Financial Crisis Explained – II

Continued from previous post……………

 

With investment banks and financial institutes sitting on stockpiles of toxic mortgage backed securities and credit default swaps, the same instruments that Warren Buffet had dubbed “weapons of mass financial destruction” (with the only point to note is that unlike the “weapons of mass distraction” and Santa Claus, these really existed), lenders were as eager to loan these people money as anyone would be to leave their kid alone with Michael Jackson.

 

Money market mutual funds are considered to be some of the more conservative (i.e. safest) investment instruments. Just as a normal index fund is a distributed investment in a bouquet of companies and a mortgage-backed security in a collection of mortgages, a money market mutual fund is an investment in a basket of short-term loans. It is this well of money that investment banks and businesses in general tap into as sources of short-term financing.

 

Let us assume that Shankar, the main protagonist of a company named “Gunda”, runs a coolie agency in an airport. In a typical month, his assets are tied up in his various investments like the hotel in Ooty (a hill resort) he is building and advance payments for rocket-launchers that he uses to get rid of evil men.

 

However, he still needs a steady supply of liquid cash to keep the business running— pay his employees (back-up dancers) and creditors, buy fresh inventory and also to make fresh investments (like in increasing the fleet of auto-rickshaws he owns). How does he get this money? By taking out short-term loans from money markets. In brief, money markets (the markets for money) serve as the grease that keep the wheels of the financial world spinning.

 

Now however, with investor panic, this grease was drying up. And fast. On a single day in September, nearly $90 billion dollars of cash flowed out of the money market.

 

Not just money market mutual funds but people were moving their money out of Banks also. Now the FDIC (Federal Deposit Insurance Corporation) insures for every person $100,000 dollars of his investments in every account type (single, joint) at each bank . So as long as investments were below that amount, there should be no reason to withdraw. So why then the obscene rush to move money out of savings and checking accounts?

 

That’s because most people, because they have believed normal banks to be solid as rock, had left deposits in accounts that had gone way over the FDIC limit. They now realized how risky that was in the present economic situation and had started moving their money out and redistributing it to the banks perceived to be stronger, leaving the weaker banks, already under credit pressure, gasping for air. In addition, because no one trusted anyone any more, some investors were skeptical whether facing a series of massive bank failures, the FDIC would be able to make out the payment to which they were committed to in a timely manner (not much good being compensated for your money years later). Better to move the cash out.

 

This hemorrhaging of deposits from banks and money markets is what is known, in common parlance, as a “run on the bank”, considered to be possibly one of the most catastrophic national consequences of loss of investor confidence. While “runs on the bank” have historically been associated with a bunch of rioting people outside bank branches trying to withdraw whatever they could before it folded, with electronic withdrawals, the run, while not so visible, was still as insidious and as potentially damaging to not only the credit markets but also to the economic security of the country.

 

This was serious stuff. The financial equivalent of a 9/11.

 

The government reacted by announcing a guarantee program for money market funds. (by extending a FDIC-like assurance of the government “covering” your investments for period of time in money market instruments). That was however trying to put a band-aid on a shotgun exit wound.

 

In order to stem the downturn, the federal government imposed a temporary ban on short-selling, a form of speculative bet that people place on the decline of a company’s value. This was because short selling is considered to be something that destabilizes the market artificially and contributes to driving stock value even further down. (For those who want to know what short selling is, read the following paragraph. Else fast-forward over it, as you would over an “item song” in a Hindi movie, as the paragraph does not affect the rest of the narrative.)

 

[Say Kundan is a short seller. He is convinced that Shankar’s Airport Coolie (AC)

business is going to go bust. He devices a plan to profit from his hunch. But what can he do— he does not own any stock in Shankar’s AC company. Kala Shetty however does. Kundan takes as a loan from Shetty 10 shares of the AC business, with the guarantee that within a week, he will give Shetty his shares back and also $100. Kundan now sells the stocks at $100 (its current value) a share and makes $1000. A week later, due to the fact that Shankar has been sent to jail by Inspector Kale and also because of the fact that Kundan has just dumped a large quantum of AC stock (10 is considered to be a large number as per this example) on the market thus increasing supply and creating a resultant value drop, the stock value of AC crashes to $10 a share. The sly Kundan buys 10 shares of AC back, spends 10 times 10 = $100 on the transaction, gives the shares back to Kala Shetty and also $100 as promised and has now made a profit of $1000 in a week. Which Kundan now presumably spends on bottles of Chandan which he gifts it to his girl-friend from London? ]

