Archive for December, 2008

The World Financial Crisis: Part 3- Bankers: From Hunter-Gatherers to Farmers

        Till roughly  10,000 BC, humans subsisted in small wandering groups that hunted and gathered food for survival. Then, in the  Neolithic age  the Sumerian civilization of the Middle East domesticated animals and plants, settled in one place, founded villages and started farming.

A similar evolution is  underway in the financial services world. The great financial centres of today’s world, New York and London are probably the  equivalent of the  Sumerian civilization and are  working through the painful transition of the financial services world from the hunter- gatherer era to the farmer era. Just as Sumerian farmers had to learn to deal with the domestication of plants and animals (some were useful to man and some were dangerous), we are learning to deal with the world of financial derivatives — how to make them useful and how to curb their dangers. The enormous pain that the world is going through now may just be the pain of this transition in which we are learning when and how to use derivatives and when and how not to use them.

One of the lessons we have learnt is that derivatives ought not have been used to solve a structural problem that banks face. Banks, Alan Greenspan points out in his memoir, “The Age of Turbulence”, have historically relied on passive depositors, mainly working and middle class people, who keep their savings in passbook accounts, as the source of funds. These depositors are happy to leave their money around in banks without worrying too much about the return they are getting from it and accounted for 95% for banks resources in the 1950’s in the United States.  They now account for only 60%, say Greenspan, making banks dependant on the same volatile investors that the securities market depends on.

Such expensive borrowings force banks into two risky moves- investing in mortgage-backed securities and taking on leverage. For example,  when a billion dollars gets a return of only $2 million you need to leverage your trade 20:1 or 30:1 to get a 20-30% return. The risk here is that should the trade go against you and you lose $2-3 million, that has effectively wiped out all your  capital. If The word gets around that such an event is likely to happen,  crowds may not form outside bank branches but  lenders   will instantly demand their money back forcing a bank into bankruptcy.

In other words, banks have to find a long-term solution to their financing problem now that passive, unsophisticated depositors are a fading breed.

While all this was unfolding, Mr Greenspan, inspired by his early contact with Ayn Rand, depended on innovative entrepreneurs and market forces rather than government intervention to find solutions to this explosive use of derivatives.

Not that its easy to regulate financial entities  by treating then as a homogeneous  group.  Doing that  is somewhat like trying to have a single set of traffic rules for cars, trains and commercial airplanes. The nature of risks that hedge funds , financial entities who are fervent believers in derivatives, for example,  deal with, are as varied as the risks facing car passengers are different from those facing train passengers as are those facing airplane passengers. Hedge funds that do options trading face what are called gamma risks, those that do relative value trading face risks with the sizing of trades and the usage of leverage and edge funds that deal in distressed debts face event risks specific to the firms they invest in. Having a common set of regulations to deal with all these risks has proven so far to be challenging.

While derivatives are a modern innovation like the microprocessor and antibiotics, we have clearly not learnt all that we need to know about this potent invention. Central to  derivatives  is that make computers crunch reams of historical data to detect discrepancies in the way prices moves across different tradable financial assets. This has been the classic way to diversify risks. But there are occasions, rare as they may be, when the prices of these assets instead of offsetting each other can all fall steeply and in unison. When that happens, all hell can break loose.

Then there are cases where good intentions can go wrong. Subprime mortgages, financial instruments whose original purpose was to make home-ownership possible for a class of citizens who were not eligible for home loans because normal lending standards were too high for them to qualify, is an example. The idea was that a higher interest rate would cover the possibility of higher delinquency, a classic free-market way of using price as a way of rationing credit. However, during the last few years, when interest rates dropped and remained low, many homeowners used subprime financing to repay their earlier loans and even get some cash released, called cash-out financing. According a study published in the Federal Reserve Bank of St Louis Review, “slightly over one half of subprime loan originations have been for cash-out refinancing.”

Earlier this week, I went for a stroll by the big, bronze statue of a crouching bull   near my office in New York. I could not help wondering whether, in times to come, this bull would  spring to life and bring back the good times of the past decade or whether, like the Tower of London, or Qutab Minar, it will merely be a curiosity for tourists, a reminder of the power that Wall Street once was.

