Thursday, November 27, 2008

The Global Financial Crisis: Part 3 - A Guide to Self Preservation

(Published in DNA Navi Mumbai - 27/11/2008)

There are some inescapable ironies in the way the above drama has played out and in what is still happening out there in the markets. 

Contrary to what happens in all stories, the bad guys have not been punished.  They are being “bailed out”.  The rationale is that they are “too big to fail”.  If you are small you will be punished when the time for reckoning arrives.  If you are big, and if you have succeeded in creating a deadly contagion, and spreading it across to others in such a way that your collapse could cause the system incalculable harm, you are likely to be granted immunity.  You are also likely to be rewarded handsomely for your culpability.

There is huge systemic incentive for people who take these decisions to take a lot of risk with other people’s money.  This must stem from the fact that the people who do this make a lot of money on the upside but lose nothing on the downside.  If this were the middle ages, the perpetrators would perhaps have lost their heads, in the literal sense.  What is galling is that it is our money they are playing with.

While the system conspires to move in a particular direction, it is very difficult for an individual player (except individuals who are acting on their own behalf) managing funds to move in the opposite direction.  The herd mentality tends to prevail, magnifying events both on the upside and on the downside.

Contrary to what popular theories of diversification are based on, there seems to no true diversification among asset classes any more.  All asset classes have moved in the same direction in the recent past.  This is due to the huge inter-linkages in the financial systems.

Volatility has increased and is here to stay.  Those with weak hearts should not participate in the markets. It used to be thought that this was true for individual investors; investing money through funds would ensure peace of mind.  Unfortunately, no one in the financial system is immune from volatility.  Probably we need to train our kids for this new reality to prepare them for the real world.  I propose to start with roller coasters and then work them up to financial markets.

Commonly held notions like “debt funds are safe” are now under review.  Several debt funds who have lent to companies in the real estate and financial sectors are now facing defaults, not considering those funds which have already lost enough money “marking to market” all their CDO investments.  Money market funds across the world are in danger of “breaking the buck”, a situation where their NAV drops below the principal.

Capitalism and free markets, much touted as the best economic systems,  holy cows of the modern age, are now coming under cloud.  Unbridled free markets with minimal regulations seem to have unleashed the forces of human greed, allowing entire systems to be corrupted by market manipulators operating under the cover of perfect legality.  This is not to say that any other system is necessarily better.  Modern economic growth in the first place may not have been possible without these institutions and constructs. 

Insulating oneself from the world is not an option in this day and age.  The Indian market deluded itself for some time believing that we are “integrated” with the rest of the world when it comes to taking advantage of global business growth, but are “decoupled” when it comes to stock markets.  In the last few months, the co-relation between the Dow and the Sensex, as well as the Sensex with other world stock indices has been so high as to lay permanently to rest the myth of decoupling.  The exchange rate movements that we see now are also a result of cross-border cash flows reacting to global events.

How do the decision makers, the politicians and central bankers of the world, plan to address this?  With more regulation, naturally.  There is a clamor for regulations to be tightened.  How, in what fashion, and to guard against whom, does not seem to be very clear.  I have no doubt the system will arrive at a list of culprits and causes by consensus, and move to take certain steps to contain “such” excesses in future.  The only problem being that any excesses in future will be of a different nature.  The system will soon enough find a way to work around the regulations; it will possibly use them to advantage.  The current round of liquidity being infused into the markets is just the beginning for such a cycle to start again.  We can be sure there will be another set of scams a few years from now; that a few hundred individuals will benefit hugely; and a few million lay people will again have to bear the consequences. 

What can the individual investor, i.e., you or I do to safeguard our money given the above somber conclusions?  It is impossible to predict how the markets will move over the short term, and how economic indicators like inflation, interest rates, or exchange rates will behave over any defined span of time.  What we can attempt to do is to draw some general conclusions from what has been happening in the markets, and keep tabs on certain trends that are likely to emerge in the near future.  We can draw up a plan of action based on this; and keep checking our assumptions and correcting our strategy and direction from time to time.  It is no doubt going to be painful process, one where we will have to correct our course as we go along.

Some of the fundamental truths of investing still hold good.  You need to invest regularly and for the long term.  You need to diversify over different asset classes by using asset allocation strategies.  You need to understand the risk, return and liquidity profile of every asset class that you are investing in.  You can hand over your money to someone else to manage it for you, but you need to be knowledgeable enough to know where and how your money is being deployed. 

