This explanation is comforting mainly because it is simple and understandable while at the same time by and large true.

However, the fly in the ointment in this simplistic attribution of blame is that “human greed” is not fundamentally a bad thing—one may argue that it is the very “basic instinct” that drives human endeavor and the creation of wealth. If one is not greedy, one becomes satisfied with what one has and there never is the incentive to do anything more.

A better explanation, which is a little less simple but similarly abstract, is that the problem lies in the failure of the system to regulate greed through the creation of an appropriate set of negative incentives which if had they been properly implemented would have controlled the recklessly risky behavior that has brought us to this state.

Nassim Taleb (considered a blowhard ignoramus by some and a subversive genius by others) identifies this systemic failure in the compensation system which he argues is asymmetric—while it provides positive incentives when the going is good, there is not an equally compelling negative incentive when things go bad. So while Banker Patel may take home a $500,000 bonus when things are good, noone makes him give back $300,000 when a few years down the road, things go bad. This Taleb argues is not true capitalism because the banker class is only raking in the profits but not taking responsibility for the losses. The financial executives know they can get away with this “heads I win and tails you lose” because the banking system, being too “big to fail”, will be bailed out by society if things go terribly terribly wrong (which is exactly what has happened) and that the consequences for “personally optimal but globally risky” behavior will ultimately be absorbed by the ordinary tax-payer.

Critics of Taleb’s argument would say that he is merely mirroring street blood-lust for bankers when he suggests that somehow financial executives should be expected to pay back their bonuses from previous years. Say Shahrukh Khan is signed on for a three year contract by Yashraj movies. His first two movies are megablockbusters and Shahrukh Khan gets a healthy bonus as an incentive. The third movie tanks spectacularly on a  “Roop Ki Rani Choron Ka Raja” scale.  Would anyone expect Shahrukh Khan to pay back the money he got as bonus for the first two movies to Yashraj ? All that can be expected is that Shahrukh Khan would get a lesser or perhaps even no bonus for his flop and that his future market worth will take a hit. Why should one expect things to be different for Banker Patel ?

The counter-counter-argument is that in the context of performance bonuses, Banker Patel and Shahrukh Khan are not equivalent. When Shahrukh Khan delivers a mega-hit, it is not at the cost of his next movie. The fact that “Om Shanti Om” is a hit does not increase substantially the risk of “Rab Ne Bana De Jodi” being a flop (unless of course SRK is releasing movies every week where audience boredom may come in). However in the case of Banker Patel, he can increase his performance (and by extension his remuneration) by taking risky investment decisions which while profitable in the short run are likely to be disasters in the long.

However because of the way the remuneration system is structured, all that he is expected to do is to show short-term gain.

Looking at it another way, the years in which Patel’s firm does bad, this “doing bad” may likely be a direct consequence of Banker Patel having “done good” two years before by taking unreasonable levels of risk, a cause-effect relationship that is much stronger than between the box office fates of two SRK movies. Once one accepts this, one realizes that Taleb’s idea is not as retributive as it sounds.

Some may point out here that the way performance bonuses are calculated , risk is taken into account. When Banker Patel stands in front of his boss, his boss not only evaluates Patel on the potential earning value of the investment decisions he has taken but also the risk he has brought along with his decisions. Banker Patel’s boss does know that anyone, even an MBA from Jhumritaliya, can promise high returns by taking high risks. So Columbia-MBA Banker Patel is considered deserving of his Porsche only if he has increased earning potential but without a substantial increase in risk. This implies that the cause-effect relationship between the “doing good” and “doing bad” we have tried to establish does not hold and expecting Banker Patel to return his bonus, after he has exercised due diligence and been fairly evaluated against the risk that accompanied his decisions, is street justice.

Let’s go back to this sentence.

So Columbia-MBA Banker Patel is considered deserving of his Porsche only if he has increased earning potential but without a substantial increase in risk

How does Banker Patel show that there has not been a substantial increase in risk? By showing that a certain “measure of risk” has remained roughly the same.

Value at Risk (VaR)  is typically this abovementioned measure of risk. [Link]

VaR isn’t one model but rather a group of related models that share a mathematical framework. In its most common form, it measures the boundaries of risk in a portfolio over short durations, assuming a “normal” market. For instance, if you have $50 million of weekly VaR, that means that over the course of the next week, there is a 99 percent chance that your portfolio won’t lose more than $50 million. That portfolio could consist of equities, bonds, derivatives or all of the above; one reason VaR became so popular is that it is the only commonly used risk measure that can be applied to just about any asset class.

It is the simple interpretation of VaR that made it so extremely popular, popular enough even for regulatory authorities. [Link]

In the late 1990s, as the use of derivatives was exploding, the Securities and Exchange Commission ruled that firms had to include a quantitative disclosure of market risks in their financial statements for the convenience of investors, and VaR became the main tool for doing so. Around the same time, an important international rule-making body, the Basel Committee on Banking Supervision, went even further to validate VaR by saying that firms and banks could rely on their own internal VaR calculations to set their capital requirements. So long as their VaR was reasonably low, the amount of money they had to set aside to cover risks that might go bad could also be low.

So as long as the firm’s VaR stayed low, everyone was happy. Which meant if Banker Patel could keep his VaR low, his boss would pat him on his back.

But then such numbers could be gamed by transferring the risk to someone else . And with the incentive to game  being so high, it was only in the nature of capitalism that there would arrive a financial product that would be the gaming solution.

