If confidence is the gasoline, then trust is the oil in the engine of Capitalism!

Being able to trust people might seem like a pleasant comfort, but economists are starting to believe that it’s rather more important than that. Trust is about more than whether you can leave your house unlocked; it is responsible for the difference between the richest countries and the poorest.

“If you take a broad enough definition of trust, then it would explain basically all the difference between the per capita income of the United States and Somalia,” ventures Steve Knack, a senior economist at the World Bank who has been studying the economics of trust for over a decade. (Any prices for computing - it’s 99% of the US economy!!)

“Virtually every commercial transaction has within itself an element of trust,” writes economist Kenneth Arrow, a Nobel laureate. When we deposit money in a bank, we trust that it’s safe. When a company orders goods, it trusts its counterpart to deliver them in good faith. Trust facilitates transactions because it saves the costs of monitoring and screening; it is an essential lubricant that greases the wheels of the economic system.

Since last two years, world clearly don’t trust the big banks and financial companies.

Trust is gone: there is no longer trust between counterparties in the financial system. The Fed has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that uncertainty that the balance sheets of financial firms are credible. So even though the Fed has flooded the credit markets with cash, spreads haven’t budged because banks don’t know who is still solvent and who is not.

Bank lending won’t get going again until trust in the markets can be restored. Fighting a Great Depression era problem probably won’t help. More transparency, which means more write-downs and failures, is probably necessary if we’re going to get through this. Unfortunately, we’re still sailing in the opposite direction.

Importance of the feel good factor

I hope this explains why we might have a bumpy road to recovery ahead!!

Credit crisis in the making!!

Credit crisis in the making.. short and simple !

1. To understand the crisis lets first under stand the whole –process.

- Commercial banks sell loans get mortgages

- Investment banks buy mortgages from commercial banks, collaterised them and issues CDOs (trenches: superior/safe, mezzanine, equity/ unrated)

- Investors (Pension funds, hedge funds, individual investors) buy these trenches/ securities and keep with them / rebundle.

2. Scenario in 2002-2005
- Treasuries rate remain very low @ 1% even after a recovery in 2003 (loose monetary policy)
- Mortgages become really cheap and there was a lending boom
- Investors were not getting much returns on treasuries and started looking for other safe alternatives
- CDOs (superior trenches having AAA ratings) give better returns to the investor vis-à-vis treasuries.
- Demand for CDOs/ CLOs/ ABCPs increased.

SUB Prime:
- Commercial banks started lending to the sub prime lender to accommodate the demand.
- They introduced various schemes to rope in sub prime segments:
- No down payments, step up interest rate, no securities etc. All this under the premise that housing prices will keep increasing and the sub prime home owner can dispose of the property after few years.

3 Scenario in 2006-2009
- Home prices stagnated and even started decreasing. Interest rate also started to increase. This resulted in an increase in Sub prime default rate.
- This had a cascading effect:
...... Investors become weary of CDOs and other financial instruments (this was the result of bundling and rebundling of other financial securities with CDOs and subprime)

...... Lack of market for CDOs broughtdown the market prices
...... This further put pressure on already stressed LTV (loan to value) ratio.
...... Investors having these CDOs as financial assets had to report losses due to MtM (marked to market)pricing concept
...... Consequently they had to unwind their portfolio and sell securities (CDOs in the market) putting further pressure on prices and a vicious cycle took place.

4 Spreading of the crisis:
- Banks started taking less and less risk and started hoarding cash. They almost stopped lending to banks (call money rate went up), individuals (mortgage market further declined) and companies. Causing a financial meltdown.
- Institution and economies that worked on principle borrow short and lend long started failing as they found it increasing difficult to refinance the loans. Causing further pressure on the market. (Classical example is the case of Dubai).
- Businesses found it difficult to get loans. Banks were hoarding cash and bond markets were practically dead. Businesses stopped new and existing projects.
- Businesses started downsizing. Consumer confidence fell to the rock bottom. Consumerism went down and another vicious cycle took place!

Can't live without it, but can't live with it (in my portfolio).