We need to add some more fundamentals in light of recent happenings.  You need to be reasonably aware of economic cycles and how to take advantage of the ups and downs.  The recent meltdown may have been too severe for most people to have taken timely corrective action; however, it is likely that not all future swings will be this dramatic, and with enough vigilance you might be able to act in time to avoid potentially nasty situations.  You need to be aware of global economic trends at least in a broad general sense; it may not be prudent to be completely oblivious of what is happening in the rest of the world.

As to some concrete steps for the immediate future, you could consider the following.  Equity markets are at  artificially low levels right now, more so in India.  You should start entering the market by buying in small lots.  The index is likely to swing wildly for the next few months – my guess is between 8000 and 11000 levels.  While the prices are at such low levels, it would be a good strategy to invest.  However, you should only commit funds that you don’t need for the next three to five years.  While the market will surely rise, we can’t really say when.  If I were to take a guess, I would say that we will see the year 2009 end at 13000 levels, and 2010 to end at 16000-17000 levels of the Sensex.  If the markets reach those levels in a sudden spurt over a very short time period, you could even consider selling at that point if you expect a correction to happen.

For those of you who invest in equities via the mutual funds route, invest in large diversified funds or index funds.  Avoid midcap funds for now.  For those of you who like to invest directly in the market, do not jump into real estate, financial services, or commodity stocks for a while.  Pharma and FMCG are good options currently.  IT and IT Services are a bit more difficult to predict due to factors that are both positive and negative – watch the sector closely and try to take a call at the right time.  Avoid hotels, travel and entertainment.  The global economic slowdown is not likely to reverse direction at least till mid-2009 at the earliest.  Tight liquidity conditions and shrinking debt markets are likely to persist for some time. The Indian elections are likely in early 2009, which would paralyze fresh policy initiatives and spending till the new government is up and running in mid-2009. All these factors point to this strategy likely to being effective for the next six months at least.

Some part of your portfolio always needs to be in cash.  The best option for cash is to open Fixed Deposits with large banks.  The interest rates are currently  around 10% for FD’s of one to three years’ duration; it might make sense to lock in at these rates since the rates are expected to drop in 2009.

If you are willing to take some amount of risk with your debt investments, you could look at investing in long-term gilt funds.  You could benefit from the increase in NAV when interest rates drop.

Invest in real estate.  That is something that will always stand the test of time.  However, currently real estate prices are expected to drop further.  You should wait for a few months; it is expected that there will be major drop in real estate prices by the first quarter of 2009.

Invest at least 10% of your total investible surplus in gold.  This is a strategy you could adopt for the long term.  When it comes to gold, only ETF’s and gold biscuits (or coins) qualify as investments; ornaments do not.

Keep re-evaluating your strategies in light of developments.  If you think you have to exit any investments, do not hesitate to book losses.  Do not indulge in derivatives of any kind.  Commodities (except gold and silver) are also avoidable.

Remember that it is not possible to make money unless you take risks.  For an opportunistic investor every downturn presents an opportunity; currently, the opportunity is big.

Happy Investing!

Wednesday, November 26, 2008

The Global Financial Crisis: Part 2 - The Bubble bursts

(published in DNA Navi Mumbai - 26/11/2008)

The easy lending practices to subprime borrowers on home mortgages started resulting in defaults and foreclosures in the US.  The number of defaults started increasing significantly in 2007.  Our friend John Smith who got the NINJA loan, realizes that he cannot afford to make the repayment.  He goes to the bank, returns the key to Uncle Banker and walks away.  In the US, home loans are without recourse, i.e., banks can only repossess the house.  Unlike in India, they cannot pursue the borrower for the balance payment on the loan.  An additional incentive to borrowing for owning a house, and negotiating very long term mortgages.

John Smith’s loan is foreclosed and his house put up for sale. Several such houses started entering the market in 2007.  Now, when supply increases, especially of distressed assets, the price has to drop.  So home loan prices started dropping.  Once prices started dropping, a lot of people who saw the value of their house drop significantly below what they had signed up to pay as mortgage payments defaulted.  This brought more houses to the market.  Which in turn increased the supply, which in turn reduced prices, caused more defaults…. you get the picture.

