The real game in Diesel Pricing

A major hike in the price of auto fuels, particularly diesel, is once again looming large. The justification cited is the latest Kirit Parikh panel recommendation. Unlike petrol, hike in diesel price doesn’t just affect an SUV or a diesel car owner, but each and every citizen of the country. Diesel is used as a transport fuel — for both road, as well as, rail transport. Besides, in a severely energy-deficit country, diesel is also used as farm fuel for tractors/ to run pumps for irrigation and other farming activities; industrial/ commercial activities as furnace fuel/ to run gen-sets and fuel for water transport-used by fishing trawlers as also large merchant vessels and cruise liners.

So a hike in diesel price affects each and every activity, from transport to manufacturing to farming. Obviously the increase in input cost gets transferred to the consumer and that leads to a cascading effect on economy. To understand it better let’s take the example of a small-scale vegetable farmer. He would have used diesel for farming activity to transport his produce to the market and every increase in diesel price would increase his input cost multiple times. To maintain his meagre livelihood he would have no option but to pass this increase to the final consumer i.e. you and me. This perhaps will help one to understand the current food inflation scenario better.

The Kirit Parikh panel incidentally is the fourth such body (since the Congress-led UPA came to power) which is propagating the idea of “evaluating and recommending the price mechanism of petro-fuels”. The previous three were:

1. C. Rangarajan Report: 2006

2. BK Chaturvedi Report: 2008

3. First Kirit Parikh Report : 2009-10

A cursory reading of the above three reports is enough to deduce that their recommendations are consistent. All the committees recommend “freeing of pricing of petroleum fuels”, which incidentally are in line with the process that was initiated and institutionalised by the BJP-led NDA Government as early as April 2002.

Keeping its commitment to liberalise the petroleum industry, the NDA Government had dismantled the ‘Administrative Price Mechanism (APM)’, which was essentially the beginning of the process of removing Government control over pricing of petroleum products. This was necessary for three main reasons: Ending the inefficiency and Government stranglehold on the oil sector by allowing competition; attracting capital investment and reducing subsidy burden to free exchequer.

So committed was the NDA Government to free the oil sector of control that from 1 April, 2002 till 2004 general election, it revised (increase/ decrease depending on international crude price parity) the prices of petrol and diesel almost every fortnight. Had this process been continued by the subsequent UPA-I and II Governments, the petroleum industry would by now have been free of subsidy burden and the prices of petroleum fuels would have been competitive because of presence of private players in the industry. However, as they did in every other sector, the Congress-led UPA Government immediately did away with the reforms brought about by the NDA regime and took complete control over the prices of petroleum fuels. The Congress kept citing coalition compulsions for not bringing about reforms in pricing of petro-fuels as the Left and Trinamool Congress were their allies. However, even during UPA-II regime, when they were free of any such burden, Congress did not bother to implement reforms repeatedly recommended by the three aforementioned committees, ironically appointed by the Congress itself.

Indeed the NDA Government had brought about not only pricing reforms in the oil sector but also introduced many revolutionary steps to liberalise the sector, some of them being:

Waiting lists for obtaining cooking gas connections were done away with and new connection availability was made across the counter.

Selection process for appointing petrol pump and cooking gas agency operators was made transparent by disbanding the corrupt Dealer Selection Boards, a relic of the previous Congress era which mainly benefited cronies of the ruling party.

The NDA Government initiated the process of disinvestment in the oil sector which again was put on hold by the Congress-led UPA Government.

In the absence of reforms in petro-fuel pricing, investment as well as participation by private companies, which had well begun by 2004, dried up. The need for rationalising the tax structures, which were recommended by various committees, was overlooked and the sector continued to reel under a tax structure which takes away the major chunk from the price that consumers pay for the product. While various States have different tax rates for petrol and diesel ranging from as low as 15 per cent to as high as 25 per cent, the Union Government also scoops a large chunk of the revenue in the form of customs and excise duty.

Had pricing reforms been implemented in the sector, the Union Government would have been required to forgo its share of huge kitty of several thousand crores with which it sponsors its unproductive schemes through which money only leaks and reaches cronies and middlemen.

