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: worldwidewords.org]

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

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