Friday, October 31, 2008

Bear Sterns, Lehman brothers, Meryll Lynch, AIG, WaMu, Wachovia, Iceland (oh yeah, I meant the country).... what next ??

This has been my Gtalk status for the past few weeks and quite surprisingly (and sadly) the list has been growing in length consistently. While I was engaged in this publicity stint, I received many queries and thoughts from different people and most of them felt under the water when I started off any discussion on it. It's high time that I demystify the confusion that I sowed in them :). As a proven non-expert in finance, it is definitely in the reader's interest to add a pinch of salt to what I write in here.

A is A

Let's try and understand some terminologies that we come across in papers these days.

Investment bankers:

Banks which involves itself in activities of lending funds for industrial ventures and involves itself in the capital markets. Investment bankers generally do not accept deposits or make commercial loans.

MBS (Mortgage backed securities):

This seemingly daunting acronym refers to any investment that directly/indirectly refers to a credit on a housing asset. For instance when you invest by lending money to someone who buys a house, you are creating a very simple form of MBS. But practically, MBS consists of a bundle of mortgages which is securitized by the banks and sold to the investors in the market. Now that that this has become a marketable commodity, it can be bought, sold, traded, speculated or thrown about in the market.


The ease with which a commodity can be sold in the market without any substantial decrease in its value. Traditionally liquid assets are more in demand due to its characteristic nature of easy convertibility.

Credit Crunch:

A credit crunch is a scenario where in the working capital for an industry is unavailable or difficult to obtain. This generally happens when there is a decrease in confidence in the firm by its investors. This situation makes it difficult for the industries to borrow and hence they end up borrowing at higher rates. There is general loss of liquidity for the firm and they have a lot of trouble running their day to day business. Credit crunches are usually considered to be an extension of economic recessions.

With these basic ideas, let's try and figure out why financial institutions that had ruled the world 150 odd years would become bankrupt overnight. Well, it all started with the banks adopting a lending spree. Even without the sub-prime coming into play the bubble has to burst! Say, you actually have the potential to repay a loan worth 10 lakhs. An aggressive bank would give you a loan for 15 lakhs with which you buy a property. Now if this happens for a lot of people, the property value rises in the area (a simple demand-pull inflation) to say 20 Lakhs. Now that your property is worth 20 Lakhs, the bank can safely give you another loan of 5 lakhs based the property that you possess(Why should I worry when I can always sell the property for 20L - says the banker). Now with more liquid cash in the market (thanks to the bank loans) the price would again shoot up for the property as there are more people with cash who are ready to buy the property at higher rates. Now consider a hypothetical case where this happens in a vicious cycle - the property attains a spiked notional value, a value that would never have existed for the property if not for this voracious liquidity in the market.

Now why would all the world get drowned in a crisis if the reality market goes down? Welcome to the world of finance! One of the ways invented by man to make money is speculation. The banks would bundle these property loans and securitize them (say MBS) and roll them out into the market. From then on, the market plays havoc with the security, pull/push the price of the security, speculate over it, sell, buy, re-bundle - literally do anything with it. Now that the underlying security has undergone so many transformations, it is always going to be difficult to price the base commodity, it just gets lost into the multitudinal transformation that it has undergone. So when people began to realize that the underlying assets are grossly overpriced, their confidence in the derivatives began to drop. Result - Panic. We ended up with a huge amount of these securities which do not have the worth we have estimated or bought it for.

But why go bankrupt? Wont the security at least fetch me the 10 Lakhs that it initially had? The answer is it would. to understand this paradox we should first understand the fact that there is not as much physical cash as there is virtual cash - in the form of bonds, equities and what not. When there is panic, people start sitting on piles of their cash which is the most liquid assets ever possible :) Thereby, most of the physical cash which is essential for day to day economic activity is all locked up with investors. And this spells doom for any firm - the dreaded credit crunch and loss of liquidity. More so for financial firms where liquidity is essential for *any and all* activities. It is therefore very obvious why companies go for a merger when at the brink of a credit crunch. When these mergers fail, that's when it goes bankrupt.

"When American economy sneezes the world gets pneumonia, when they get pneumonia countries go bankrupt." It goes without saying that the American dollar has ceased to be an American currency anymore, its become a commodity used primarily in the world markets. You wouldn't believe when I say that when India and Japan want to trade, they do it in dollars. So when there's a liquidity crunch in America, the demand for dollar rises and it becomes more expensive (eg, 50 INR = 1 USD ). Plus when American investors pull their money out of the world markets causing a further plummeting in the country's local economy. This is worsened by the various banks across the world investing in the Realty Securities which are bundled out of America. Would you believe that Iceland, an entire country, went bankrupt because of heavy investment of its three major banks in Mortgage securities. Their currency had a free fall within days and even the government couldn't do anything about it. Imagine, a country going bust despite no fault of its citizens and without any decline in its productivity (it still has a strong tourism based economy).

The solution..well, everyone knows and no one knows. While some are of the view that the bailout plan should bring back the economy to a stable state, many are of the opinion "Bail out the investors not the banks". Some prefer to sit on cash while some perceive a smart and cheap investment opportunity. Some even say that the banks should be held responsible for the crisis that they have wrought on themselves. So what's the plan for the future? Simple - "Introduce a little anarchy. Upset the established order, and everything becomes chaos. I'm an agent of chaos. Oh, and you know the thing about chaos? It's fair."