With increasing crude price and declining rupee value in terms of Dollar, diesel, as mentioned above, being the major transport/ industrial fuel, could have been put under the category of ‘declared goods’ thus forcing all the State Governments to rationalise tax rates for it. But the Government did none of these. Instead, earlier this year, it took some regressive and retrograde steps which have not only increased the burden on the common man, exposed the oil industry business to poaching, but in an unprecedented act of not revealing full truth, instead of reducing the tax burden, the Government increased it on the common man’s fuel.

In September 2012, when diesel price was increased by a whopping Rs. 5 per litre, (the partial effects of which are now being borne by public in the form of double-digit inflation), instead of reducing the burden by cutting into its own share, an excise duty increase of Rs. 1.5 per litre was in-built in the Rs. 5 per litre increase. The impression that was sought to be given, however, was that the hike was only necessitated to meet the under-recoveries of oil companies and the entire Rs. 5 increase was on account of base rate and will go to the oil companies reeling under the impact of high crude price.

As if this was not enough, in yet another major act, the Government introduced, in January, 2013, dual pricing of diesel hitting bulk consumers like Army, Railways, State transport corporations, power plants, industries etc, by charging a price higher by as much as Rs. 14 per litre for the same product, compared to the diesel sold by petrol pumps to retail consumers. This has opened a new window for black-marketing and corruption as instead of paying a higher price to oil companies, many industrial customers and transporters now buy diesel from retail petrol pumps at a mutually agreed higher price than the official prevailing retail price, but substantially lower than the PSU bulk price, thereby reducing bulk sales of PSU’s but increasing profit of retail petrol pumps. In addition, it has also thrown major consumers like Army, Railways and Shipping companies open for poaching by private oil companies. Would not private companies, now able to access such large consumers hitherto inaccessible to them, be amenable to funding the “relevant” political parties? Would not retail petrol pumps, now making windfall profits, be a source of black money funding to “relevant” political players? Indeed, like every sector under Government control, there is much more to diesel pricing than what meets the eye.

In summation, while the inflation will further go up with increase in diesel price, PSU oil companies will continue to be in red when the year closes because of the mess created in the sector by the disastrous policy mechanism of the Congress-led UPA government.

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This article was originally published in Niti Central on 11th November 2013. Here is the link:

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The AFSPA Debate – Why we need it?

Since the debate on AFSPA has been sharply brought back in focus by the terrorist attack on CRPF jawans in Srinagar on 13th March, 2013, I am presenting a series of 20 tweets I wrote on need for AFSPA, as long as the Army operates in Kashmir. These tweets were written on 26th Nov 2012 when an effort was mounted by many to build a case for repeal of AFSPA.

 

One last point – these tweets are an attempt at explanation to those who might be curious about the need for AFSPA. As for the separatists – well, India will sort them out.

IT Act Section 66

Below is the complete Section 66 of IT Act 2008 (as amended in 2008).

Sec 66. Computer Related Offences

If any person, dishonestly, or fraudulently, does any act referred to in section 43, he shall be punishable with imprisonment for a term which may extend to three years or with fine which may extend to five lakh rupees or with both.

Explanation: For the purpose of this section,-

a) the word “dishonestly” shall have the meaning assigned to it in section 24 of the

Indian Penal Code;

b) the word “fraudulently” shall have the meaning assigned to it in section 25 of

the Indian Penal Code.

66 A Punishment for sending offensive messages through communication service, etc

Any person who sends, by means of a computer resource or a communication device,-

a) any information that is grossly offensive or has menacing character; or

b) any information which he knows to be false, but for the purpose of causing annoyance, inconvenience, danger, obstruction, insult, injury, criminal intimidation, enmity, hatred, or ill will, persistently makes by making use of such computer resource or a communication device,

c) any electronic mail or electronic mail message for the purpose of causing annoyance or inconvenience or to deceive or to mislead the addressee or recipient about the origin of such messages shall be punishable with imprisonment for a term which may extend to three years and with fine.

Explanation: For the purposes of this section, terms “Electronic mail” and “Electronic Mail Message” means a message or information created or transmitted or received on a computer, computer system, computer resource or communication device including attachments in text, image, audio, video and any other electronic record, which may be transmitted with the message.

66 B. Punishment for dishonestly receiving stolen computer resource or communication device

Whoever dishonestly receives or retains any stolen computer resource or communication device knowing or having reason to believe the same to be stolen computer resource or communication device, shall be punished with imprisonment of either description for a term which may extend to three years or with fine which may extend to rupees one lakh or with both.