END of Part 3 and the series

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The World Financial Crisis: Part 2- Brave New World of Derivatives

Some say that derivatives rank right up there with antibiotics and the microprocessor chip as one of the great innovations of the modern era.

Derivatives are financial instruments that are used to reduce financial risk just as a fire insurance policy is used to reduce the risk of a fire by compensating possible damage in the event of one .  Why did then, Warren Buffett, whose financial acumen is legendary, describe them recently as “weapons of mass destruction”? Where did they come from and how did they become such objects of veneration as well as hate?

In downtown Chicago stands the 45-story building that houses the Chicago Board of Trade, the institution that gave birth to the derivatives business. Beautiful as its art deco architecture is, there is nothing much to set it apart from the many other tall buildings that surround it. Except for one thing. Right at its very top there is a two-story tall statue of a Greek goddess. This is Ceres, the Greek goddess of grain from who the word “cereal” comes from.

This is where it all started. A group of merchants trading in the food grains grown in the surrounding Midwest came up with the ingenious and useful idea of offering farmers a firm “future” price for their crop many months before it came to the market reducing the risks that farmers took  during their  long season of labour. Grain “futures” prospered   for decades till the US government, in the 1960’s  started offering a minimum price for  the crop. This considerably slowed down the grain futures trade. The Chicago grain future traders  sat around their trading pits for a while , smoking cigars and reading newspapers with nothing much to do  till one of them thought of the idea of starting trading in another kind of futures:  using the Dow Jones Industrial Average of equity shares in the New York Stock Exchange as the “underlier” instead of grain.

But, before starting off this new line of business, they solve a problem.:   how to put a  price  on this  new form of “future”. An out-of-the-box thinker among them, Mathew Gladstein, asked for help from a group of  local Chicago economists,  Merton, Black and Scholes. The mathematical model they came up with, the Black-Scholes model did its job of pricing options so well that Gladstein made tons of money using it, Merton and Scholes won the Nobel Prize in Economics for it,  and started the rush of mathematicians to the stock market.

Soon, other enterprising people thought up other “derived” financial instruments based on many other “underliers”: bonds issued by companies and municipalities, mortgages that people took out on their homes….

It is not hard to see why such “derived” securities or “derivatives” have become so popular. A bank that makes a loan, for example, for    a house,  faces many different types of risk. . The borrower, for instance, may not be able to return the loan on due date. Or, he may not be able to keep up with  interest payments. Or, the market interest rate may rise far above the rate the bank has given the loan leaving the bank stuck with a loan at a low interest rate. Or an earthquake might hit the area demolishing the borrower’s business.    Or, high inflation may reduce the value  of the loan by the time it gets repaid.. Derivatives are a way to “hedge” against these risks.

For example, a housing loan to a  borrower in say Cochin can be combined with a housing loan  in Bombay and another one  in Bangalore under one common instrument and this  combined “derivative” can be sold to an investor. This combination reduces the risk of  disparate housing markets such as Cochin, Bombay and Bangalore all  suffering  downturns at the same time  The investor in this derivative rightly believes that the instrument he holds has a balanced risk.

If derivatives can diversify risk, as described above, what can go wrong?  For one, the borrowers  may have  mis-represented their income. Or, the loan issuer may not have verified their incomes. Or, they may have borrowed 95% of the value of their houses such that if property prices decline by say 20%, the asset cover may become inadequate. In all of these cases, should  interest rates rise sharply, from say, 6% to 10%, these borrowers may  longer be able to meet their monthly payments. When Mr Greenspan, who was Chairman of the US Federal Reserve Board was told about similar issues developing in the US mortgage securities market  he believed  that  such problems in the housing sector would  be restricted to a city  and could never become a national let alone an international problem.

This would normally have been true, but  mortgaged backed securities were sold not only nationally in the United States but also throughout Europe and Asia. When the US housing bubble burst and  borrowers in  the United States started defaulting on their mortgage payments, the value of the mortgage securities fell precipitously.The shock waves were transmitted throughout the world. What started as a crisis in some specific parts of the US now became a word-wide financial crisis.

In the next and final part we’ll examine why so many smart people in storied investment banks like Morgan Stanley,  Lehman Brothers and Bear Stearns, in powerhouses such as Citigroup and Royal Bank of Scotland found these derivatives so attractive that they just couldn’t  resist them.

END of Part 2


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