That financial product—-the infamous “Credit Default Swaps (CDS)s or as they are known as “Weapons of Mass Financial Destruction”. [Link]

It thus is not a co-incidence that the epicenter of the financial meltdown is AIG, the biggest sellers of CDSs. For Banker Patel, CDSs were a Godsend, the Lipitor that reduces the bad cholesterol of risky mortgage-backed securities.  Naturally his portfolio became full of these fun financial instruments.

So what are CDSs? Putting it simply, a CDS was a promise from AIG saying ” In case this high-risk mortgage-based security cannot pay up, I promise to make good the amount”. Banker Patels and Smiths all over the world bought these “insurance products”so that when boss asked “Hey are you sure you want to buy all these extremely shaky mortgage-backed securities” they could say “No problem. We are also buying insurance from AIG so that in case these crazy-ass securities indeed go bust, AIG will pay us back the money.” This worked good for the boss because his division was increasing its earning potential by owning high-return securities without taking any of the risk, the risk that AIG was magically removing off their balance books like a gigantic blotter.

Everybody was happy. Everybody drove their Porsches.

For AIG, the CDSs were a huge money earner. Being one of the world’s largest insurers and possessing an excellent credit rating (AAA), a promise to insure from AIG was extremely valuable, like an assurance from Alok Nath to safeguard your daughter.

Normal insurance products are regulated. Which means if you insure $200,000 you have to show the government you will be able to cover a significant portion of that money if all your insurance claims were to be called in. But CDSs were unregulated which means that AIG could sell as many of them as they would want without having to show they had the money to cover the claims.

This was heaven for Babu Batla of AIG. By selling a large number of such financial instruments each of which independently carried a small risk, his own VaR was kept sweet and the bonus was raked in.

Of course Babu Batla ignored the possibility that all those CDSs he had sold could one day, all together, be called in.  All of these mortgages could not go bad at once could they? Maybe one or two—once in a blue moon. That’s okay. We got that covered. But not all together. How could that ever happen? After all the housing market can only go up.

Of course it could not. Not indefinitely.

As the housing bubble burst, all the insured securities went bad. At the same time. The claims came in, far far in excess of what AIG could cover.

AIG simply threw up its hands and said “Shoot me. We don’t have the money”.

AIG was again too big-to-fail. If it stopped honoring its insurance commitments, the risk they had blotted out would flow back to the original balancebooks and many banks, embattled as they are, would have no option than to close shop.

So the only option was government bailout to the tune of an initial $150 billion and then on March 2, another small baksheesh to the tune of $30 billion (all of these are outside the Troubled Assets Relief Program and not bound by limits on executive compensation)

Now if only the system of compensations was such that the Babu Batlas of companies like AIG had their bonuses linked to the long-term effects of their decisions (and not merely the short term), then perhaps the instinct of self-preservation would have somewhat controlled their greed. They then may have sold only those kinds of insurance assurances which their company had the assets to cover. As a result, not such an obscene number of high-risk mortgage-backed securities could have been guaranteed. This lack of insurance in turn would have made Banker Patel’s own instinct of self-preservation kick-in and he would not gone out on a limb and embarked on a high-risk investment strategy.

And so through the flow of this counteracting force of self-preservation through the financial system, the greed that brought down the house would have been controlled  and the situation would not perhaps be as dire as it is now.

{Caveat: I am not knowledgeable about economics or finance. This post is written based on my understanding of the present situation, gleaned from reading articles in popular media outlets }

But what does the man in the street think of all this?

Let’s find out in this exclusive GB TV news report.

[Background music: Satyam Shivam Sundaram. Ishwar Satya Hain. Satya Hi Shiva Hain. Shiv Hi Sundar Hain. A haaa A haaaaaaa]

Samar is 16 years old and is in Class 11. This is what he had to say.

I don’t see what’s wrong in making a few untrue statements in the balance books. I mean come on dude. Everybody does that at school while doing lab reports. I mean how can one really get a straight line graph while plotting V vs I? It never happens. So you massage the data so that it “fits”. The teachers know it. The students know it. The teachers when they were students did it.

Mona is 33. She works in a cell center.

If you don’t have it, you pad it. Be they balance sheets or bra cups. That’s common knowledge. When prospective grooms come to our house, I always wear padded bras. My aunts told me to do so. Are they asking me to cheat? I don’t think so. And just to balance out that exaggeration, I also under-estimate. I say I am 25 years old.

And it’s not just the younger generation who are supportive of the management at Satyam.

Raghavan is 45. He works for the government.

[Angrily]

So what’s the crime here? Using shareholder money to buy shares in the company your son runs at outrageously elevated prices? I mean if you are dragged over the coals for looking after your family, what is a man to do? Apne to aapne hote hain. What next? Ban the Congress Party?

Lalaji is 65. He has run a grocery for 45 years now.

My dad always used to tell me “Before you decide to be Harishchandra, remember what happened to him. And let that serve as a warning.” I have always followed that dictum and every successful business has to. I keep a metal weight below my scales, I put small bits of stone in the rice, I adulterate the cooking oil. I have two ledger books.

It’s not just me. The dairy-boy who my wife buys milk from has more water than milk. The asli desi ghee I buy is hardly asli. Everyone is tampering with numbers and ratios. Thats how it always has been with dhanda-giri.

There is just one crime in business. Just one.

And that’s getting caught.

Not everyone was so outspoken however. When we asked Ajay, 53, himself an accountant how despite audits by a major accounting agency, nearly ninety four percent of the cash on Satyam’s books just does not exist, he merely smiled and said.

Magic !

