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.

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...

ZIRP (zero interest rate policy) – The two edged sword

From Bloomberg:

“The U.S. Federal Reserve will probably cut interest rates to zero percent over the next two months to staunch deflation, according to JPMorgan Chase & Co.”

Some economists are already feeling that additional policy easing could be appropriate ... given recent data and developments in financial markets, 'some' may have turned into ‘most’,

While this may prove to be correct, it certainly isn't an obvious move. First, most central banks regard getting below 1% short term rates is dangerous territory. ZIRP let to a deflationary trap for Japan, and there isn't a particularly good reason to think it will fare better here.

Taking the target rate to zero percent would not be costless for the Fed. Public confidence may drop and led to the perception that the Fed has run out of options. Some saw a risk that the inflation rate will fall below the Fed's objective of price stability.

In addition, once short term rates fall below 1%, money market funds have trouble operating profitably. The Fed may find itself not merely acting as a big player in the commercial paper market (money market funds are big buyers of CP), but becoming the ONLY player. That would not be good.

Prisoner's Dilemma and the Credit Crisis

There are two topics are different but related in a weird way: we are now seeing a lot of "every man for himself" behavior (liquidity hoarding is one of many examples) that seem rational (or at least defensible) on an individual basis, but are destructive to the financial system as a whole. The second is that, per Richard Bookstaber, our financial system is "tightly coupled" and in tightly coupled systems, risk reduction measures (which too often look at risks in isolation) will typically have the perverse effect of increasing risks.

In financial markets tight coupling comes from the feedback between mechanistic trading, price changes and subsequent trading based on the price changes. The mechanistic trading can result from a computer-based program or contractual requirements to reduce leverage when things turn bad.

Eugene Linden, who has written extensively on animal behavior as well as markets, gave this observation:

The problem facing the credit markets right now is yet another iteration of the "prisoner's dilemma" from game theory, at least in the sense that participants know that if everybody takes the stance of "every man for himself" the markets will crater, but they also know that if they rush for the exits there's a chance that they will get out the door relatively unscathed. Studies of the problem suggest that the more anonymous the context, the more likely that players will adopt "every man for himself," and, of course there's nothing more anonymous than markets. Nature has a long time to work out solutions for problems, and it turns out that a number of animals have converged on the same optimal solution that game theorists have worked out. It's called "tit for tat," and it simply means that if someone extends trust to you reciprocate that trust, and if not, not. The best example comes from vampire bats. When a bat is short on blood it will call on a copain for a sip, and if its bat buddy does the right thing, then the thirsty bat will reciprocate at some point in the future when the tables are turned.

It is wonderfully perverse that vampire bats are more community-minded than Wall Street.

The problem now is, save perhaps within the dealer community itself, many players deal with each other on an anonymous, one-off, or transactional basis. So the opportunity to discipline bad behavior is diminished considerably (but ironically, one of the big factors behind Bears' demise was anger in the community that it had behaved badly both in the LTCM crisis by being the only firm called by the Fed who refused to participate, and its reluctance to shore up its failed hedge funds last June).

Now consider how this conspires with the second element, the perverse outcomes that result from trying to reduce risk in a tightly coupled system. We had written about these examples of efforts to fix the housing/credit crunch backfiring. I'll start with the first, which is that aggressive cuts at the short end of the yield curve initially did nothing to lower long-term rates, which are the basis for pricing most mortgages; the later cuts have steepened the curve, making matters worse.

Reader Lune came to similar observations independently and put them together well, so we'll continue with her list:

We've already seen the law of unintended consequences so far:

1) Congress raises conforming limits on Fannie/Freddie to help unfreeze the mortgage market. Result: agency spreads skyrocket, bringing down Bear and a host of hedge funds. Mortgage markets still remain frozen.

2) Fed opens TSLF to unfreeze mortgage market. Result: Carlyle goes bankrupt as people rapidly arbitrage the difference between holding MBS in firms that can and can't access the new credit facility. Mortgage markets remain frozen.

How It could be a part of Indian Democratic Culture?

I am not commenting anything my own, on the what are going on in the recent few days, in the context of survival of Indian Democracy (this is not a question of survival of 14th Loksabha). I am placing few words from various news items from Newspapers, which quoted as UPA : United Poachers Association, NDA: Non Delivery Agents, SP: Service Providers, BSP: Buying Samajwadi Party and CPM : Cross Party Manoeuvres, Jailbirds spice up humdrum day; and Dealers not Leaders. Is it a result of a democratic/election process, of democratic India, or it suggesting to looked in to the root of the basic problem caused by our democratic/election system, which encourages role of the money and muscle powers to keep the rein of the powers in command, adopting all illegal, corrupt and wrong means. The basic principal of a democracy should be based on “Truth Shall Prevails” and that Government must be for the People, by the People and through the people.

If we postmortem that why such a situation is developed in India, we find in clear terms that since we have adopted British Module of the Democracy, without examining its feasibility in India in the context of varied cultural, linguistic, religious established differences from the Britain. Our Constitution is based on British Rule, adopted in India through the Government of India Act, 1935, which was basically aimed to divide Indians to Rule India. Result, now we can see that India is divided on various counts, supponsored by our political system. Our democratic culture, is developed in such a way under which Prime Minister is not a Popular Leader and nor he is a Member of Lok Sabha, rather he is appointee and assignee of some one else. To save his Government, a so-called clean Prime Minister is bound to become a silent spectator what is going on to survived his Government, and what compromises are made by his party for survival of his Government. In fact, this is result of our faulty election system, which not suitable to Indian Society, which divided Indians by various means.