If this were a repeat of the US Savings and Loan crisis in 1989, it would have caused grief to a few banks who would have had to repent for their generously avuncular lending practices; there would have been a lot of hue and cry, along with demands for greater regulation and a few hundred small banks across the country would have gone belly-up.  Their depositors would have lost any of their deposits with a single bank above $100,000. There would have been a correction in housing prices along with perhaps a small impact on the overall economy.  People would have concluded that those who did not know what they were doing and lent to NINJAs had it coming to them anyway, and their shareholders deserved to lose some of their money.  That history repeated itself within such a short period of 20 years would have evoked a lot of comment and commentary, but would not have surprised those in the know of financial markets.  History has a way of repeating itself with monotonous regularity in the financial markets – it’s only the perpetrators and the minor details that vary each time.

History repeated itself with a twist, and an ugly one at that.  The securitization of the loans had resulted in the risk of default being passed on to millions of others in the market.  The amount of packaging, repackaging, bundling, collateralization, securitization and derivative transactions that had taken place with the housing loans as the base had spread so much within the system that no one knew who held what.  John Smith walking out of his house in Nebraska, resulted in several people losing half their retirement savings, people losing their jobs, markets across the world going into a tailspin, and the world entering into a recessionary phase.  On second thoughts, that is not a really fair comment – the risk caused by securitization was merely waiting to erupt, and the trigger was the housing loan defaults.  If it were not this trigger, sooner or later some other trigger would have caused it to erupt anyway.

There were lots of banks, mutual funds and hedge funds holding bonds whose income stream depended on these loans.  The prices of the CDOs that they held started dropping as the defaults in the housing market increased.  Mutual funds had to adjust their Net Asset Values (NAVs) to reflect the drop in prices.  Holders of units in mutual funds saw their holdings lose value.  Banks who held these securities had to “mark to market” their holdings, resulting in a drop in asset values.  The drop in asset values resulted in a situation of capital inadequacy, since banks are mandated to maintain equity of a certain percentage of their assets.  This resulted in banks needing money to recapitalize themselves. 

We have just spoken about the banks and the mutual funds.  What about our friends the merchant bankers, the ones who borrowed heavily from the market to invest in the securities which they helped create and hype up? If you borrow up to 30 times your net worth and invest it in a certain class of asset, and that asset class loses value, what happens when the asset value drops even by, say, 20%?  You have lost six times more money than you own.  That’s what happened to them. They lost several times their net worth, and it was all their creditors’ money.  The so-called AAA companies to whom people lent without security, believing their money to be as secure as with the government, were bankrupt, or nearly so.  Bear Stearns was about to go under, when the Fed brokered a deal with J P Morgan who bought it at fireside sale prices.  This was in March 2008.

Banks and other institutions who lose money in one area need to sell other available assets to make up for the shortfall.  They started cutting back on their lending.  They of course stopped subscribing to further CDOs backed by home mortgages.  They started calling back some of their loans made to other institutions.  Credit in the economy started becoming tighter.  They also started selling stocks. They sold stocks not only in the domestic markets but in the international markets as well.  The merchant banks and other institutions who owed them money in turn had to start selling their stock holdings both in the domestic and international markets. 

Stock prices started falling.  This resulted in equity mutual funds seeing a drop in their NAVs and hedge funds seeing their portfolios shrink.  A lot of investors started pulling out their money from these funds. This increased redemption pressures on these funds, which had to sell more stocks to obtain money to pay the redemption calls.  The fall in prices triggered computer trading models to place sell orders.  All this resulted in stock prices falling steeply which resulted in more sales, which resulted in more drop in prices, which … by now we are familiar with this cycle.

What happened to AIG in the meanwhile? They had insured a lot of the CDOs against defaults and they started to get calls against these defaults.  They had to recognize the greater risk of all the insurances they had so liberally handed out.  This resulted in actual outflows due to payouts as well as fresh collateral requirements.  One of the most solid and respected insurance companies of the world was in deep trouble. Insuring millions of houses across the country against an earthquake is based on the premise that when disaster strikes, it does not strike the whole country at once.  Insuring millions of CDO’s against defaults is a bad idea, since when disaster does strike, they all go under at the same time.

Lehman Brothers, another big ticket Wall Street merchant bank, went out looking for suitors while it was on the death bed.  It found none, and applied for Chapter 11 bankruptcy protection in September, 2008.  This was the one exceptional case where the Fed didn’t play broker to arrange a marriage.  No one really knows, but Hank Paulson, the US Treasury Secretary, could have harbored a grudge against Lehman. 

Other established institutions in this sordid saga have succeeded in selling themselves to other institutions or have been taken over by the government.  The justification offered by the US government is that they are “too big to fail”.  Their failure would have caused such ripples in the system that the fallout would have been unimaginable.  It would also of course have been catastrophic for those in power at several governments in the world.