66C Punishment for identity theft

Whoever, fraudulently or dishonestly make use of the electronic signature, password or any other unique identification feature of any other person, shall be punished with imprisonment of either description for a term which may extend to three years and shall also be liable to fine which may extend to rupees one lakh.

66D Punishment for cheating by personation by using computer resource

Whoever, by means of any communication device or computer resource cheats by personation, shall be punished with imprisonment of either description for a term which may extend to three years and shall also be liable to fine which may extend to one lakh rupees.

66E Punishment for violation of privacy

Whoever, intentionally or knowingly captures, publishes or transmits the image of a private area of any person without his or her consent, under circumstances violating the privacy of that person, shall be punished with imprisonment which may extend to three years or with fine not exceeding two lakh rupees, or with both Explanation.- For the purposes of this section–

(a) “transmit” means to electronically send a visual image with the intent that it be viewed by a person or persons;

(b) “capture”, with respect to an image, means to videotape, photograph, film or record by any means;

(c) “private area” means the naked or undergarment clad genitals, pubic area, buttocks or female breast;

(d) “publishes” means reproduction in the printed or electronic form and making it available for public;

(e) “under circumstances violating privacy” means circumstances in which a person can have a reasonable expectation that–

(i) he or she could disrobe in privacy, without being concerned that an image of his private area was being captured; or

(ii) any part of his or her private area would not be visible to the public, regardless of whether that person is in a public or private place.

66F. Punishment for cyber terrorism

(1) Whoever,-

(A) with intent to threaten the unity, integrity, security or sovereignty of India or to strike terror in the people or any section of the people by –

(i) denying or cause the denial of access to any person authorized to access computer resource; or

(ii) attempting to penetrate or access a computer resource without authorisation or exceeding authorized access; or

(iii) introducing or causing to introduce any Computer Contaminant. and by means of such conduct causes or is likely to cause death or injuries to persons or damage to or destruction of property or disrupts or knowing that it is likely to cause damage or disruption of supplies or services essential to the life of the community or adversely affect the critical information infrastructure specified under section 70, or

(B) knowingly or intentionally penetrates or accesses a computer resource without authorisation or exceeding authorized access, and by means of such conduct obtains access to information, data or computer database that is restricted for reasons of the security of the State or foreign relations; or any restricted information, data or computer database, with reasons to believe that such information, data or computer database so obtained may be used to cause or likely to cause injury to the interests of the sovereignty and integrity of India, the security of the State, friendly relations with foreign States, public order, decency or morality, or in relation to contempt of court, defamation or incitement to an offence, or to the advantage of any foreign nation, group of individuals or otherwise, commits the offence of cyber terrorism.

(2) Whoever commits or conspires to commit cyber terrorism shall be punishable with imprisonment which may extend to imprisonment for life’.

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.

 

Financial Crisis Explained – I

Warning number 1: This is a long post, part of a multi-post series on the crisis in the financial markets.

Warning number 2: I never took an Economics or Finance course in my life. I will not quote economists or provide citations and statistics. Not because I want to be simple and lucid. It’s because my knowledge of finance is extremely limited. All that follows is based on my understanding of the present financial situation, an understanding formed by reading the popular press.

Warning number 3: Which means that everything I say below may be wrong. But what’s wrong in that? At least, I didn’t get half a million dollars bonus and an apartment in Manhattan as reward for being “wrong”. Right?

The Backdrop

In a land far away (the United States of America) a long time ago, there was a great housing boom.

Okay wait. I am getting a bit ahead of myself.

So first a little perspective.

In the US, buying a house is considered to be one of the best investments one can make. This is particularly true because the government, as part of long standing policy, encourages people to own their own homes by allowing tax-deductions on mortgage interest payments. This means if you took a loan to buy a house and is making monthly payments towards the mortgage as well as toward property taxes; the government puts some of that money back into your pocket by allowing you to deduct a percentage of those expenses from your federal taxable income. In other words, a certain portion of your house-ownership cost is written off by the government from your tax bill.

Since the US government does not consider providing any such relief to people who rent (though such people are generally worse off than home owners), the financial incentive to own a home is that much greater.