The Internet Is Dead… well as an Investment.

I can spend the whole day on the Internet and it would be a day well spent. I can chat, listen to music, watch videos, study, trade stocks, play games, do work - all on the Internet and I believe that its true for almost everybody in my generation. But still when it comes to getting advertisements(revenues) on the Internet, even big names scramble to find a few.

To share a few stories: Microsoft has spent zillions on Internet strategy without a single ray of hope. Every other day Yahoo is closing some of its offering, today it was geocities. Even Google finds it difficult to introduce any other business model other than the one they stumbled upon when they bought Applied Semantics in 2001 that had a little piece of software called AdSense. Google's flagships- Gmail, Youtube, Orkut, Google Earth are all bleeding. Time Warner would rather keep their legacy old media businesses than hold onto one of the biggest Internet companies out there, AOL. News Corporation is shaking up its MySpace business as it figures out its next steps. And the new business in the block: Twitter and Facebook are still struggling for profits despite exponential usage growth

Don't just ask me. Ask the best – Warren Buffet. Nobody can figure out a business model.

Gone are the days of infinite margins, 1000% productivity gains, and growth of market throughout the universe. Internet companies are, at best, like utility companies albeit the only difference being that they get bought at about 10 times earnings and sold at 13 times earnings.

Let's face it. Electricity greatly improved our quality of life. But we are not going to get excited about buying a basket of utility companies. Now, the same applies to the the Internet. Can't live without it, but can't live with it (in my portfolio).

CDS riddle

It isn’t the housing market devaluation, or the sub-prime mortgage market defaults that have us in real trouble. Those are nice fakes to sway attention away from the place where greed truly flourished — trading phony instruments to the tune of $700 trillion.

Let’s figure how to get out from under that. Then maybe the capital will begin to flow again through the markets. Right now, this elephant isn’t just in the room, it’s sitting on us. Banks in Europe and the US face a new wave of losses linked to contracts issued to insure against companies going bust and defaulting on their loans, City analysts have warned. After the billions lost over the US subprime market and leveraged loans, investment banks such as Morgan Stanley, Deutsche Bank, Barclays, UBS and RBS face losses on credit default swaps (CDS) – contracts that allow an investor to be repaid if a company loan or a bond defaults. CDS contracts became a favourite tool of speculators, mostly hedge funds, which bought the contracts without having any link to the original lending. They bought the contract to trade or in the expectation the company would in fact default, meaning they could claim back the full value of a loan they never made.

The CDS market exploded to be worth as much as $50 TRILLION, many times the size of the underlying assets. Each loan could have thousands of protection contracts, even if there were only a few lenders. Hedge funds accounted for about 60% of CDS trading, according to ratings agency Fitch.

The reality of the situation is akin to a game of musical chairs — without any chairs. So now the music has finally stopped.

Lingering financial crisis - a satirical explanation

My apologies for putting an old joke in this blog (Actually, of late I got tired of reading the bad news all over the net). Nevertheless, this joke does a pretty good job of explaining the lingering financial crisis and aptly ridicules the corporate world’s reactions towards solving this crisis. The joke:

Boat Race
Two teams, Team A and Team B decided to engage in a competitive boat race. Both teams practiced to reach their peak performance. On the big day, Team B won by a mile. Afterwards, Team A was shattered by the loss. Their morale sagged. Corporate management decided that the reason for the crushing defeat had to be found. So a consulting firm was hired to investigate the problem and recommend corrective action. The consultant's findings: The Team B team had eight people rowing and one person steering; Team A team had one person rowing and eight people steering. After a year of study and millions spent analyzing the problem, the consultant firm concluded that too many people were steering and not enough were rowing on Team A.
With this new finding they decided to go for another race. So as the D day nears, Team A decided to completely reorganize their team structure. The new structure: four steering managers, three area steering managers and a new performance review system for the person rowing the boat to provide work incentive.
The next year, Team B won by two miles. Humiliated, Team A's corporation laid off the rower for poor performance and gave the managers a bonus for discovering the problem....