The fall of Lehman did have huge consequences.  Whoever had lent to Lehman of course suddenly saw their chances of getting back their money evaporate, or at best, saleable for a few cents to the dollar.  Apart from direct money from institutions, there were also thousands of individual investors who had invested in structured products created and marketed by the financial geniuses at Lehman.  These structured products, like any of their kind, were very fancy complicated derivative products built around the performance of underlying benchmarks like the Dow.  What people do not realize or probably ignore, in the hoopla surrounding the marketing of such products, is that structured products are essentially unsecured debt with uncertain returns and risks that are not well understood.  The risk most ignored is the risk of the issuer himself going bankrupt.  There were a lot of derivative contracts where Lehman was a party to the deal, that suddenly were worth nothing.  The securitization, packaging, and bundling of financial products had reached such a level that people are still trying to figure out who lost how much due to the Lehman collapse.

Stock markets around the world had dropped significantly in September from their January levels.  The Sensex was around 14,000 after reaching a high of 21,000 in January.  Investors who saw the Sensex rise from a level of 3000 in April 2003 to seven times that in five years, suddenly saw a drop of 30 percent in a few months’ time.  The fall in the Sensex was attributable to growth projections moderating due to a slow down in the world economy, deleveraging and tight money, as well as major redemptions by foreign funds to meet their domestic redemptions and capitalization requirements. The pulling out of money also resulted in the rupee starting to appreciate significantly.  However, there were no CDOs and excess leveraging issues to deal with in the Indian economy.  The cautious regulatory framework followed by successive governments, a lot of which was due to political paralysis induced by their allies in the left front,  and the cussedness of the Reserve Bank in refusing to “accelerate” financial reforms, saved the economy from what would have been a disaster of great magnitude.  India still does not allow full scale capital account convertibility.  The RBI had not allowed banks to borrow from other banks and institutions more than a certain percentage of their net worth, thus restricting excess leveraging.  Clampdown on certain “bubble” sectors like real estate had already been instituted with strictures on excessive lending and more stringent capital requirement norms against such loans.  Times were difficult, and the signs were ominous, but the worst was over, or so most people wanted to believe.

The worst was yet to come. 

In September 2008, the same month that Lehman Brothers filed under Chapter 11, Merrill Lynch was taken over by Bank of America.  The Wall Street firm which was known for its aggression and derring-do even among other Wall Street firms, which had a charging bull for its logo, had to sell itself to prevent a bankruptcy filing. Goldman Sachs and Morgan Stanley announced that they would be converting themselves into bank holding companies, losing their investment bank status.  This way they would be leveraging themselves far less and be under greater regulatory scrutiny in return for government assistance. Several icons of Wall Street all fallen in a single month; the casualty list was growing.

The government announced a bailout package for AIG, and took over the ownership.  Fannie Mae and Freddie Mac were also similarly taken over.  Wachovia, a large bank with substantial retail presence got acquired by Wells Fargo.  Due to the vicious cycle of asset selling, price dips, and further selling, bond and stock prices started crashing across the world.  

The US government announced a bailout fund of $700 billion to buy out “distressed assets”.  After a lot of confusion on how this fund would be administered, Gordon Brown from across the Atlantic ironically showed the way.  Following his lead, it was decided by the US authorities that the fund would be used to recapitalize ailing banks and not to buy out distressed assets.  This was dole on a large scale, being handed out to people who least deserved it, in order to avert a world economic collapse.  Central banks across the world started cutting interest rates and announcing bailout packages for banks in distress.  

Panic set in across all markets.  Banks were unwilling to lend to each other since they were not sure whether their money would come back.  Being insiders, they were also the people who understood best that the whole industry was facing a crisis which could have weakened most of them. Overnight call money rates shot up to absurd levels.  Central banks announced various measures to infuse liquidity and confidence in the markets including reducing the deposit money that banks had to keep with them, announcing reductions in rates, increasing insurance guarantees on deposits, guaranteeing debt funds against default and arranging special credit lines for mutual funds who were seeing their NAVs drop and redemption pressures rise.  The Reserve Bank did all this as well.  It also announced relaxation of the curbs on investments of FII’s through Participatory Notes, thus effectively doing away with know-your-customer norms.  Desperate measures all, launched with a hope and a prayer, sandbags being thrown on the seashore to keep the tsunami waves at bay.

