Pumba Online Connection

I think the best way to
explain this financial crisis would be to use Warren Buffett’s Annual Shareholder
report methodology. In the report he assumes that he is trying to explain his
investment thesis and objective to his two sisters who don’t have any idea
about Finance and Investment. Probably explaining this crisis would be tougher
for even Buffet cause what has happened is unprecedented and it requires an overall
understanding of financial markets ranging from monetary policy to CDS (Credit
Default Swaps).

With time I think we will see a slew of books
covering this financial crisis with names such as “Housing Bubble”, “Credit Crunch”, “End of Investment
Banking Era’, the most petrifying among all of them is certainly “Financial Crisis : The Great Depression 2.0”.
You will find everyone from Hank Paulson to Nouriel Roubini writing about this,
I won’t be shocked if somebody comes out with 10 books “Volumes I – X :- A Synopsis of Financial crisis”. Yes, the
pun was intended.

Let us get to the point. It all started when US
started experiencing current account deficit, which probably started since 1991.
This was exacerbated by Fed making interest rates as low as 1 % around 2001-
2002. And yes a lot of people will go all vocal on blaming Greenspan for that.
I think it is very easy to blame but you have to look from his perspective as
well. What was the option he had considering the debacle of LTCM and a banking
crisis on the offing at that time? I don’t think he had much choice. It does
not mean that I am a Greenspan fan but America was having a tough time. The
consequence of such a low interest was aptly put by Ted Forstmann (a high
profile PE player) in one of his interviews. He asked “That why so many Hedge
funds have spurred up in the last 4-5 years and from where did they have all
this money from”. Another valid question “Why you require so much of money to
be in the Top Forbes List today, is it that suddenly there are so many smart
people who have figured out to make fabulous ROI from their business and become
extremely rich” …the answer is simple - it’s just an over supply of money. To
put in better terms there was easy availability of money. When you are having
an Interest rate that is less than Inflation (which was around 3 % at that time),
you are incentivizing risk i.e. promoting leverage.

This rate was kept low for a long time because China continued a surplus with US and they don’t
know what to do with their money so they put all in US treasuries ditto with Oil
Economies since a bull run started in oil they also had a lot of USD. This
materialized into an artificially low rate. Now the typical Joe thought “Wow! I
can buy a house, interest rates are so low and amortization starts two years
from now, that means I just have to pay the interest for first two years.” So
lot of Joes and Joanne’ started buying houses and as interest rates started
going down purchase of houses started getting bigger. Yes its wide knowledge now that China funds US consumption but in the process
they inflated Real estate prices.

The focal point of this crisis is that this time lending
for home loans did not happen in a conventional way. To reduce their exposure banks
sold their home loans to other Institutions who packaged different types of
loans (i.e. from prime to subprime) together in one basket and sold this basket
of different loans in very small units as shares to other financial
intermediaries. You will not be surprised to know that these entire three
letter loans CDO’s, CMO’s and ABS were made by Freddie Mac and Fannie Mae and
in some cases at least insured by them. This financial innovation widely known
as securitization was crafted by the skills of Goldman Sachs in 1990’s. The way
it works is there are different tranches that you can choose depending on the
risk / return appetite, the first tranche will be the safest bet cause even if
there are some lenders who will default, the first tranche has the priority
over being paid. The problem which nobody realized that when price start
falling there will be negative equity that means your mortgage will be more
than your house price and if you doubt that house price is not going to rise
much in future, why do you want to pay such a big mortgage to buy a falling
asset. So there will be lot of people who will just walk away from their houses
and lot of foreclosures if there is a correction in house price. As you know,
the foreclosures have started but due to Fed intervention, the house prices
have started stabilizing. Nevertheless, this can turn into a massive default of
mortgages.

Another important aspect of this so-called “Financial
Engineering” is that default on mortgages would hurt the eventual buyers of the
securitized product that can be a gold plated IB in Wall Street or a School
Teacher’s Fund in Florida.
The reason why a School Teacher’s Fund in Florida would get into this cause
there a lot of Credit rating agencies who gave a rating of AAA to first tranche
of these products making it an investment grade security. There’s one more facet
of “Financial Engineering” i.e. CDS. CDS is an insurance contract and if the
underlying security defaults the CDS writer has to cover the default (I will
discuss more about this in next write up and try to prove that bail out of Bear
Sterns was basically a bail out of JPMorgan) . The most worrisome part is that
CDS is an OTC i.e. the CDS market is not regulated. Therefore, nobody knows who
has what exposure in there balance sheet. The CDS market is an interlinked
complicated web of CDS between multiple parties with multiple terms the
consequence is, if one goes down others might follow soon having a domino
effect. This has led to a serious credit crisis, nobody wants to lend each
other and inter-bank lending markets froze for a long time. It’s been said that
IB’s have an oligopoly in CDS market when Lehman Brother went down everybody
got scared and people started having doubts about the whole existence of IB
industry. It went to such an extent that an ex- CEO of Bear Stearns made a
public statement that IB model cannot work any more.

There will be lot of offshoots of this write –up like
where the CDS market is heading, Is IB industry dead. We can put one of the
topics as agreed by all on the podium and ask everybody to put their views on
it. Let’s make this a fertile exercise. In this financial turmoil, let us make
one thing for sure that when dust settles down, we should know what caused this
crisis pretty well. I recently heard a history professor of Harvard made a
statement “Financial markets are still in an evolutionary phase”. I think he is
damn right.

Mohit Shrivastav

21 Nov 2008