AAA-rated institution has triggered risk aversion that has manifested in sharply lower equity prices; increased credit risk perception towards financials in general, and NBFCs in particular. Valuations have eased across the board.
Equity investors in Indian financials have been happy to pay for growth. Underlying profitability has been trending lower across the sector over the years. Lower profitability and lower return on equity ought to manifest in lower valuations. However, the opposite is true for private banks and NBFCs currently. Both pockets currently enjoy historically high valuations for average operating health.
The Ponzi Gambit
In the immediate aftermath of Lehman, no one predicted the rise of the central banks as the primary force in finance. The Lehman episode demonstrated that the greatest edge financials can have is to grow large enough to become too-big-to-fail.
The post-Lehman response mechanism has nudged economies and markets to implicitly assume the omnipresence of the Ponzi Gambit: new capital infusions as a reactionary/preemptive response to crises.
Long Ponzi Gambit plays are rational in this changed world.
Paradoxically, markets may stutter if belief in the Ponzi Gambit were to falter!
What are the things that no one is talking about?
