comparing STI with Dow and Shanghai index over 6 & 3 months - Wall Street psychology has fundamentally shifted to pessimistic; note that because of dropping US$, in terms of S$ Dow is flat over the past year, China was slowly falling from 2000 to 2005, had a huge rise, then collapsed; HK almost so till the last few months when the actual and anticipated inflow of mainland money gave it a burst, but that went bust too.

Boil Bubble Toil Trouble

Since November 2006, when the Republicans lost both houses of congress, I had been expecting a US recession, because I thought asset prices, both real estate and shares, had reached unsustainable levels and were kept up by hot air optimism which the less business friendly attitude of the new congress would start to prick. I was wrong of course, and Wall Street share prices continued to rise, setting one historical record after another, while house prices only dropped by a negligle percentage overall, though I was right in one sense: the US $ dropped, and in most currencies US share prices were basically flat for the past year while houses became significantly cheaper (though still much higher than 10 years ago). However, I believe the hot air optimism is about to crack, and as the delayed cracking has allowed the bubble to blow even bigger, the recession will not be a mild one.

In this article I try to trace the course of the bubble, which has its origin in the lenient monetory policies of the Greenspan era - given the almost God-like status he had acquired, this might sound jarring to many ears, but history is cruel. In many ways, Greenspan was the victim of unfamiliar and unexpected circumstances which are only beginning to be comprehensible.

1. black monday

On 19 October 1987 the Dow Jones Industrial Index suddenly dropped 22.6%. There was no specific event or bad news that could be held responsible for this sudden panic. For the earlier part of the year the index had risen from the 1800s to 2700, a historic high, from which it had retreated somewhat, supposedly a healthy correction. Yet, this mild correction triggered a large scale selling on that particular day, because a number of investment funds used similar computer programs that said "this looks a good time to take profit".

But the matter goes further; Alan Greenspan had recently been appointed Chairman of the US central bank or Federal Reserve Board, and the investment community was still learning to read his mind and interpret his words; this slight uncertainty about forthcoming monetory policies had a curiously large impact, heightening the tendency to play safe and take profit when prices are still high. For the next 18 years Greenspan's words, even his demeanour and facial expressions as he spoke to reporters, gave speeches at meetings or testified before Congressional committees, became the single most watched, market moving phenomenon.

In physics, a stable system resists forces that attempt to push it out of equilibrium, whereas an unstable system would respond drastically to a small impetus. For one man's minor gesture to have such a big impact on a system, the system, in physics terms, is unstable. Financial and social systems are of course not so easily characterized, but the phenomenon does reflect a certain underlying dynamic in today's densely linked financial system: we are part of a complex chain of activities that can magnifiy a small impetus and produce major consequences.

To take an example, one reason for the latest rise in Wall Street was a series of buyouts by private equity funds, which collect subscriptions from wealthy investors. When a fund pays premium prices to take a company private, the previous shareholders have a windfall. What do they do with their money? A lot of it goes into other private equity funds, which go and buy out some other companies, whose shareholders... In other words, the same amount money circulates many times and the impact of the initial fund input is magnified. Similarly, companies have been buying back their stocks, sometimes by borrowing from banks; cashed out shareholders then put their money into new investments.

To take another example, some Indonedian and Mainland China investors buy some luxury condos in Singapore, causing a rise in the valuation of all properties in the same category, since valuation numbers are based upon recent transactions of similar properties. This allows future buyers of such properties to take out larger loans, since these are tied to valuations; hence, there is an increase in the amount of money circulating in the real estate market, since previous owners and property companies that sold the condos inject the cash into other projects.A number of previous owners and speculators who have made a good profit would go to buy properties in cheaper areas, causing prices to rise there too, and ...

These are not new phenemena, but two things are different these days; first, information flows electronically, much faster now, and events jump from one to another in the chain faster; second, various new financial products have been formulated that allow previously unknown chains to be formed. For example, banks offer unit trusts, which are a form of fixed term deposit, but instead calculating payback according to principle + interest, the payout formulae are based on some financial indexes or shares/bonds/commodities/etc packages. Since the bank has to make a larger payout if the so used index rises, it has to invest part of the deposit in some products that would provide the rise, and use the remainder in other ways. Thus, a bank customer buying a unit trust produces a chain of financial events, different from the previously known chain of bank deposits being lent out as bank loans. These new chains have different speed and complexity from the older chains.

In particular, the US housing situation was partly caused by such new chains. Most house buyers would go to a mortgage broker, who earns a fee of a few thousand dollars for each successful mortgage applications and has a strong incentive to ensure success, without risking his own money. The mortgage companies and banks do take a risk, but they pass the risk to others by turning a package of mortagages into a financial product held by a investment fund, which passes on the risk to its subscribers. In other words, almost everyone involved in the chain is risking someone else's money, while the final risk taking subscriber is so far removed from the original mortgage application that he has no means to judge whether the risk is worth taking or not. Instead, the investment funds and subscribers rely on credit valuation agencies to apply classification formulae on the funds and mortgage packages. Like real estate prices, the valuation and perceived risk level of any asset is based on similar assets that were recently traded. Hence, a previous unclassified product would get classified to be as good (or as bad) as others similar to it. A cynical way to look at it is "some fool paid X for something like this, so if you also pay X, you are no greater fool than he".