The heavy injection of liquidity was considered essential to stave off certain economic crisis.  Governments across the world wanted to avoid a repeat of the 1930’s kind of depression that the US went through.  On news of this kind the markets used to recover  somewhat; only to sink again within hours on receipt of another set of bad news.  The period from September to now has seen extreme volatility in stock markets across the world.  They have all sunk to record multi-year lows and are yo-yoing within a wide range right now.  The Sensex is wildly gyrating – it is likely that it will keep fluctuating madly between 8000 and 11000 levels for the next few months, before starting to go up again.

The inquiries and the witch hunting have of course started at the same time.  Alan Greenspan was hauled before a committee where he admitted, or was forced to admit, that the cheap money policy that he followed to stimulate economic growth may not, on hindsight, have been the best thing to do.  Hedge fund managers like George Soros and Philip Falcone who to the dislike of all made a lot of money betting on the markets in 2007, are right now being hauled up before some committees in Washington to depose, and presumably to express contrition for their moneymaking skills.

Stock regulators across the world, including SEBI, have found their new villains in short sellers.  They have taken measures to ban short selling.  Buying long or selling short are bets taken by speculators who take a call on the market, and help in infusing liquidity into the market.  They put their money on the line while placing such bets.  Restricting short selling is a completely knee jerk reaction to the crisis, like putting band aid on a festering wound and pretending that it would heal.

How is the common man and the establishment reacting to this?  The common man, poor chap, is suffering from acute shock.  In the US, the 401k savings invested in equity mutual funds are down 50% forcing people to plan to work till 95, home values have dropped, and jobs are not easy to come by.  There is a significant economic downturn due to markets shrinking and credit drying up.  Citibank has just announced that they would be laying off in excess of 50,000 people, by early 2009.  People from troubled institutions are out in the market looking for jobs. This situation is expected to continue for the near foreseeable future.  Job losses are mounting.    In India, several sectors are facing trouble, including IT and outsourcing, real estate, commodities, shipping, and travel and entertainment.  Layoffs have begun to be announced.

Europe and Japan are in a recession. The US is likely to enter into a protracted recessionary or slow-growth phase.  Several stock markets in the world do not open for days fearing imminent meltdowns.  The property market which had witnessed an unprecedented boom for the last four or five years is melting.  All growth projections for most industries across the world have been revised severely downwards.  India and China have also seen downward revisions of growth projections – GDP growth in India is expected to slow down to 6% levels from the earlier projections of around 9% - which is still good news since these two economies are at least growing.

The Sensex is currently at 9000 levels, down from 21,000 in January, 2008. The pulling out of FII money has also resulted in the Rupee depreciating to Rs.50 to the dollar, from Rs. 39 levels a few months back.  Companies in sectors depending on exports of goods and services have seen a drop in profit projections and share prices, though to a certain extent offset by the depreciation of the rupee.  IT, ITES and garment companies have seen significant erosion in share values. Companies in sectors which depend on leverage and rising asset prices are in trouble.  Real estate companies are in the doldrums and all set to default on their loan obligations.  Infrastructure and logistics companies have seen severe correction in share prices.  Sectors that depend on general economic activity being robust have been affected. These include hotels, travel and entertainment industries.  Though no company or sector has been spared the meltdown in share prices, there are some sectors which have withstood the shock better than others. These include FMCG and Pharma companies, the so-called defensive sectors, which depend on the India growth story which still has some steam.

The media coverage has of course resulted in further confusion and panic; the local paanwala is talking about the global economic crisis.  Sentiment rules, and the prevailing sentiments are fear, panic, and confusion.

Tuesday, November 25, 2008

The Global Financial Crisis: Part 1 - Bring on the Bubbly!

(Published in DNA Navi Mumbai - 25/11/2008)
The world as we knew it is collapsing around us.  Stock markets are in a free fall, real estate prices are tumbling, loans are difficult to get, interest rates are high, inflation is higher than what we have been used to in the recent past, we are worried more about retaining our jobs than getting that 20% increment… the litany of woes goes on.  Newspapers feature financial stories in the finance section, the crime section, and the horror stories section.  There is blood on Wall Street and the contagion has spread to other parts of the world.  Several stock markets are being shut down for extended periods of time, and investors are rushing out in droves, driving the prices further down. 

The genesis of the problem is now widely known; the so called sub-prime crisis.  Is it the only cause, or were the machinations in the financial markets in the last few years, coupled with the so-called rules of free markets such that a denouement of this kind was inevitable? 