So yes. Where were we? Yep. The housing boom. For the last few years, prices of houses were going up and up in the US driven by ever-increasing demand. So much so that people, many of them in fact, started thinking like Mr. Bullah below:

“Hey this house is worth $500,000. In a year it will be $600,000. So if I can sell it then, I can get a 20% return on investment. ”

Of course there is a small problem. Bullah’s net worth, in terms of his savings, is $10,000 (2% of the house’s cost). And just to make things worse, he has a bad credit history having defaulted on his credit card bills a few times. In order to make the very basic minimum down-payment for the house (usually 20% of the cost), he needs $100,000 i.e. $90,000 more straight away.

He goes to the bank.

Now in normal situations, the loan officer would look at Bullah’s bank statement and his credit history and show him the door telling Bullah politely (after all his name is Bullah) that he just does not have the equity to make such an expensive purchase.

However these are not normal times.

What happens is that on seeing Bullah’s loan application, the loan manager smiles, shakes Bullah’s hand and provides him the loan on his down-payment. Yes the full $90,000. Plus the loan manager also provides as loan the rest of the house cost (i.e. loans him an additional $400,000) enabling Bullah to take possession of the house right away with zero-down payment.

So what does Bullah provide as collateral? Nothing.

The only catch is that in exchange for the high (and unreasonable) risk the bank is taking on giving this loan, it expects a very high rate of interest from Bullah. This transaction between Bullah and the banker (let his name be Lucky Chikna) is what is known, in common parlance, as “subprime lending”.

Lucky Chikna is happy because he is going to get a lot of money as interest for his investment (albeit more than a bit risky), which, in turn, is going to translate to a higher commission for him.

And Bullah—he is only too glad to get any loan. As he tells his worried brother Chutiya: “Don’t worry about the high rate of interest. In a year, we will recovered our money and quite a bit more. So no problem.”

And so this came to pass that thousands of such “sub-prime” loans are written by greedy creditors out to make a fast buck on the high interest rates and then accepted (often many loans at once), with glee, by equally greedy common citizens who think, based on advice given by “pundits”, that the housing market would be the golden goose that would keep on giving. Year after year.

The Federal National Mortgage Association, nicknamed Fannie Mae, and the Federal Home Mortgage Corporation, nicknamed Freddie Mac, are special private corporations that have strong government ties. Fannie Mae and Freddie Mac were started by the US government so that they may provide credit to the banks (i.e. the primary lenders who loan money to people to buy houses). This was to enable primary lenders to provide more mortgages to common people and thus promote home ownership.

In short a Baap ka baap. 

Let me explain how I think this works (the actual process is a bit more involved). Say I buy a house for $500,000. The total amount I have to pay back to my bank at the end of thirty years (my mortgage period) is $600,000 distributed over monthly payments. The bank however has to pay the seller of the house $500,000 right away and then wait for 30 years before they have their full principal and interest back. In other words, the money would be “stuck” for that period of time.

This is where Fannie Mae/Freddie Mac comes in. They go to the bank and if they believe that the bank has followed sound lending practices, they buy the mortgage from the bank for say $520,000. Which means that the bank gets its $500,000 back immediately along with $20,000 interest without having to wait for years. It has thus not only made a profit but it has recovered its principal leaving it free to re-invest this amount into another mortgage. Now Fannie Mae/Freddie Mac will be the party responsible for collecting on the $600,000. Since the mortgage was bought for $520,000, at the end of the mortgage period it will have made a $80,000 profit.

Now where did Freddie Mac/Fannie Mae get this $520,000? Why doesn’t it worry about the fact that its money will be stuck for 30 years? That is because Freddie Mac/Fannie Mae sell what are known as mortgage-backed securities to investors.

Just like an index fund allows an investor to invest in a bouquet of companies with the spread of companies reducing his risk of betting his money all on one horse, a mortgage-backed security (MBS) allows an investor to own stakes in a large number of different kinds of mortgages.

So when Freddie Mac/Fannie Mae make the $80,000 profit on its $520,000 investment, it can keep a percentage of the $80,000 as its commission and passes on the rest as dividend to the MBS- holders i.e. all those who made an investment in that particular mortgage.