In other news, unconfirmed reports suggest that the embattled CEO has been seen in half-sleeve shirts and suits and is reportedly currently working on developing 8 pack abs. This has lead many to speculate whether a “Ghajini” defense of anterograde amnesia may be mounted against a 7 year jail term, a defense that is intensely popular among powerful business owners. Viewers may recall that such a defense was successfully used by Sanjay Singhania, the telecom giant, to get an acquittal after he went on a murderous rampage for which he was not only accused of mass murder but also of gratuitously breaking all the laws of Physics and of good cinema.

Fade out music: (paraphrased song from movie “Gunda Mawali”) Raju awaara barsaat main, chori chori kya kar baitha…..

The Dow Jones Industrial Average (DJIA) gains 936 points on a spectacular Monday. And then, like the proverbial monkey on the oily pole, drops 733 points on Wednesday, making it the second worst single day drop in Wall Street history.

The stock market has now entered a most dangerous period—-a time of high price volatility. As an investor, you say to yourself—”The market has gone the lowest it can go, equities are as cheap than they have ever been for a long time and I can start buying stocks now.” And the moment you think its safe to go into the water, the market goes into a free fall once again. Naturally, you panic even more and keep holding onto whatever investments you have. Unsure as to which direction the market will go and fearing for the worst, you start having a fire-sale of your holdings. Other people do the same thing. The market drops further. Then perhaps some little gains are made, market sentiment perks up and you again wade in. The shark however sneaks up once again and before you know it, you are holding a bloody stump where once your investment portfolio was.

Welcome to 2008. What the pundits are now saying is as close to the Great Depression as we have ever been. The very worst of times. The last time they used the word “depression”  was in the context of the 1929 economic cataclysm. Markets then took decades to recover—-General Electric, one of the leading corporations of the day, took almost twenty five years to recoup its losses in value.

Which means that if we accept the assessment that we are inside a depression (or something close to it), then what we are seeing is much more severe  than just a “market correction”, a “bear market” or a “recession”.

And the most disquieting thing of all.

Evidently, as the big brains tell us, matters are even now nowhere near the worst.

The only silver lining. The big financial gurus have been proven very wrong in the past. Maybe, after a spell of irrational over-exuberance in the last few years, they are now compensating for it by being over-pessimistic. Or perhaps, by the law of “a broken clock is right twice a day”, they are finally “on the money”.

The kind of disquiet and apprehension for the future that exists in the US today is almost unprecedented in recent memory. National debt is so high that the debt clock in New York city had to be taken down as it had run out of digits ! Unemployment figures are at historic highs, consumer confidence (very critical to the economy for the Christmas shopping season) low and real estate prices keep falling every month (Recently, a house sold on Ebay for $1.76)

People are angry. And angry people obsess about identifying the “guilty party”. Not that the act of identification serves any purpose other than to provide the mental satisfaction that the apportion of blame, even if it be as effective as shouting in a dark room, brings about .The verdict is unanimous —–”Wall Street” is the culprit but since there is no single person who can be lynched, all America’s anger has focused on the Republican administration, that is widely perceived to have let investment banks run loose. And the man who has suffered most as a result of this has been John McCain, who has seen his election lead being wiped out to be replaced with a significant lag behind Obama (Gallup) on the back of the economic collapse. So concentrated has the tide of public opinion been against him that he was found to be pleading with the nation in the third presidential debate— “I am not George Bush”.

This post is not about who is to blame for the credit crisis—I think that has been discussed in the previous posts on the subject. However I cannot go to the main course without telling you about something that has fascinated me—-in the same sense that Shibu Soren “fascinates” me, in the same sense that two cockroaches making love hold me enthralled.

And that is greed. Vulgarly arrogant displays of it. The kind that brings the world’s strongest economy at the doorstep of collapse.

Story 1: After the Paulson plan became law, many financial institutions (who had lobbied extensively for a government bail-out) were reported to be no longer as keen to avail of the provisions of the  plan because the politicians, in an acknowledgment of popular anger, had put a ceiling on executive compensation for any institute that wished to avail of the plan’s benefits. Instead, these financial fatcats were preparing to go it alone, at least for now, to see if they could solve the problem without taking a pay-cut. And if they can’t, they can always extend the begging bowl later on. For now, let’s empty out whatever we can.

Story 2: 70 of AIG executives, after (and I repeat after) they had been bailed out by the government, went on a pleasure trip to an exclusive resort and spent many thousands of dollars on spa treatments and the other corporeal pleasures of the Wall Street life. If that was not outrageous enough, what send me into fits of maniacal laughter  was when I saw one of the AIG bosses on TV justifying it by saying that perhaps the executives were stressed out by recent developments—-of course later on the story was changed to be: this trip had been planned “in advance” and surely once you tell kids about a planned excursion, it would be most unfair to “cancel it”.

Story 3: By the high standards of Wall Street compensation, 50 per cent of the total revenue of a financial institution is spent on executive salary, when times are “good”.  In the first nine months of 2008, when times were undisputedly bad, Merrill Lynch (now bankrupt) paid their execs 13 times their total revenue as salary —yes that means 1,300 per cent. So next time, one of your Wall Street friends tell you that that they earn more because of their astounding “performance” (and so jealous outsiders should “get over it”), kindly throw this figure in his/her face. And you do have the right to be a bit arrogant here. After all, its your tax dollars that’s providing the downpayment for his Porsche.

But greed is not what this post is about. Its about trying to answer whether the crash of 2008 is really as big as it is being made out to be or is all the hullabaloo just an extreme knee-jerk reaction to the inevitable bad times that follow periods of high Wall Street numbers?