 

The root cause of investor loss of trust needed to be handled. Namely how to dispense of the billions of dollars stuck in stinking mortgage-based securities. “Put on the ghungroo on my foot and watch the deramaaaaa”. No that perhaps was not United States Treasury Secretary (the equivalent of the finance minister) Paulson actually sung but the point is that his 3-page recipe to rescue the economy (with the innocuous title of Troubled Asset Relief Program) was a trigger for much drama.

 

According to the plan, the US government was to spend $700 billion to buy out troubled mortgages, thus providing financial institutes with much needed liquidity (i.e. real “instruments of transaction” they could use as opposed to worthless pieces of junk paper with numbers on them) and thus restore normal flows of capital through the financial system. In other words, a by-pass surgery to make blood flow again to the heart of the economy, gasping for oxygen from toxic asserts blocking all the arteries.

 

The $700 billion, we were assured, was not going to go into a bottomless hole. Since the MBSs were backed by actual assets (houses) on some of which mortgage payments were still being made, the MBSs bought from the banks through the $700 billion investment would be earning money right away and later on when the housing market comes back to normal, the MBSs could even bring in revenue for the taxpayer’s, thus making the $700 billion payout sound less bad than it actually was.

 

Paulson stopped short of saying that this government action would pay for itself (i.e. realize the $700 billion investment fully) as that spin of “paying for itself” had already been used for the Iraq war. And we know how that turned out.

 

An additional provision of the bill was that this buy-out was going to be affected by the US Treasury Secretary and his staff under a process which was going to be above scrutiny by elected officials and the courts effectively making Paulson the economic dictator of the US, free to take whatever decisions he deems fit without any kind of oversight or threat of prosecution. In other words, Paulson wanted to turn the US into Dongri-La and himself into Dong with the proposed Bill asserting, as clearly as possible, “Uparwala wrong ho sakta hain, par Dong kabhee wrong naheen hota” (God may be wrong, but never Dong)

 

Greeted with guarded optimism by Wall Street, the proposed piece of legislation unleashed a tidal wave of public anger at what Paulson was proposing. The Bill (initially referred to as the “bailout package” and then changed to the more politically apposite “rescue package”) was widely seen as the federal government’s plan of diverting tax payer’s dollars to pay for Wall Street’s excesses, effectively telling Wall Street “When you guys make a profit, it’s yours to keep. When you make a loss, the whole nation shares the financial grief”.

 

Public resentment against the Wall Street types, (i.e. the ones in long black coats and mufflers with a Starbucks latte in hand earning a million in bonuses on average) perceived to have brought about this economic cataclysm as a result of unbridled greed was at a historic high. At this time, the message of forgiveness and support for Wall Street was needless to say, extremely unpopular. The resentment against the Paulson plan was magnified when the popular press kept reminding everyone as to how the very same people had lobbied extensively (euphemism for “paid off politicians and decision-makers”) for reduced government oversight under the umbrella principle of “free markets solve everything”, were now asking for the most blatant form of socialistic financial interventions in order to save their asses.

 

A further contributory factor to the public outcry was that, thanks to their record over the past many years, not many in the US trusts the government to do anything other than benefit their paymasters (lobbyists, special interest groups).

 

Paraphrasing one of the greatest prophets of the modern era:

(Today Wall Street and political leaders are the bastard twins of the same father)

 

If the deficit of trust had led to the freezing of financial markets, a similar lack of confidence was responsible for the fact that Americans were unable to believe anything that the administration told them. The problem is indeed systemic—there is an undisguised animus that many Americans feel towards the political system, something that was exploited by Obama with his message of change and even to an extent by Palin with her cultivated image of a bumbling, but good-at-heart Washington outsider, reflecting the values of common middle-class Americans as opposed to those of the Columbia-Harvard business school gasbags who had run the country to the ground.