Now as is evident, higher the rates of interest are on the mortgages that form an MBS, more are the payouts to the investors in that MBS. With financial experts betting on the housing market to grow and with the consistently high returns on such securities, the prices of MBSs appreciated greatly with investment banks, institutional investors like pension funds and hedge funds all rushing in for a piece of the action. And added to the fact that securities issued by Freddie Mac/Fannie Mae had an implicit backing of the federal government (i.e it was “expected” that the government would cover the investment in case of financial downturns) and one can understand the craze for Freddie Mac/Fannie Mae MBSs.  

Now were Freddie Mac/Fannie Mae head honchos well-aware of the shaky foundations of the MBSs they were peddling? You bet they were. But then why should Bullah and Lucky Chikna be the only greedy ones when Lambu Atta, the big boss of Freddie Mac/Fannie Mae is also in the game? Buoyed by the high returns on MBSs, the management of Freddie Mac/Fannie Mae helped themselves to obscene bonuses and vulgar pay-increases. Of course, in the midst of all the excesses, they conveniently forgot that their charter officially stipulated that they were to use their profits to buying more mortgages, increase capital flow in the housing market and thus push down mortgage interest rates.

 

Money as they say does strange things to memory.

In the lucrative business of buying mortgages, Freddie Mac/Fannie Mae were not the only players in the town, though they were the largest. Different kind of financial institutions like insurance companies and even normal banks were falling over themselves in order to buy sub-prime mortgages from the primary lenders and sell them as part of their investment products. Yes those very loans that had been given to credit-unworthy people like Bullah who had no assets to cover the huge amounts of money they had taken out.

Something was bound to give. With a financial disaster of a war, rising national debt, falling dollar, job losses and out of control oil prices, those people who had taken multiple mortgages out on their $10,000 bank account no longer had the money to make the high monthly payments.

The buyers they had predicted would buy their houses at a premium—well they were no where to be found.

So thousands and thousands of home-owners just threw up their hands and declared bankruptcy. Houses were foreclosed and seized. People were evicted.

But then the question remained: who would buy these seized homes?

No one. Because people had no money—a state technically called “Loot gayee Laila”. Banks, once they realized that the housing bubble had popped, had tightened their lending policies (after the horses had all bolted) and so loans were no longer easily available. Houses stayed on the market forever. Their prices nose-dived. And mortgage-owners were left holding non-performing, fast deprecating assets on which they had to pay property tax in order to keep holding onto them till a buyer could be found. Remember that $600,000 payment Freddie Mac/Fannie Mae needed in order to pay the dividends to the MBS holders and also take their commission, the expectation of which had forced MBSs to stratospheric levels?

Well the news was that there was no $600,000 coming.

MBSs , once bought at high premiums, had started losing their value rapidly.

Disaster was now at the gates. For banks who had invested in mortgages themselves. For Freddie Mac/Fannie Mae. For people who had bought MBSs. For anyone who had guaranteed a mortgage or bought one. In short, ruin for most of the economy as black suit bankers sat on a mountain of useless MBSs that was often not worth the piece of paper written on. Was that all? 

As the line from Bombay Boys goes “Abhe khatam naheen hua chutiye”.  

I made one gross oversimplification in my preceding narrative. (Well more than one. But bear with me.) When greedy banker Lucky Chikna gave the loan to Bullah, he told him that Bullah will get the loan only if he takes out insurance on his mortgage so that if in the (unlikely) case that Bullah cannot make good on his financial commitment, the insurance company will pay the remaining amount on the mortgage.

Bullah now has to make monthly payments for his mortgage insurance (over and above his mortgage payments) but Bullah doesn’t care. Cause he has the pot of gold at the end of the rainbow. The fact that the mortgage is insured is also good for Lucky Chikna as he has covered his bases, should someone ask him what kind of risk mitigation steps he has taken.

Now let’s consider the situation from the point of view of the insurance company. Ibu Hatela, the big chief, suddenly gets all these house-buyers who want mortgage insurance and are ready to pay a nice premium for them. Ibu thinks to himself :” This is good. With the way the housing market is, there is not much chance of the house buyer going bankrupt–he will always be able to sell his house and make a lot of money. So no chance of him defaulting. Let me keep on selling these insurance products.”

And so he keeps selling. Because his company is well-known, the insurance-buyers never ask him “Do you have assets to cover all your insurance liabilities?”After all, when we buy car insurance from ICICI  or Tata AIG, do we ever stop to ask them if they actually have the money to pay $25,000 for damages, if I total someone else’s car? No we do not.