After all, the Depression was more than 70 years ago. The science of managing economic crises has changed since then. Surely the same follies in 1929 that drove the US deeper into Depression will not be repeated. Steep declines in stock values and wiping out of investments have happened many times since, from single day bloodbaths like Black Monday to a period of free-fall like from 2000 to 2002 when the Dow Jones lost more than 50% of its value with $7.4 trillion dollars “vanishing”. Some would say that after prolonged periods of increase in stock prices (“`overheating”‘) [about a year ago, on October 9 2007 the Dow Jones Index had reached its highest ever number] such a crash is inevitable.

In passing, isn’t the state of the investor today, after the highs of 2007, somewhat like the hedonist party-goer who after a deliriously debauched night on town wakes up in a bathtub with a “You have one kidney left”‘ message scribbled on the mirror in red lipstick?

As to big and perceived-to-be-solid corporations, they have failed before. Penn Central Transportation Company, the biggest railroad in the United States, declared bankruptcy in 1970, shaking up the system and sending people into panic. This is also not the first time that major banks have gone bust—the 80s had quite a few major catastrophes in the banking sector. Inflation? Today’s inflation in the US is still nothing compared to the early 80s.

So what is it that has changed over the years? What is it that is so special about this economic downturn that has necessitated the biggest government intervention in modern history? Needless panic? Or is there something unprecedentedly wrong with the US economy?

First let us look at what has not changed. That is what has remained constant over the last 100 years.

The follies of the common investor.

People still make the same mistakes while investing their money in the stock market that their grandfathers did years ago. After all what is the stock market except a composite measure of a nation’s economic sentiments, reflecting both the fundamental irrationality as well as the capriciousness of the homo sapien ? It is these emotion-driven swings between hopeless optimism to debilitating pessimism in the blink of an eye, that has historically driven markets to heights unheard of and then brought it to the ground with earth-shaking violence.

So what are these follies, so eternal that they bind together the monocoled banker of the 30s to the rimless framed soccer mom of the 2000s?

Error Number 1: This is the big one. And by far the most common. Whereas in every business transaction, people believe in buying low and selling high, when it comes to the stock market, they end up doing exactly the opposite.

How many times have you heard something on these lines:” Did you hear how much money Rajesh has made on the stock market. He used to ride a bicycle. Now he has a Bajaj scooter. Everyone is making money on the market. Let’s take money out from your provident fund and buy some shares.”

I have. And this is, on the face of it, a rather persuasive argument for buying stocks. After all if Rajesh and Rukmini are making money playing stocks and riding a bicycle or buying a new fridge, why the hell should not I?

The problem is that if indeed Rajesh and Rukmini are making money off stocks and so is Riaz and Rahim, then the chances are that just like you, everyone else is making a beeline to buy stocks, pushing their values up way above their true worth as investments.  Hence if you “jump in” as soon as you hear Rajesh’s scooter vroom, the chances are that you are buying “high”. It stands to cold-hearted logic that the more the market does “good”, the greater is the risk that tomorrow it will do “bad”. And once that happens, you shall be forced to sell your stock “low” (the same stock you bought “high” in the hope of buying a scooter) in order to minimize your loss.

Smarter than that? Perhaps you are. But this error sneaks upon you, often in a very insidious, indirect way.

Consider Tandiya Bhai, who after capturing Gol Basti decides to do some investment. Having learnt a lesson from his old boss, Lukka who put all his money in risky investment and then lost it all (as Lukka said about his investments: the share certificates he holds are like cinema tickets for a show that has already taken place) Tandiya creates a portfolio where he puts 50% of his savings of $200 i.e. $100 in a company bond (paying 5% simple interest) and the remaining $100 in a high growth stock. Namely in Lucky Chikna’s Latakta Circus Limited (ticker symbol: LCLC).

A year later, based on bumper earnings of LCLC and a huge Bull(ah) market, Tandiya’s $100 stocks are now worth $150 netting him a 50% return on his stock investment. His $100 in the company bond gave him $5. Tandiya’s total worth is, at the end of 1st year, $255 ($105 of his original bond investment and $150 in stock).

Note that the 1:1 balance from the previous year is now tilted in favor of stocks. In other words, Tandiya’s exposure to the stock market (i.e. the chance that something “bad” in the stock market will affect him adversely) has increased because he has almost 60% of his assets in stock. As a result, the insurance against risk (the $105 holding in the bond account) is not as strong as it was before. This lack of “insurance” is even greater a problem than it appears because since the market is now higher than the level at which it was a year ago, the chance that the stock markets will subsequently fall and reduce the values of his investments has increased. In short, Tandiya has a bad risk management policy in place.

And as luck would have it, the stock markets  do go south. Lucky Chikna and business partner Haseena Tantan (duplicate of Raveena Tandon) fall out publicly and this adversely affects investor confidence in LCLC.  Result: LCLC stock falls by 50% i.e. Tandiya’s $150 in stocks now becomes $75. So now in comparison to two years ago, his total portfolio is now down to ($100 [bond principal from 1st year] + $5[ bond interest from 1st year] +  $ 5[bond interest from 2nd year]  + $75 [new value of stock portion of his portfolio])=$185 i.e. he has lost 7.5% of his principal in 2 years.