 

And one could not blame the Americans for being anything but skeptical of the plan considering the people who were endorsing it. First of all, considering the esteem with which President Bush is held in by the general public as of now, his throwing his weight behind the Paulson plan was a huge blow for it.

 

After the blatant lies of the weapons of mass destruction, torture and wire-tapping, the mismanagement of Hurricane Katrina and the complicity in financial scandals, the present Republican government’s ability to be even moderately truthful to the nation, manage a complicated process and safeguard the interests of the common man (as opposed to the upper crust of the financial world who were historically their biggest financial donors and backers) was seriously in doubt. To put it mildly, lest it be assumed that the Democrats were the knights in shining armor (because of the fact that while Republicans are known to represent big businesses, the Democrats are perceived as the party of the common man), it should be said that they were as deep in the mud of public mistrust as the Republicans.

 

It was Democrat hero, Bill Clinton who had, under pressure from Wall Street, signed the repealing of the Glass- Steagall Act that had been instituted during the Great Depression to prevent commercial lenders from making certain risky investments. With its repeal, banks were now free to trade in instruments like MBSs, thus increasing both their risks as also their profits. Also it was President Clinton who had aggressively pressurized Fannie Mae/Freddie Mac to promote home-ownership among weaker economic sections by relaxing restrictions on what kind of mortgages they were allowed to buy, a presidential directive that was enthusiastically followed by Fannie Mae/Freddie Mac as they started guaranteeing mortgages taken out on risky sub-prime loans. Now whether their enthusiasm about sub-primes was because of the social commitment of the Fannie Mae/Freddie Mac management or because of the higher rate of return that sub-primes brought in (the higher rates promising higher executive payouts) I leave the astute reader to judge.

 

People with Freddie Mac/Fannie Mae links had always held influential positions inside the Democratic party hierarchy—be it the person who decided Obama’s running mate to the deputy attorney-general under Bill Clinton.

 

And the top four people who had benefited from Freddie Mac/Fannie Mae campaign contributions were

1) Chris Dodd , 2) John Kerry, 3) Barack Obama and 4) Hillary Clinton

 

(do we see a pattern in 2, 3 and 4—hint: all prospective presidents at some time or the other).

 

Chris Dodd you ask? Why him? We do not know but the fact that he is the chairman of the Senate Banking Committee that has jurisdiction over, among other things, public and private housing and banking and federal monetary policy, may have something to do with it. Or not.

 

And the final nail in the coffin of lack of public trust in the whole bail-out process. Paulson, who was asking for dictatorial power and freedom from all oversight, was an ex CEO of Goldman Sachs. What were the chances that he would look after the interests of the common folks as opposed to those of his old friends on Wall Street?

 

What were the chances of Mamata Banerjee and Ratan Tata doing the “funky chicken” dance (this explains the dance) together?

 

It was not just the trust factor that made the bill such a turkey. It was clear that the bill, cobbled together like a homework assignment, had little details of how exactly the buyout was going to be performed. Perhaps because Paulson himself did not know. Perhaps Paulson did not want to tell us. For instance, how would mortgage based securities be valued? Say the paper value of an MBS is $100. The actual market worth, as of today, is $2. What is the value at which if the government bought it, it would benefit both the bank as well as provide the government the opportunity to make a profit later? Should the government buy it at $3? If it did, that won’t really increase the institutes’ liquid assets defeating the bill’s purpose. Should the MBS be bought at $90? The financial institutes would be ecstatic but the government would now be holding a grossly overvalued asset with no chance for profit.

 

Since the valuation of toxic securities was not a straight-cut thing, the question was who would do it? Experts from Wall Street would be paid a consultancy from the government to use their “expert” knowledge to determine a fair value! Which means that Wall Street fat cats would collect once again, from the pockets of taxpayers, while wiping the detritus of financial excreta from their own soiled bums. Not to speak about the unacceptable conflict of interest that exists in the whole transaction.