Gaussian Distributions .. the building block of Risk management OR the building block of a financial CRISIS

I came to this topic as someone who understands a bit of statistics and a bit of engineering. The usual way to get Gaussian fluctuations is to add up lots of independent little fluctuations (the central limit theorem). The little ones (the individual traders in a market) have to act independently of each other, or the theorem doesn't follow. Obviously, in real markets, the traders' behavior is influenced by the actions of other traders. In the aggregate system, small fluctuations about the mean will still often be Gaussian, but that doesn't mean the big ones are. It was Mandelbrot that discovered "fat tails", that very extreme price movements are far more likely than the theories predict. His findings were initially rejected, and continued to be resisted even when they were replicated in other markets (and then proved out in the real world: a daily price move like that of the 1987 crash was so extreme as to verge on being statistically impossible). 

As a practical matter, non-Gaussian 1/f noise (as opposed to Gaussian -white noise) has been well known to radio engineers since the 1920s and 1930s.

I was shocked when I read a vice-chairman of the Fed , at the time of the LTCM breakup, saying that information feedback is always a stabilizing factor. Any engineer who has studied control theory knows the opposite is true. The math of control theory was first developed by Maxwell (his equations still haunt me), who studied a lever arm connecting a pressure gauge on a steam boiler back to the feed at the bottom of the coal hopper (for that reason called feedback). If the pivot is too close to the boiler (too much feedback), the boiler goes into uncontrolled oscillations and explodes.

Recently, I read a friend's blog whose batchmate from college had become a quant on Wall Street. He said, ofcourse they know that fluctuations aren't Gaussian, but Gaussian fluctuations are the only ones they could model. They're paid to develop models like everyone else's models, not to develop models that are correct !! Shocking but very true. I believe that his revelation is also pervasive because if anybody models in the fat tails, as against the market, the risk premium would be comparatively high, which means costlier end products and little or no sales.

Sometimes I feel that in the race to become effecient, we manipulate facts in our favour and undermine basic risks...

BAD BANK .... is this the only solution

This week, banks ran into yet deeper crisis - the sector is in more trouble than was feared.

In October, following a British lead, governments around the world recapitalised their banks. This drastic measure saved the sector from collapse. But, as the events of this week have demonstrated, the banks are still on the ropes. Bank of America required $20bn of capital and guarantees from the US taxpayer and Anglo Irish Bank was nationalised to halt a run by depositors. Deutsche Bank, revealed striking fourth-quarter losses. Banks are not lending, but are hoarding capital in readiness to absorb losses from existing bad loans and securities. Governments must now act swiftly to move ahead of the crisis. Ad hoc nationalisation of insolvent banks and recapitalisation of impaired ones is simply not enough. Governments must act to draw out the poisonous uncertainty caused by the toxic assets held by solvent banks.

The first option is to create a “bad bank”: in this model, the state would buy up toxic securities from a range of banks and hold them. This would force participating banks to declare large losses, but by removing these illiquid assets from the balance sheet, create certainty about their solvency. It would be a difficult policy to run: it would involve pricing assets that have proved unpriceable and require enormous, up-front costs. The US Treasury’s $700bn troubled asset relief programme was originally intended as a bad bank programme, but changed focus for these reasons.

A better solution, albeit one that must be worked out bank-by-bank, is the insurance model used at Citigroup and, this week, at Bank of America. Governments can, for a fee, issue insurance on the value of a bank’s unpriceable assets, making up the difference if they fall below an agreed floor price. Investors would know that the bank is secure – as with the bad bank model – but it reduces the need for already stretched finance ministries to find money immediately. Simply writing the insurance makes it less likely it will even be needed.

Even after that, however, governments may need to do yet more. They may guarantee credit yet further, perhaps even lending directly, in sectors where commercial lenders have all pulled out. Countries that used to rely on credit from abroad that has now disappeared, as is the case in the UK, may still be stretched even if their domestic banks extend themselves fully. Fixing the banks will not cause a return to growth: we are now caught in the jaws of a global recession. It is, however, a necessary precondition for recovery.