So how could Tandiya have done better risk management? By taking  $25 (half of $50 profit from 1st year) out of his stock account at the end of the first year and putting it into the low-yield but safe savings account. If he had done that (that is maintained the 1:1 ratio between his stocks and bond account) his total portfolio would have now been: ($100 [principal from 1st year] + $5[ interest from 1st year] + $25 [added principal to the bond in the 2nd year] + $6.25[interest from 2nd year]  + $62.50 [new value of stock portion of his portfolio]= $198.75 i.e. he would have almost recovered his principal.

Looking at it another way, if at the end of the 1st year, he had sold some of his stock (i.e. cashed in) when the market was high, he could have reduced his loss to a large extent.  However Tandiya did not. He told himself “The stock markets are doing so awesome. It would be a sin to take money out of it when the going is good” and did not balance his portfolio. However as pointed out, just because the market was doing well, the risk of it going down had become higher and Tandiya would have been better advised to take out a larger “insurance” to cover the increased risk (technically speaking, he should have made a better hedge).

Taking away money from a stock fund when things are doing well in a smart manner, as means of managing risk, is one of the toughest things to do. Which is why this is a folly that is made not only by small investors and tyros but also by the big boys and the market gurus.If one looks closely, one would see that the major losses on Wall Street sustained by the big players have come because of similarly improper risk management strategies where the potential of higher returns have made fund managers take more and more risk till the camel has buckled down and rolled over under the weight of one straw too many.

Error Number 2: The Nostradamus syndrome. When you hear people saying “Biotech is going to be the future. I am putting $10,000 on Toxic Pharma”, you know that they are making Error Number 2.

While you may definitely get lucky and choose a winner among companies perceived to have potential, putting an inordinate amount of your investments in so-called “growth stocks” (i.e. those companies that have shown healthy per share earnings in the past one or two years or are tipped to grow) has historically been extremely risky. As well as extremely popular.

It is indeed because of this popularity, that growth stocks are almost always “over-valued” and that is because everyone wants to buy them. It is worth remembering that an investment, even in a company that is “great” or may become “great”, may be bad if you paid too much for it.

Also the potential for growth of a sector does not necessarily mean that their share prices appreciate as much as expected. The classical example of this are “air-transport-stocks” which were considered to be the growth industry of choice in the early 50s. Mutual funds that invested in the airline industry (like Aeronautical Securities) have proven to be disastrous and despite the popularity of air-travel today, the airline industry has never performed as impressively as was believed.

In addition, just because a sector looks good to grow, does not mean that you will be lucky enough to separate the wheat from the chaff. For every IBM, there are hundreds of tech companies that have been brought to their knees. Amerindo Technnology Fund, a mutual fund that concentrated on dot coms, rose 249% in 1999–however if you had invested $10,000 in it, you would have about $1,200 left at the end of 2002.[source "Intelligent Investor"]

Error Number 3: The stock tip. Whether it be your paanwala, the guy who sits in your cubicle, or the market expert on TV giving you a stock tip, people should treat such advise with more than a healthy dose of skepticism. Not surprisingly, they do not.

Unless the information is of the type that is not by nature publicly available (i.e. reliable “insider” information from a direct trusted source), stock tips are almost always misleading. If the stock tip is “good” (which is rarely the case), everyone knows it, and then acts upon it. This pushes the price of the tipped security up making it not as attractive an investment as it originally was.

In most cases however such insights into the future are misguided.

Remember that the most intelligent men of our times with great heads for figures have suffered humiliation in the stock market.  Case in point: a certain Isaac Newton who lost a lot of money thus.

And as to the so-called experts on TV and on the Internet, the lesser said about them the better.  James Cramer, a stock evangelist and expert, who comes on CNBC and is known for his animated sports-casterish way of analyzing markets, gave ten “hot tips” for the future in 2000 (read them here). Most of these companies have now gone bust and according to the “Intelligent Investor”, a $10,000 investment spread  equally across Cramer’s picks would have lost 94% of their value by 2002, leaving the hapless investor with a total of $597.44.

Coming back to the original question. So given that people still make the same mistakes and will continue to do so, what is it that makes the situation so bad in 2008?

First of all, and this is perhaps because stock investments have done fairly well over the years,  they are considered much less risky than they were considered to be in the 50s and into the 70s.  Which is why many people in the US think nothing of putting almost their entire life savings in the stock market.

Even more important has been the democratization of the investment landscape brought on by low-cost online brokerages. Traditionally, investment in the stock market was an opportunity reserved for a privileged few, that is those who had a significant corpus of assets that would make it economically feasible  for them to hire a money manager and to shell out large broker commissions (the money a broker takes from you as his payment for doing a stock transaction) and engage in sufficient volume of transactions that would make it worthwhile for the broker to service the customer.

However the last decade or so has seen the proliferation of online brokerages whose low fees and low limits  on volume of transactions has removed the entry barriers to the stock market in a way that is nothing less than revolutionary. Housewives, truck drivers, college students, grandpas—are now all “in the game” , connected by their cellphones and laptops at all times to the market, having real-time access to market data and an always available corpus of financial knowledge, things that even a few years ago were the prerogative of the professionals.

This increased involvement of all sections of the society in the market has increased, in general, society’s exposure to the vicissitudes of the stock market. Which means any slight perturbation in the markets affects people’s wealth to a far greater extent than they would two decades ago. This also works the other way—-people’s emotions (of panic as well as of optimism and of course collective follies) affect the market more significantly than they used to.

Add to it the fact that instantaneous online trades, automated trading and the availability of real-time quotes make shock waves propagate through the market faster than before, and one begins to understand why share markets are much more volatile and exert a greater, almost instant impact on the common man than ever before in their history.