Asset prices all over the world in the last few years leading to 2008 had been driven up due to an excess of money flowing around.  One of the primary drivers for this was the easy money policy followed by the US and some other central banks of the world, starting around 2002 and extending for the next few years when the benchmark interest rates were kept low to fuel consumption and growth.  The cheap money fuelled an unprecedented growth in lending, leading to higher investments, greater production of goods, increase in commodity prices and increase in asset prices.  Also contributing was the construction boom in China, some of it attributable to the Olympic Games.  Brazil, India and Russia, the other three countries making up the so called BRIC block were clipping along merrily. The markets in the Far East were doing well and Dubai was booming. Stock markets all over the world were shooting up like rockets. 

Meanwhile, in the US there was another kind of bubble emerging.  House prices were going through the roof, more houses were being built than ever before, and every homeless person without any source of income was suddenly buying a house.  People with one house were buying a second house.  People with two houses were speculating in real estate and buying a few more. There were TV shows dedicated to the subject of making money from “flipping” real estate. All this demand helped push up the prices of homes, and any person watching from the sidelines felt left out.  The demand went up still further when these people started rushing to the party.  .

On the sidelines, India was having its own little party.  Housing loan rates were the cheapest for years, people were rushing to buy land and homes, little known villages were suddenly invaded by urban money bags who desperately wanted to hand out bags of money to the farmers, land prices in tier 2 cities started spiraling, the Sensex was clipping along at a furious pace, and everyone was happy.  Everything was, in short, all right with the world.

This was not very different from boom times of the past. All booms of this kind have been followed by busts. The state of denial induced by the high caused by irrational exuberance ensures that people don’t think of the morning after while the party is on.  But there was something else lurking within the system this time.  The intoxicants were laden with a toxin. Highly innovative lending practices coupled with excessive leverage had contributed to magnify the rise; when things would start unwinding and going the other way, the same factors would contribute to exacerbate the fall. 

If you are running a shop which disburses housing loans and Mr. John Smith from Nebraska, who is a person without a steady job comes to you claiming that his annual income is $50,000 against which he has commitments of $45,000 a year; his total net worth is $3000 in the bank; and he wants a loan of $200,000 how would you deal with the situation?  The banks in the US were quite glad to go out of the way to make sure that they did all they could to help the poor deserving chap.  They first did away with all documentation requirements like income proof and so on and called it the “No doc Loan” – a great innovation in the financial markets.  They then structured a “step up” repayment scheme where John starts by paying only the interest for the first few years – “don’t worry about the principal, old chap – you will be earning a lot more in a few years’ time”.  Uncle Banker was also glad to give him a personal loan for covering his down payment on the house.  They presumably added a bonus to enable him to buy his furniture.  In return the rate of interest they charged was a little higher than normal, a rate which is higher than the “prime” rate; certainly fair, under the circumstances.  They even gave these loans a name; whether the name emerged after people realized its true nature or before that, is not very clear, but these loans were widely known as “subprime”.  Much later, when the ramifications of the problem became truly well known, they referred to such loans as “NINJA” loans – loans given to persons with No Income, No Jobs, and No Assets!  The English language has always enriched itself with its ability to coin new words to describe what’s going on with the world.  The current financial crisis is playing its part in enriching the language.

Talking of the English language, there is a word “spiv” which describes a certain kind of salesman.  The dictionary meaning of spiv is as follows:

Spiv is a British word for a particular kind of petty criminal, who deals in stolen goods or fraudulent sales, especially a well-dressed man offering goods at bargain prices. The goods are generally not what they seem or have been obtained illegally. It was particularly used during the Second World War and in the Post-War rationing period for black-market dealers. [source: Wikipedia]

A spiv was typically a flashily dressed man (velvet collars and lurid kipper ties) who made a living by various disreputable dealings……  He was small-time, living on the fringes of real criminality…. [source:]

I believe a word that is gaining currency now in connection with the current financial markets is “spoon”; it has been observed that the scamsters now are not spivs, but spoons, those who have been born with silver spoons and belong to the Wall Street old boys’ network. What I like about spiv is that it also an acronym for Special Purpose Investment Vehicle (more about SPIV later)! 

Uncle Banker, and there were several of them, then went to Fannie Mae or Freddie Mac, two government sponsored institutions who took over the entire responsibility of the loan and paid Uncle a little more than what he loaned to John Smith.  Uncle immediately offered a loan on similar terms to another deserving nephew.  You see he had nothing to lose. Grand Uncles Freddie Mac and Fannie Mae would take the loans off him by paying him a nice spread over what he lent out.  Thus Freddie and Fannie had thousands of loans on their books which they had paid for upfront, where the repayment was spread over the next, say, 30 years or so.