For the past decade, everything looked rosy in the US housing industry; interest rates were low and funding was easy to get. Banks offered mortgages with attractive initial interest rates, and assessed borrowers' abilility to service loans using formulae based on the initial discounted rates instead of the future long term rates, ignoring the risk that when rates rise the borrowers may be financially strained. With generous availability of finance, even people with weak credit histories and modest incomes became qualified to take out mortgages, though at higher rates (called the sub-prime mortgages - which was where the crisis started from). As more people could afford to buy houses, general prices rose, so that if anyone did turn out to be unable to maintain payment, he could simply sell the house and pay back the mortgage, and still made a profit (which he could use to buy another house). The various parts of the chain reinforce each other, thus making it easy to produce a bubble (or to put it another way, an elaborately linked system like this is unstable because any weakening of one link could spread to the whole system)

This happy chain is of course maintained only if interest rates stayed low. For much of the Greenspan era, rates were low, for some period very low. Let us trace back the events that caused this.

2. Neither borrower nor lender be:

After Black Monday the Fed calmed the market by making it clear that a liquidity squeeze was to be avoided at all cost, and the crash was contained. Economic growth was, however, anemic for the remaining Reagan year and throughout the reign of George Bush Senior, though USA avoided the sudden economic collapse that took hold in Asia in 1997, a crisis infecting even the previously invincible Japanese economy (from which it has not quite recovered even now).

It was in Bill Clinton's second term that the boom began to take hold. This was also the period when dotcom companies began to show an impact. Venture capital funds pumped huge sums of money into all sorts of dotcoms, however dubious their business plans. While Greenspan made occasional mild remarks about "irrational exuberance", interest rates were slow to be raised. Partly, there was fear of prematurely choking off the late-coming economic boom and exciting new technology developments, and partly there was the Millenium Bug paranoia on everyone's mind. The prevailing nervousness about the possibility of something nasty occuring after the last day of 1999 made it hard to add to it by quick rises of interest rates, even though the NASDAQ index was appreciating incredibly. Almost as soon as interest rates finally began to rise in early 2000, dotcoms crashed. We can only speculate that if funds were not so easily available in the previous few years, the bubble would not have grown as large and the bursting would have been less painful.

Though the pain level in Silicon Valley was high in 2000, by 2001 people were beginning to agree that a weeding out of all those unrealistic ventures was not such a bad thing, and life would soon be bright again. However, in September the World Trade Center received its terrorist attack and chaos reigned in New York City and in the air transport system. All the major airlines were on the verge of bankrupcy. Again, a year later things were getting back to normal, but the collapse of Enron struck a new blow, and a few months later a weird, highly infectious and deadly version of the common cold spread from China to Hongkong to Canada and Singapore, once again throwing things into chaos after the region had just begun to recover from 1997 and later blows.

In short, for nearly 15 years of his chairmanship, Greenspan faced one crisis after another, each deterring the desire to tighten monetory policies that might have existed. In any case, the desire was not a strong one, the reason being that consumer price index was rising very slowly, because America began to import huge amounts of consumer goods from China at dirt cheap prices, with Walmart's growth to be the world's largest company tied at least partly to this.

It was, however, misleading to say that inflation was low throughout the period, because house prices were rising rapidly in the last few years. Adding to the rise in share prices, there was clearly asset inflation present.

We see that, a unique set of events caused a prolonged period of easy money supply, pumping the whole world full of liquidity, some circulating rapidly within the US system itself, others following various paths around the world, including in particular China. For a while at least, everyone seems to be benefitting, and old fashioned reservations and cautions seem to be inapplicable in this brave new world. However, the old world is about to reassert itself.

Like Greenspan, Bernanke initially had a hard time establishing a smooth commucation mode with the financial and journalistic world, and a few simple words about "determination to control inflation" at dinner with a reporter panicked the market the next day. Bitten once, he was many times shy. As the housing crisis loomed, he continued to make soothing remarks about things not getting much worse and not for very long, while "firm about controlling inflation" was repeated but regarded as mere officialese. But these bandaids are beginning to look irrelevant, and while financial system sputters get louder, Bernanke adjusted his level of upbeatness downward though always a little higher than the situation warranted.

3. How things look in Singapore

Singapore has had its share of bubbles. Chartered Semiconductors, for example, once traded at nearly $30 a share, while the mid 90s property bubble was wide reaching, spreading from the central area to both east coast and bukit timah/hillview, even bishan HDB units, though the price increases did not reach the level of the recent orchard/sentosa condos. When prices tumbled, after 1995's government tax measures to cool down the market, followed by the 1997 regional crisis and later events, a large number of people were put into negative asset situations. Those who also lost their jobs and could not keep up loan repayments got into dire straits, since many couple required the CPF contributions and additional cash contributions from both spouses to meet the mortgage repayments, so that the loss of one job had serious consequences. Those who held onto their jobs were in a state of paralysis.

These lessons are still fresh in people's minds, and it only takes a few small raps on the knuckle from the government signalling its concern to start a significant cooling off. The psychology has to turn. We already heard news that the government has raised charges for increasing the usage of residential land, causing listed property counters to tumble that day (though settling down next day) and I believe this is only the start of a set of measures to cool down the property market, both to prevent rents and other business costs going too high thus deterring investors, and to stop the formation of too big a bubble whose bursting could start a recession.

Some carryover effect from the coming US recession is inevitable, but China could provide a compensating factor as it increases domestic consumption and exports tourists and students.

previous content may be found at http://blog.360.yahoo.com/singaporeshares/

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