The second reason why the crash of 2008 is different from previous collapses is that for the past few years, both individual investors as well as financial institutions have exposed themselves to almost obscene levels of risk through high leverage. This means that they have not been investing with just their own money but also with money borrowed from others, with this borrowing many many times greater than their own assets.

This borrowing of money to increase your returns is called investing on margin.

And why is it so attractive?

Consider aggressive investor Inderjit Chadda, the lawyer from “Damini”. He has $20,000 in assets and borrows another $180,00 from a lender, promising to pay him back the principal along with $10,000 as interest at the end of one year.  Seeing that the housing market is booming, he then buys a $200,000 house. In a year the price of the house becomes $230,000. Chadda sells the house, returns the money to the bank ($180,000) and pays them the interest ($10,00) and has $40,000 left for himself. Since his initial share was $20,000 he has now obtained $20,000 as return on his investment—in effect doubling his money in a year.

Consider passive investor Alok Nath. He waits for many years till he himself has saved $200,000 and in the process misses many opportunities for profiting from rising housing markets. Ultimately, he times his house buying at a time the housing market is going up and like Chadda manages to sell the house for $230,000. His profit is $30,000 but on an initial investment of $200,000 making it only a 15% gain per year. Good but nothing like Chadda’s returns however. Expect Chadda to do an exaggerated toss of his head,as a sign of victory, every time he sees Alok Nath

But what if Chadda made a miscalculation, like the time he dared to cross paths with Sunny Deol. What if instead, the market went down while he held the house. That is, at the end of the year, the house’s value had become $170,000. Now Chadda would still have to pay the bank their $180,000 + $10,000= $190,000. Which means he would need to get $20,000 ($190,000 – $170,000) from somewhere in order to prevent being in default of the bank. And his own investment of $20,000? That would have been wiped out. Chadda would now effectively have lost $40,000 in a year, $20,000 of which he himself never had.

In a similar situation, Alok Nath’s loss would be only down 15% i.e. he would still have 85% of his original investment. And he would not have to sell his kidney. At least for now.

If you think that Chadda was being excessively cavalier in his investments, you are mistaken. At $190,000 debt for $20,000 of assets, he was well within the leverage (i.e. debt to assets) ratio of 12:1, traditionally what has been considered, by US law, to be the upper limit to the amount of leverage a bank can carry. In 2004, under pressure from the sharks at Wall Street and from their greasy lobbyists, the federal government entity SEC (Securities and Exchange Commission) allowed 5 investment banks to carry leverages of, hold your breath, 30 and even 40 to 1.Which not only opened the doors to the potential of mind-boggling returns (mind you ‘potential’) but also unleashed the dogs of absolute financial ruin on five of the strongest pillars of the US economy.

And who indeed were the chosen 5?

Lehman Brothers, Bears and Sterns, Merril Lynch, Goldman Sachs and Morgan Stanley.

And we wonder why a firm like Lehman Brothers that survived a Great Depression and two World Wars could not survive 2008 !

Operating under dangerously high leverage ratios is not a prerogative of the Big Boys, even ordinary investors, seduced like Inderjit Chadda, have fallen prey to it like never before. Not only are they carrying higher risks by operating “on margin” (i.e. investing borrowed money), many Joe the plumbers and Jane the programmers are using the borrowed money to venture away from stocks into riskier, but higher pay-off financial instruments like options and futures(which are bets placed on the price of a financial commodity in the future).

In short, ordinary investors are not only more plugged into the markets than ever before, they are also carrying higher levels of risk. Which means that while billions will be made when the going is good, in times like 2008, the impact of a weak market on the country is like a rifle shot through the brain whereas in past decades it was perhaps like a slash with a long knife on the thigh.

And finally what makes 2008 so hellish, in comparison to the past, is that the main fuel for a vibrant economy—corporate growth has come to a standstill in the US. The cumulative effect of years of  steady flight of manufacturing jobs and investment capital away from the US, high oil prices that not only have led to the biggest transfer of wealth in human history but brought to its knees many of America’s most venerable automotive corporations and the three trillion cost of a needless war have all detrimentally affected the foundations of the market. So while money can still be made on Wall Street through well-placed bets and the markets will go up (and down) based on trading, the fundamental supply of oxygen that keeps earnings growing, the dividends coming and leads to overall economic prosperity have been severely constricted.

Which is perhaps the most worrying aspect of this whole affair.

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 “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 tax-payer’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 histoic 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:

Aajkal Wall Street-giri aur netagiri eki baap ka do harami aulaad hain

(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 has been 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’s 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 fatcats 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 who 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-marketeers, 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 WMDs led the country into another quagmire a few years ago)—presidential politics added to the drama. And uncertainty. With the presidential elections a little more than a month to go 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 I had done many years ago in a digital logic viva. He froze, staying silent through most of the meeting. Obama took the initiative and the contest which had been effectively tied, 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 re-imburse the taxpayers for any losses on their investment after five years. (note the way the re-imbursment to tax-payers is not mandated directly by the Act but is merely postponed for another bit of legislation—a bit of legistlation that is likely to be quietely defeated once the spotlight shifts away from 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 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 economic crisis be looked upon as the historic event which decided the US presidential elections? Will the housing market go south for two-three more years?

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 Ganga ask Shankar in “Gunda”: ” “Kyon tu baraf peeta hain whisky main daal ke?”? [Why do you drink ice after pouring it in whisky?]

I wish I knew.

[Part 3 here]

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 far away (the United States of America) a long 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 are 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 per centage 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 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, are $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.

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 come 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 per centage 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. Cause 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 an 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 doesnt 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 Geico or Progressive, 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.