And so insurance companies kept on making out these insurances far beyond their covering capacity.

The premiums were like “free money”, insuring (as one expert opined) cars in a country where there were no car crashes. Why just housing? Companies started insuring any kind of big loan with the guarantee of coughing up the cash should the loaner default. Just like mortgage-backed securities, these “I shall pay up when you cannot” instruments (technically called credit default swaps) were being bought and sold on the market at high premiums and companies who were dealing in them were raking in the profits.

What that meant was Ibu Hatela would sell the rights to collect premium from Bullah to another guy, say Ballu Bakra and Mr. Bakra would in turn sell that credit default swap to someone else. The market for credit default swaps were red hot —AIG, one of the biggest names in insurance had $78 billion worth of swaps !

Again, all this was fine till the day the housing market went boom. Thousands of people began to default on their loans. All the cars in that crash-free world had just run into each other. The insurance companies and the buyers of credit default swaps, needless to say, did not have the cash to cover the claims. With the housing market going down, different other kind of business deals started going sour. Even more debt insurance claims were made. And the more they were made, the deeper the owners of credit default swaps sank into the swamp.

Then of course there were the investment banks—the Bears and Sterns and the Lehmans of the world.

They had their proverbial finger in each of these superhigh yield pies be it the mortgage-backed securities or the credit default swap markets. As a result of years of high-paying lobbying initiatives, the investment banks had made sure that they operated under the minimum of controls and oversight, freeing them to take unreasonable risks while investing. Initially it all went according to plan. Even better than the plan as a matter of fact. The more they raised the stakes and the more outrageous the risks they took, more money they got. Income forecasts were manipulated by taking into account the so-called “value” of the credit default swaps whereas in reality it was nothing but “funny money” that existed only in an optimistic future, a tomorrow that would ultimately never come. And with such rosy forecasts and on the back of its great current “performance”, Wall Street paid out record performance bonuses across the board.

Till of course disaster struck. The MBSs sunk to junk and people started calling in the credit default swaps. The banks did not have enough assets to cover even a fraction of its liability. When angry young man Amitabh Bachchan says on screen: “”Main paanch lakh ka sauda karne aaya hoon, aur mere jeb mein paanch phooti kaudi bhi nahin hai!” (I have come to conduct a deal for 500,000 but I do not have even 5 paise in my pocket) it sounds macho and cool.

Now when investment banks are shown to have followed that same principle, it’s quite horrifying. To put it mildly. No wonder then that investor confidence and their overall credit-worthiness suffered.

The only way for the Lehmans and the Bears and Sterns to be able to survive would have been to raise money from the market and use it to discharge their obligations. But the credit market had frozen up. No financial entity in Wall Street was trusting anyone else with their resources. Starved of its cash flows, an investment bank like Lehman Brothers that had survived the Great Depression and two World Wars went belly-up. So did Bear Sterns before it was acquired. AIG and Freddie Mac/Fannie Mae were in danger of coming to their knees but since they were considered too critical to fail , they were given federal life-lines through infusion of tax money to keep them afloat.

Two of the biggest banks–Washington Mutual and Wachovia were not so lucky and was taken over by other corporations.

And most importantly, the High End Girlfriend Index, the true indicator of the value of Wall Street fatcats, collapsed spectacularly.

The face of the financial world had changed within a few weeks.

But the drama..that was just beginning.

To be continued…………………………………………………


 

 

 

The Great Financial Crisis – Preface

Hello All,

Considering that the present financial crisis has been variously described as the most challenging after the “Great Depression” of the 1930’s and certainly the greatest of our generation, I thought it would be fitting if the issues involved could be put in perspective. So here is a take, which has been doing the rounds on the internet which I found very interesting. I have not been able to elicit who the original author of the piece is. However, I liked the write up immensely because of the very lucid way in which it explains the complex maze. Therefore, I have decided to post it in a new category called “explanatory musings”. I especially recommend this piece to the uninitiated in complex financial matters ( like me).

Warning: Since the article is going to be long, it will be in the form of a series. So if the reader wants the complete picture, she is advised to read the entire series.

PS: I am posting the two part series in exactly the same form as I received it in email. Please do not be misled by the first person style of the writing. I am not the original author of this piece.

Regards,

Akhilesh