The collateral for these loans was the home against which the loan was obtained, which of course was considered sufficient, since the prevailing wisdom was that home prices would go in only one direction, and that was up.  The people who doled out the loans were salesmen whose income was dependent on the loans they doled out, not on the quality of the security obtained against those loans.  The banks which wrote out the cheques in the first instance were reimbursed by another institution along with a profit margin for all their trouble.  It was in their interest to dole out as much money as possible in this fashion, no doubt feeling very self righteous in the process since they were aiding home ownership which, as we all know, is a noble goal for any society. 

How did the Grand Uncles Fannie Mae and Freddie Mac get the money to fund this?  This is where it gets interesting. 

Wall Street got into the act somewhere along the line.  The investment bankers and financial whiz kids contributed in several ways to the boom, primarily as a means to enrich themselves, and one of the most ingenious ways they found was Securitization of home loans.   They wanted to help sell home loans in the form of securities, in order to make money on the spreads and commissions, and of course on their own proprietary trades with huge amounts of borrowed money. However, if they had to make money on the sub prime loans they had think of something innovative. Here is where financial ingenuity starts coming into play.

They realized that no one  would want to buy individual home loans – there were too many of them, they were too small, they were not glamorous, and a piece of paper that promised the customer repayment from this unemployed blue collar worker from a small  town was not very marketable - in other words, they were not sexy enough.  There was also the fact that the loans needed to be aggregated in some fashion so that it would interest the big institutional purchasers.  Now, if  merchant bankers know to do something well, it is this: they can take Ugly Duckling and dress her up to look like Cinderella at the ball, and market the bride to a few millions of salivating suitors.  Long after the marriage, when the prince wakes up, it is too late!  He has been sold a lemon.

So they aggregated a few million of these loans.  They pooled them together into what was generally known as Special Purpose Investment Vehicles, a much fancier name than merely calling it a Shell Company to Hold a Pool of Doubtful Loans to Dodgy Debtors.  These SPIV’s, which went by a few different names, some of which had words like “high grade” and “enhanced” in them, and had enough legal mumbo jumbo around them to make them look impressive, created and issued bonds against the income flows expected from these “assets”.  Anyone who purchased these bonds paid upfront to receive a piece of paper that entitled them to the proportionate income flow (the EMI’s) from the pool of assets (in this case the pool of subprime loans) for the next 30 years or so.  Why would anyone buy such a bond? For one, the investment was projected to yield more than US Treasury bills, which is the bench mark for a risk free rate of return. 

How is one sure of the quality of the paper being issued?  Here is where the rating agencies stepped in.  They duly appraised the securities on offer and pronounced that they were “AAA”, which is a rating indicating “high safety”.  One of the factors which influenced them to reach such a conclusion was the fact that a reputed highly solvent insurer like AIG had insured them against default.  Another factor that might have influenced them in their rating was the fact that their fees were being paid by the same institutions whose securities they were appraising.  This last contention is being debated in some quarters and hotly refuted in some others; the latter group includes the rating agencies. 

The insurance we referred to earlier went by the interesting name of Credit Default Swaps, or CDS.  AIG while insuring it of course charged a premium which was calculated on the assumption that perhaps 0.5% (or some such percentage) of the loans would default.  One doesn’t know if AIG agreed to insure them because they were rated AAA in the first place. 

Grand Uncles Freddie Mac and Fannie Mae offered up their loans for aggregation.  They were duly converted into bonds and the bonds were offered for sale.  Who would buy such bonds?  The investment managers of the pension funds, debt mutual funds, and sundry other funds are always in the market looking for safe avenues to deploy their moneys in AAA rated securities offered by reputable institutions, with a rate of return higher than the treasury bills.  Anything originating from the Grand Uncles’ stables had to be safe since they were widely known to carry Uncle Sam’s approval.  It so transpired that Uncle Sam had to take them into his own house, since they blew the roof off their own, but that comes much later.  Right now we are at the stage where eager fund managers are rushing to subscribe to bonds issued by the Grand Uncles.  Any fund manager who preferred to lend only to Uncle Sam directly would look foolish after some time since he would end up showing a lesser return on his portfolio than the other fund managers. 

