Friday, September 26, 2008

The Crash of Titans: Making Sense of a Financial Carnage

The current crisis in the international financial markets reminds me of a quiet sunny morning in December 2004. We were driving down NH-47 in Kerala and, as we neared Kollam, there seemed to be anxious people crowding everywhere - ambulances and police jeeps wailed to and fro; vehicles going with their headlights on in broad daylight. When we stopped to ask what happened, somebody simply said, "കടല്‍ കയറി" (the sea climbed out).

It seemed such a strange reason because we could still see the sea glinting in the evening sunshine, looking as peaceful as ever. Only when we reached home and turned on the TV did we realize the magnitude of the disaster. This was a Tsunami, a monster that sprang out of an earthquake 4000 km away, off the coast of Sumatra, Indonesia. It had killed about 20,000 people in India alone.

The recent disasters on Wall Street may not kill so many people directly but its impact is just as catastrophic. America's fourth largest investment bank, Lehman Brothers, has filed the biggest bankruptcy petition known to mankind. Just how big? - $ 613 billion. - more than three times the current annual budget of Government of India. About 30,000 people are expected to lose their jobs globally (at least 2,500 in India).

World largest insurer American International Groups (AIG) is going hat in hand to US Fed., JP Morgan and Goldman Sachs, for a $85 billion lifeline. Meryl Lynch has been bailed out by Bank of America.

Things may look sunny & peaceful in India but that is perhaps because Indian firms have not disclosed client-specific details.

How will this drama unfold? Prof. Prof. Martin Feldstein of Harvard University, puts it this way -
"Declining house prices are key to the financial crisis and outlook for the economy, because mortgage-backed securities, and the derivatives based on them, are the primary assets that are weakening financial institutions. Until those prices stabilize, these securities cannot be valued with any confidence."
Now that's quite a mouthful. Its easier to chew if you take the key words separately -

Mortgage-Backed Securities

This is the crux of the problem. Thanks to cheap credit and inflated expectations, millions of not-so-credit-worthy Americans were able to buy their own houses during the early 1990's. Banks gave them home-loans (mortgages) at special discounted rates (Sub-Prime Lending). These were "no recourse" loans, so if the home-owner defaulted the creditors could take the house but not other property or income to make up any unpaid balance.

When the home-owners started defaulting on their installment (EMI) payments, the banks had already packaged and "sold" their loan portfolio as bonds & derivatives to institutions that were ultimately owned by financial giants like LehmanBros.

People who could not pay their EMI's simply abandoned neighborhoods and cities. In Monero Valley, 60 km east of Los Angeles, about 2 million people have moved away.

Derivatives & Principal Transactions

Traditionally, financial firms were advisers and intermediaries to institutional investors (insurance cos., pension funds, mutual funds) but, over the years, they themselves got involved in "Principal Transactions" - using partners' or shareholders' money to bet on stocks, bonds and other securities.

LehmanBros' own shareholder investment was only $23 billion (2007) but it relied heavily on borrowed money ("leverage") worth almost $700 billion! So the leverage ratio here was 30 to 1 ($700/$23). Fannie May and Freddie mac, America's biggest mortgage lenders had a leverage ratio of 60 to 1!

Robert Samuelson explains the game nicely in Newsweek -

"Leverage can create huge windfalls. Suppose you buy a stock for $100. It goes to $110. You made 10 per cent, a decent return. Now suppose you borrowed $90 of the $100. If the price rises to $101, you've made 10 per cent on your $10 investment, (Technically, the price has to exceed $101 slightly to cover interest payments.). If it goes to $110, you've doubled your money. Wow."

So, in this maze of dubious bonds and baseless derivatives, nobody really knows who is holding the lemons. Thanks to this uncertainty and broken trust, few want to lend, and fewer are willing to borrow. House prices have crashed, reducing household wealth and consumer spending. Employment and salaries have come down; higher prices of food and energy have worsened matters.

American institutions are trying to prevent a complete paralysis by injecting the patient with billions worth of tax rebates and bail outs. Will it work? Everybody is watching very carefully.


References / Links:

* The Economist - "The end of the dream?" Aug 14th 2008 MORENO VALLEY
* "Bubble, bubble, toil and trouble" - Martin Feldstein, Professor of Economics at Harvard University
* "Risky Business" - Robert L. Samuelson, Newsweek
* Wall Street transforms U.S. presidential race - P. Sainath, The Hindu, Monday, Sep 29, 2008
* What else could $700 billion buy? - Nancy Benac, AP / Star News Online Sep. 30, 2008


Addendum, 15 Jul., 2010

Here is another illustration of Derivatives Game from the book "The Dignity of a Nation" by the Japanese mathematician, Fujiwara Masahiko:

Originally derivates acted as a risk hedge. they were a means of avoiding the risk associated with things like product prices, interest rates, and exchange rates, whose future movements were unclear. Recently, however, derivatives have started to be used for speculative purposes.

Let us say, for example, that Mr. A thinks that the stock of Company B, currently worth 1,000 yen, will be higher in three months time. Mr. A only pocesses cash resources of 3 million yen, but by making use of derivatives, he just needs to put down that 3 million yen as margin money and he can buy the right to acquire 100,000 shares of B company at the current 1,000 yen price in three months time. With a margin payment of a measly 3 million yen, Mr. A has thus bought the right to purchase 100 million yen's worth of shares.

Let us say that the shares rose as Mr. A anticipated and hit 1,500 yen. A has the right to buy 150 million yen's worth of shares for 100 million, he has made a profit of 50 million minus 3 million yen. If the share price goes down and Mr. A does not exercise his right, he gets off with a loss of his margin deposit of 3 million yen.

Conversely, let us imagine taht Mr. A thinks that the shares of Company B will fall in value. In this instance, Mr. A can use the same margin payment of 3 million to sell the right to purchase 100,000 shares (worth 100 million yen) at the same 1,000 yen price as now in three months time. But the seller, in return for getting the margin payment of 3 million yen, cannot run away from the deal. If the share falls as Mr. A anticipates, the buyer will abandon his right with the result that Mr. A pockets the 3 million yen as profit. If, however, the share price rises from 1,000 to 1,500 yen, the privious scenario is reversed. Mr. A has to procure shares at the current value of 150 million yen and sell them at the agreed price of 100  million yen, making a loss of 50 million yen minus 3 million yen.

...With derivatives, what you are buying and selling is a right. Since this creates no immediate profit or loss, derivatives are not recorded on the balance sheet, with the result that large-size companies can go unexopectedly bankrupt.

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