It's the Speculation, Stupid

Two weeks ago Eran received some bad news from the bank. The securities consultant at his branch phoned him up: "Eran, listen," she said. "We seem to have made a mistake."

When your banker says "we" - you have an inkling who made the mistake, and who will pay for it.

A few weeks before, the adviser had suggested that Eran diversify: instead of dully squatting in deposits or savings accounts, she thought he might taste the hottest dish in town. She sold him units in mutual funds specializing in emerging markets.

On the morning she called to discuss "their" mistake, he had already lost 10% of the money he'd placed in these new funds.

What comes easy, goes easy, they say. Seasoned capital market animals know that's twaddle. The truth is that what comes with enormous effort over time goes easy.

The experts, aka the people who make mistakes with other people's money, now say there is no real reason behind the emerging markets' tumble in the last month. The economies of India, Russia and China continue to grow at impressive rates, so there is no reason for the crash, they say.

But it is not the economy, stupid, it's speculation.

A slope like the Pyramids

The economies of the emerging markets in Asia, eastern Europe and South America did present eye-popping growth in recent years. But the rub is, the increase in their stock markets had been even steeper.

It would be interesting to know how many investors - or advisers - realized just how much these stock markets had risen in the last three years.

Egypt? 1,000. Turkey? 500%. Peru? 600%. Brazil? 800%, and Colombian stocks had galloped north by a full 900%.

Now investors are asking themselves whether a 10% to 50% drop in the stock markets of emerging markets, and the 10% slide in the developing markets, is the harbinger of a horrible recession to come, and the first growl of an approaching but protracted bear market.

Paul Samuelson, one of the great economists in the last century, once quipped that the American stock exchange anticipated nine out of the five latest recessions. Too often, economists try to explain fluctuations that are financial in nature through significant real change.

The driver behind the enormous leap in those markets was not only their promising economies, but the tremendous surplus liquidity that the central banks of the U.S. and Japan poured into these markets in recent years. Much too much money was sent chasing after much too few stocks.

At the forefront were the hedge funds, an industry that mushroomed at warp speed in recent years. The fund managers borrowed cheap money and, starved for returns, hared around the world trolling for markets rising fast.

Now the speculators are blaming the foreign central banks, mainly Japan's, for the crash. Interest rates began to rise, the hunger of the hedge funds and the other leveraged investors on the market for risks and gambles financed by borrowing began to wane - and the markets imploded.

Just ask Eliezer

Just ask Eliezer Fishman, one of Israel's greatest investors, a financier who has been involved in one way or another in every crash there's been.

Over the last three years, Fishman had gradually begun to recover from the crisis his business stumbled into, after enormous leveraged gambles in telecommunications during the boom years.

Then came 2005, and Fishman decided (again) that he was smarter than the markets. He entered a leveraged position greater than NIS 10 billion on the Turkish lira, which was offering investors interest greater than 17%.

Interest like that in an economy bearing a gigantic deficit in its balance of payments usually signals high risk too. But Fishman, like many an investor in the emerging markets, was blinded by the momentum of the market, and figured he'd have the nous to get out in time.

And then the Turkish lira collapsed.

Within two weeks most of the wealth Fishman had accrued over two decades had been wiped out. One gigantic gamble crushed his hard work in streamlining the companies in his giant concern. What came hard with tremendous effort, went inside a month.

The banks had started to become more comfortable with their exposure to the tycoon. Suddenly there they were, sweating yet again about how Fishman, one of the great borrowers in the annals of Israeli business, could return the money.

Why did Fishman fall? George Soros has an idea. Last week he was asked to explain the Turkish implosion: "Excessive risk appetite," he summed it up.

Like Fishman, the Israeli investor seems unable to pass a crash without participating. Three months before the great crash of the emerging markets, a fad erupted of mutual funds investing in the likes of China, Turkey and India. No less than NIS 5 billion went into these funds; Since then NIS 3 billion have fled and en route, investors lost 10% to 20% of their money.

Sweet dreams

But unlike other financial upheavals in the Israeli capital market, this time the collapse of the trendoid mutuals, and even Fishman's, shouldn't cost the bankers any sleep.

Until five years ago, Israel's investors, business and private, confined their activity to the local puddle. Everybody would jump in together, and flee together, too.

In 1993, when the People of Israel bought into mutual funds using money borrowed from banks and the market collapsed, everybody fled in synchronized step. Share prices plunged by 40% to 60% and some turned into poison: like it or not, you couldn't sell. Nobody would touch them with a barge-pole.

In 2001, when the economy entered what turned out to be a 2-year recession, the big borrowers were forced to rely on Israel's three-and-a-quarter big banks. The banking system's scope of problem debt was greater than its shareholders' equity. With their backs to the wall, the banks had to cut credit to good and bad borrowers alike.

Now it's 2006 and Israel's capital market is far more diversified, broad, liquid - and mainly, global. Foreign investors own a hefty proportion of the Tel Aviv stocks and Israeli investors own a hefty and growing proportion of foreign stocks in their portfolios. Some major borrowers tap the capital market instead of the banks and the danger of a credit crunch has very much ebbed.

Eliezer Fishman is not imperiling the banks and investors in the mutual funds investing in emerging markets are not threatening the Israeli capital market. Fishman learned his lesson, and Eran and tens of thousands of investors in the offbeat funds did too. Until the next time, of course.