[Part two has the political fall-out of the Wall Street Collapse]

[Note: All names used for exemplary purposes in above blog-post are characters from the surreal epic "Gunda" (1998), one of the greatest movies ever made. More details here.]

In other words, nothing worth commenting on or getting too worked up about.

But then once in a few years, usually right before election time, the government decides to make a grand populist gesture. It gets excellent press, is politically extremely correct, can be spun of as a “crowning achievement” in the coming elections, allows poster painters to put down “savior of the common man” below gigantic cut-outs of leaders, and most importantly serves a vested interest or two. What’s positively evil genius about such gestures is that once you take even a slightly close look at it— you see that it’s blatantly unfair, isn’t that much of a big deal anyways, helps people who don’t need it that much, does not help all those whom it is supposed to and does absolutely nothing to solve the larger problem.

Yes I am talking about Sonia mam’s historic 100% government loan write-off to farmers who own less than 2 hectares and 25% loan write-off for overdue loans for all other farmers (provided they pay back 75% of their loan as negotiated) irrespective of financial condition or location , an amount that will directly cost the exchequer, as originally reported, 60,000 crores.

What the Rath Yatra is to the BJP, the loan write-off is to the Congress. Ever since the infamous loan-melas of decades ago where banks and cooperatives were forced to give out “bad loans” on the basis of non-existent collateral as a means of buying rural votes for the Congress I, nothing thrills the party base more than the word “loan forgiveness”.

Ask our President Pratibha Tai and she will tell you that loan-writeoffs are the greatest thing ever invented. That is after, of course, “shudh desi ghee” and the Nehru-Gandhi family.

With farmer suicides in places like Vidharbha and Andhra Pradesh and with the memories of BJP’s Waterloo “India Shining” campaign, the Congress needed to show its agricultural chops and since the Gandhi topis know of nothing as simple and appealing as government handouts, it was no surprise that loan waivers would be the order of the day.

Though the Congress I is going to run with the number of 60,000 crores the actual amount of subsidy according to the Business Standard is about 38,000 crores with the average hand-out to the lowest rung of farmers (which I presume is defined as only those small farmers that have defaulted on their loans, not all small farmers) being quite a bit less than the average hand-out to the lowest strata in the income tax regime (at least according to the calculations in the above linked article). In other words, its hardly the historic game-altering decision that Sonia-ji would like her rural vote-bank to believe.

What’s of course utterly wrong about the whole “write-off” business is its underlying principle of an universal amnesty. The word “universal” is of critical importance here in more ways than one. There are specific areas in the country, notably Vidharbha and parts of Andhra Pradesh that are suffering from systemic agricultural crises as evidenced by high rates of farmer suicides. A pervasive loan-relief package for these specially distressed areas would definitely have a positive effect as farmers, who have been black-listed by the government as loan defaultees, can again apply for credit and not have to rely on predatory moneylenders.

However, there are those who see a glimmer of hope. Like Gangaram Meshram of Gopalpur in Yavatmal, who owns two hectares. “I borrowed Rs 15,000 from the cooperative bank which will now be waived,” he says, though he adds hastily that he has borrowed double that amount from a moneylender at an exorbitant rate of interest. “Even if it is only Rs 15,000, it’s a big relief for me,” he says.

Similarly, Vandana Anil Shende, 25, a widow from Bharumri village, had taken a loan of Rs 16,000 from the local cooperative bank after she lost her husband. “I’m happy that I don’t have to pay back that loan and can get a fresh loan,” she says. But, her eyes brimming over, she whispers, “If the government had done this a couple of years ago, I would not have lost my husband.”

[Link]

However what the government has done, instead of concentrating on those regions that need special attention, is that it has written off loans universally for all small farmers all across the nation. By doing so it has kept out of the ambit of its munificence all those who have repaid their loans, not because all of them could afford to but because they felt they had to. By rewarding loan defaulters, irrespective of their financial conditions, the government has sent an unmistakable “Tough luck suckers” message to those who made their payments. Such a gesture can only have detrimental effects on recovery for future loans—those who have been penalized for obeying the terms of the loan will not, and should not, make the same mistake again.

Because the loan relief initiative exists purely to appease certain sections and not to solve any of the problems, the way the relief has been structured makes little sense. A big farmer is defined as anyone who owns more than 2 hectares and a big farmer is not liable for a 100% loan waiver. However, from what I understand, in the domain of cotton cultivation where larger farm sizes are de-rigeur, even a farmer who owns 10 hectares is in desperate need of help.

Half an hour after Union Finance Minister P Chidambaram wound up his Budget speech, Durgadas Desapawar of Boriijara village in Vidharba’s Yavatmal district swallowed a large dose of pesticide.

The Finance Minister’s guilt-laced sop of Rs 60,000 crore for India’s farmers meant nothing to Desapawar, overcome by debt and despair. The cotton farmer had borrowed Rs 25,000 from the local cooperative bank. But he had also borrowed Rs 30,000 from private moneylenders because what he got from the bank was not enough to work his nine acres of land. Eventually, he could not repay both amounts because the price he got for his cotton was simply not remunerative enough. When Desapawar learnt that the loan waivers announced by the Finance Minister applied only to farmers with two hectares of land or less, and that he would not be eligible, he took the ultimate step. His family rushed him to the Civil Hospital at Pusad, 45 miles away. The doctors declared him dead on arrival.