So they all subscribed to the bonds. These bonds went under the classification of  Collateralized Debt Obligations, or CDO’s.  CDO’s that were issued by highly reputed institutions, rated AAA by rating agencies of impeccable standing,  backed by a CDS from a most reputable insurer, routed through an SPIV named “Enhanced High Grade Investment Fund”, offering a higher rate of return than plain old boring treasury bills – who could resist?  You can imagine the fund managers salivating at the mere description.

The merchant bankers who packaged all this made a killing in the process.  Actually, being smart merchant bankers, they did more than that.  They borrowed money at lower rates of interest and invested those moneys in these same bonds.  If one does this in small measure, the profits would be small.  So they did it in large measure.  The Bear Stearns’ and Lehman Brothers’ of the world borrowed up to 30 times of their net worth to invest in such assets.  This is called leveraging.  A corollary to this would be you as an individual taking a personal loan from the bank of up to 20 or 30 times your annual income and investing it in the stock market.  If you win, you stand to win big time.  If you lose – but wait, that is not supposed to happen.  You would be accused of being a Cassandra if you voiced such thoughts in happy times; the bankers and everyone else were making huge bonuses on the profits that they generated out of these transactions; and they were not in a mood to hear unhappy thoughts. There was still a fringe group of  people with a conscience who cried out from the rooftops warning about the dangers of such behavior.  They were probably labeled as party poopers by the charitable, and as crackpots by the not so charitable.  One such Cassandra was Warren Buffett, the sage of Omaha, who famously declared long ago that “derivatives are the weapons of mass destruction” and refused to have anything to do with derivatives in any form. 

Where did these merchant bankers borrow moneys from?  From banks and sundry other financial institutions, from debt mutual funds and from short term debt mutual funds which were mandated to invest only in treasury bills or equally risk free securities. These institutions were glad to lend money to them since they were large venerable institutions themselves whose executives made pots of money.  Since their executives made pots of money, they must of course be good.  What is more they had impressive looking buildings on Wall Street. Banks are always looking for avenues to deploy funds which they receive from their depositors.  Lending to a Lehman Brothers or a Bear Stearns is what  prudent bankers always do to safeguard his depositors’ money and the implicit trust the depositors repose in them. 

Where did the mutual funds and the banks get their money from?  From millions of people across the country of course.   They also got them from the sovereign debt funds and wealthy sheikhs who had tons of money to invest. These countries made money from selling goods and oil to the US which they promptly invested back in the US. 

What did Grand Uncles Freddie Mac and Fannie Mae do with the money they got from selling their bonds? Why, they bought over more loans from the bankers, who in turn wrote out more loans with the money they received, which in turn helped push up the demand for houses, which increased the prices of houses still further.  The wisdom of lending more was borne out by the fact that the house prices were going up, as the bankers premised they would, when they lent the money in the first place.  This was leveraging on a grand scale.  The whole financial world was on a giant merry go round.  As we all know who have sat on merry go rounds, after a point you have to start coming down, and the feeling in the stomach when you do that is not very good.  The fact that interest rates and inflation were inching up in the meanwhile did not seem to make too much of a difference; the momentum that was created by easy money now had a life of its own; people borrowed more to invest in assets since they were assured of profits as the asset prices went only one way and that was up.

The stock markets, as we noted, were also shooting up. It was a period of easy money, low inflation, cheap loans, large investments in infrastructure, increased production of goods and services and more trade flows between countries.  Commodity prices of course shot up as a result of all this activity.  Meanwhile, the price of oil was also rising, and so was gold.  Mutual funds of various hues thrived and prospered.  The common man saw his mutual fund investments go up in value; the wealthy were very pleased with the performance shown by their personal portfolio managers.  The super rich of various kinds rushed to hand over their moneys to various hedge funds which were quick to cash in on the upward trend of prices.  Being relatively unregulated they enjoyed a much greater degree of freedom in their operations than regular mutual funds. 

Hedge fund managers usually charge a fee and a cut of the profits above a particular benchmark rate of return.  They of course exceeded the benchmark return by miles, and enriched themselves beyond their wildest dreams.  The top fifty hedge fund managers took home a combined 26 billion dollars in pay in the year 2007.  The returns earned by merchant bankers, though staid in comparison, were not puny.  The average pay of the 32,000 odd employees of a leading Wall Street firm in 2007 was in the region of $600,000. 

December 2007. If this were a Bollywood movie, this would be the stage where the hero takes the heroine to Paris for a honeymoon and they dance around the Eiffel Tower.  The villain has not yet entered the scene. The storm clouds are gathering on the horizon.  It is time for the Interval.  A time to eat popcorn and feel happy with the state of the world