 

So if the proposed legislation was flawed, what were the alternatives? A section of conservative and libertarian economists were opposed in principle to any kind of government intervention. They argued that banks that were weak should be allowed to go under and file for bankruptcy. The owners would be wiped out, and the debtors (to whom the bankrupt organization owned money) would be free to sell the company’s assets or take controlling equity in the company. In this way, the markets themselves would rectify the anomalies. The problem with this is that this whole process of self-stabilization often takes a lot of time and the existence of normal economic conditions to work out. In the present situation, a quick fix was needed and the conditions of the general economy were anything but normal.

 

The other alternative proposed by more liberal economists was that since the basic problem was the stoppage in the flow of liquid assets, the government should deal directly with that problem rather than try to buy deprecated assets like mortgage backed securities. They argued that the federal government should pump in money to the tottering institutes in exchange for shares (i.e. a portion of ownership) and options (the rights to buy stocks in the future at low prices) so that the government not only has share-holder control over the organizations that took aid but also stands to benefit when they finally make profit and their value rises. As a matter of fact, this was precisely how the federal government had done the AIG insurance bailout because even they were not fool-hardy to pay for toxic credit-default swaps.

 

However this measure was opposed by Wall Street (which still had more than a bit of influence) who wanted their toxic investments off-loaded but did not care to give government a role in running their business. And also opposed by conservative experts who were dead-set against the concept of government owning equity in major financial institutions as this was nothing but “nationalization”—-something that is, to true blue free-marketers, a nightmare of the proportion of having Hugo Chavez as son-in-law.

 

Amidst the confusion of multiple voices—-some of which were saying that the US economy was a few days away from apocalypse and some of which were saying that the magnitude of the problem was being magnified by spin-meisters in order to bail out powerful agents in Wall Street (the same way in which the bogey of WMD’sled the country into another quagmire a few years ago)—presidential politics added to the drama.

 

With the presidential elections a little more than a month to go (the time that this bailout was being discussed, in last week of September) and both parties eager to at least postpone the economic collapse, should it happen, to at least after the elections, it was assumed that the House (the lower house of parliament) and the Senate (the higher house) would pass Paulson’s plan after some modifications of course.

 

In order to take credit for the passing of this plan, McCain suspended his campaign and jetted to Washington DC. There in a meeting with Bush and Paulson and Obama, McCain, whose arrival in Washington had been cheerled by Fox as the game changing moment in the crisis, did what many had done many years ago in the internet logic viva. He froze, staying silent through most of the meeting. Obama took the initiative and the contest which had been effectively tied till then, opened up with Obama sprinting ahead.

 

The final version of the bill that went to the floor of the House had gone from 3 pages to 110 pages. Paulson’s Dong-like powers were removed for one. Secondly, the government would acquire equity stakes in the firms that were being helped so as to let tax-payers get their money back through future profits. Thirdly, banks would work with authorities to avoid foreclosures and give relief to people struggling to make payments (after all if the Lamboo Attas were being bailed out, why not the Bullahs [reference last post]) Fourthly, to calm public anger, limits were put on executive compensation in the institutes that would benefit from the bailout.

 

The bill was put to vote on the House. While most people expected the bill to pass, albeit by the skin of its teeth, in a surprising turn around, the Bill was defeated as House Republicans, whether it be because they were scared of public disapproval or whether they felt they were personally not getting anything out of the deal, engineered a sudden revolt in the ranks and the Bill fell. The Dow Jones fell over 700 points, the single largest drop in twenty years. Investors rushed to move their money into gold and government-issued Treasury bonds. Over more than a trillion dollars in assets were wiped out in the ensuing carnage.

 

All however was not doom and gloom. Warren Buffet, the financial prophet of our

times, announced his investment of $3 billion in troubled General Electric to follow his $5 billion investment in Goldman Sachs. In exchange for his investment, he would be getting stocks and options (i.e. equity stakes) of the two companies. The move was clear—following the immortal principle of “value investment” championed by his guru Benjamin Graham, Buffet was buying equity in companies whose current market value he considered was less than their net value. In other words, he was betting that these companies were better off than the market thought they were and so their stock values were bound to rise.