Here again, the government has gone for a one-size-fits-all solution by treating the cotton grower in Vidharbha who owns 10 hectares of land at the same level as a grape cultivator with say 30 hectares of land. By not structuring benefits appropriately on the basis of need, a large number of farmers in despair like Durgadas Despawar are being deprived by the powers that be of any kind of remedial assistance.

Needless to say, the government has taken no administrative steps to combat the immediate reason why farmers are committing suicide—the predatory practices of private money lenders for whom subjecting their debtors to the most heinous of interest rates and defaulters the most hideous of humiliation and violence is standard practice. That a local Congress MLA with political protection is one of the biggest loan sharks in the Vidharbha region may not be a totally irrelevant factoid in this context. One of the principal reasons why farmers knowingly walk into the clutches of private moneylenders is that in many cases, farmers are unable to get credit through official channels. That is not simply because all of them have outstanding loan obligations —-in many cases the real reason is that local bank officials are in cahoots with moneylenders and political bosses, with beneficiaries of government loans determined by influence, both political as well as financial.

Will the government do anything about this? We know the answer.

There are of course many things the government might have done if it was really serious about solving the problems of the farmers. A stratified, tailored-to-problem-areas loan relief scheme with no means for any benefits (like the 25% rebate) percolating to prosperous farmers would have been a good start. A fertilizer subsidy scheme that takes the focus away from filling the coffers of the fat cats (50% of government subsidies go straight into the pockets of big fertilizer companies) would have been another good thing to look at. Better and cheaper “crop insurance”, access to better farming technology, creation of better distribution systems for produce —-there are a hundred things that can be and need to be done.

But no.

The Congress government had to go for the cheapest form of titillation possible—the econo-political version of the Hindi movie rain song where the audience thinks its seeing something exciting, the heroine knows its just a padded bra, and the producer is smirking at the gullibility of the audience while counting the box office receipts.

[Apologies for not answering comments in the last posts. As I keep saying, things have been unusually hectic on the work front. Been meaning to write this post for quite some time.]

A little background. My father is (was, he is retired as of March 1) a professor of Economics at IIMC and my mother is a Masters in Economics from the University of Rochester. Thus watching the budget was a family ritual—-Baba would be taking down notes, Ma would be engrossed in the proceedings while I counted the seconds as to when this torture would end.

Its not that I did not like the Budget—-but that was only because following the Budget, Baba would be asked by newspapers for analytical articles and then there was the occasional television/radio interview where Baba would explain to the laymen the inner workings of the government’s fiscal policy in the same gentle tone that he used to teach me. Except that he did not threaten to stop explaining when the other panelists disagreed. He almost always did that with me. Of course to be fair to Baba, the panelists did not throw temper tantrums.

Coming back to the main point, I personally never understood the Budget process or why the entire nation should go ga-ga over it. It always seemed to me to be a kind of a socialistic hangover (like the Five Year Plans) where the assumption was that national economy was guided more by government policy (i.e. its system of tariffs) and less by the market. Of course this opinion could be because of my naiveté in economics—I never studied it—only smelt the tomes of Samuelson, Jones, Mckenzie et al as they sat on the bookshelves near the TV.

Also each Budget to me sounded just like the one before. The reactions to it were also unfailingly similar—-the ruling party would call it a “dream budget”, ” a budget for the common man” while the opposition would call it “anti-people”. The Communists always dubbed it as “written by the World Bank”—even when they were nominally supporting the government. One big-name politician-economist-pressman reportedly had a template for his budget-analysis he used every year: half of it would be “pre-filled” depending on which government was in power.

“Anal”-ysis indeed.

The biggest mystery however were the articles on which tariffs were imposed/removed each year. Let’s see whats cheaper this year. Pasta. Now why would “pasta” need to be made cheaper?

Okay issue solved. Sonia Gandhi, India’s de-facto ruler, made some phone calls.

Actually I understand why some articles have tariffs reduced—lobbies greasing appropriate palms. Which is why seemingly random articles are selected—following no apparent rhyme or reason. There was the case in the 80s when a company with extensive “links” in the government got import duties waived on a very specific kind of machinery for a few days, brought in their equipment , after which the government again clamped the old duty so as to prevent its competitors from availing of the same advantage.

So the lowering of duties I understand. But what about the articles that will cost more? Do their selection follow any logic?

Sometimes it does. For instance, the government increases tariff on Internet telephony even though calling India is way too expensive from US even with Internet telephony compared to say China. The reason is simple: it wants to protect its bloated telecom companies by levying surcharges on internet telephony.But some things—-I don’t understand where they come from.

For instance, why does “Henna powder” cost more this year? Which demented mind in the ministry thought…hmmm which goods can be taxed more…let’s see let’s see………aha…Henna powder. Was it because he was dissatisfied with the Henna he was using and decided “screw the industry”.

Could it be that a roadside Romeo, who works in the Finance Ministry, got beaten up by a gallant, old gentleman with his walking stick? For which he retaliated by increased tariffs on walking sticks. Yes. Walking sticks are going to cost more this year.

A few years ago, when the government levied a tariff on zari (the sparking thing on the lining of a sari)—-was it because of an official’s disgust with Shefali Zariwala’s thong show in “Kaanta Laga”? Was it the same reason why tariffs on hosiery also went up that year?

Or are the folks at the FM more benign—they just have a million chits with names of products on them, throw them into a gigantic hat and get Ram Singh, the official Parliamentary monkey to choose winners (losers in this case) ?

I never asked Baba these questions. Maybe it’s time I did.

Happy Retirement, Baba. Many more happy budgets to you.

I am sure you are proud of your son’s understanding of economics.