 

Now would Buffet’s decision convince skeptics that if played right, the government too, on the back of its equity stakes, could come up with a profit under Paulson’s plan? The vote went to the House again. This time, the 110 page bill swelled to 400 pages. Included in it was a direction to the president to propose a law that would ensure that financial institutes would reimburse the taxpayers for any losses on their investment after five years. (Note the way the reimbursement to tax-payers is not mandated directly by the Act but is merely postponed for another bit of legislation—a bit of legislation that is likely to be quietly defeated once the spotlight shifts awayfrom the economy !)

 

An important addition was the measure to raise FDIC insurance from $100,000 to $250,000 (i.e. the government will give back $250,000 of your money per account type per bank if your bank fails), a move that was expected to soothe the frayed nerves of ordinary investors.

 

However bizarrely, along with some of the most critical legislation of modern times were tagged on items that guaranteed government spending for critical infrastructure items such as children’s wooden arrows and wool research (politicians pulling the wool over people’s eyes?) and a tax break for that thing that can restore liquidity, albeit in a very different way—Puerto Rican rum.

 

No I am not kidding. These were the sops that were added to the bill as “incentives” to House members so that they can turn their votes from “No” to “Yes”. And nothing makes politicians happier than when special interest groups that support him/her are happy. The Bill was then passed by the Senate and the President signed it into law.

 

And how does Wall Street react to the bail-out? By firms expressing their disinclination to participate in the bail-out because executive salaries are capped if you take help. Yep that’s Wall Street !

 

If there is one thing that the whole fiasco teaches us (not that this lesson is anything new) is that while the concept of free markets are good and that of government controls very bad, the operation of free markets almost without any kind of oversight or control (which is what happened on Wall Street where government restrictions were over the years subverted by lobby-driven legislation) is doomed to lead to catastrophe. This is not the first time this has happened— in the 90s unbridled capital flows caused by uncontrolled market operations (what Jagdish Bhagwati called “gung-ho capitalism” in his book “In Defense of Globalization”) brought down the economy of many of the South Asian tigers. I dare say it will not be the last.

 

So what happens now? Experts believe that $700 billion is a ball-park figure and the actual cost to fix the market would run into trillions. Will inflation run wild in the meanwhile? Will the US sink into a severe recession? Will the housing market go south for two-three more years?

 

Will the economic crisis be looked upon as the historic event that eventually influenced the US presidential elections decisively and created the space for the first non-white president?

 

With the massive cost-cutting measures that will be put into place at financial institutions sure to affect IT spending straight-off (the first people who get fired at investment banks are the IT guys), will US banks abandon their unconditional love for closed-source proprietary vendors like Microsoft and Oracle (this love is because of the supposedly high levels of security these companies provide) for so-called “riskier” but orders of magnitude cheaper open source computing infrastructures and will that decision bring about a re-alignment in the IT industry?

 

And why, oh why, does Rahul Mahajan ask Ashutosh in  a movie being made titles “Big Boss”: ” “Kyon tu baraf peeta hain whisky main daal ke?”? [Why do you drink ice after pouring it in whisky?]

 

I wish I knew.

 

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2 thoughts on “Financial Crisis Explained – II

  1. Nandan Gogate says:

    Its been interesting beer/wine discussion here in the US. Here is my take on it. everyone is to blame – from greenspan for not envisioning what cheap credit will let genius minds do, to wall street executives who only care about the bonus and company stock (obviously, thats what they are paid for), to traders who are rewarded only for risky behaviours (being conservative doesnt do them any good), to rating agencies who get kickbacks from the very companies whose products they are supposed to rate, to predatory lenders to uneducated (you can read dumb) consumers, who didnt know that they should not buy anything that they cannot afford.
    If you want to trace the timeline, it has to start with cheap credit cheap credit _. exitic products based on derivatives (CDS), leveraged CDOs, to and end with consumers with upside-down mortgages and defaulting.

    Like

  2. Akhilesh Mishra says:

    Yes Nandan you are right, and I guess that with hindsight and present evidence, history may not actually judge Greenspan, the messiah he was made out to be.

    His one stop solution to all issues was “rate cut” and which frequently earned him the sobriquet of “Genius”. Some justice and pretty soon !!

    Regards,

    Like

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