The Great Wall Street Meltdown Part 2

[Continued from Part 1. Again this is a long post.]

With investment banks and financial institutes sitting on stockpiles of toxic mortgage-backed securities and  credit default swaps, the same instruments that Warren Buffet had dubbed “weapons of mass financial destruction” (with the only point to note is that unlike the “weapons of mass distraction” and Santa Claus, these really existed),  lenders were as eager to loan these people money as anyone would be to leave their kid alone with Michael Jackson.

Money market mutual funds are considered to be some of the more conservative (i.e. safest) investment instruments. Just as a normal index fund is a distributed investment in a bouquet of companies and a mortgage-backed security in a collection of mortgages, a money market mutual fund is an investment in a basket of short-term loans. It is this well of money that investment banks and businesses in general tap into as sources of short-term financing.

Let us assume that Shankar, the main protagonist of “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]

49 thoughts on “The Great Wall Street Meltdown Part 2

  1. kahan hai frst response?

  2. mere paas iPod hoga! toga toga togga!

  3. Phew! You could convert these two posts into an ebook. Any more coming?

  4. You can study and get any certificates. But ucannot get ur death certificate.

    You may have AIRTEL or BSNL connection but when u sneeze u will say HUTCH.

    You can bcome an engineer if u study in engineering college. U cannot bcom a president if u study in Presidency College.

    You can expect a BUS from a BUS stop … u cannot expect a FULL from FULL stop.

    A mechanical engineer can bcom a mechanic but a software engineer cannot bcom a software.

    You can find tea in teacup. But cannot find world in world cup.

    You can find keys in Keyboard but u cannot find mother in motherboard.

  5. Kishor, Has your brain got radio-active after being wiped out by the financial mess?

    Excellent posts, GB.

  6. “Phew! You could convert these two posts into an ebook. Any more coming?”

    I second that. Or more so, this looks like course material for an Finance (meltdown) course. [Pre-req of this course would be to have attended Gunda 101 for 3 hrs at least ]

    On a more serious note, I think this is the best tutorial I have seen for a layman who does not understand the ABC of money markets/lending etc. Good post. GB, take my advice and run for President 🙂 .

  7. Great post GB, though I was expecting some parallels to emerge here – was Bullah not “khulla” enough, are bank fates “latak”ing in the balance like Lucky Chikna’s beds, is pure hard “bust your ass like Shankar” labour everyone’s fate from this point? Did you pick Gunda characters for a specific reason.

  8. Again an excellent followup. Just what was needed by finance challenged person like me.

  9. Excellent – I actually like this part a lot more than the first one. This one does not have a single loose end, everything has been explained so lucidly and every conclusion is spot on.

    I would be careful of reading too much into Buffet’s stake in Goldman and GE. For one, Goldman are his prime brokers, so there’s a long standing personal relationship.

    But Buffet being Buffet, he drove a hard bargain and basically got a sweetheart deal from Goldman – preferred stock at 10 per cent interest and warrants – he makes a profit from day 1. He had a very similar deal for preferred stock with GE, a company that now makes most of its money from investments, not production. These companies gave Buffet what he wanted because the Buffet name is such a gold standard in the investment community.

    That is not the same as the government buying very hard to value mortgage backed securities, where mortgages are diced and spliced and split and recombined in so many different ways, that you have a hard time evaluating how the risk of the underlying mortgage affects the value of the MBS.

  10. Who are you .. o Bong?
    movie critic ? cricket fan ? economy ? social issues ? is there anything you don’t follow?

    btw, excellent post and I learned quite a lot.

  11. Hey Kishor, I got this same forward the other day. For those wondering what’s wrong with Kishor – these are dialogs supposedly uttered by Tamil superstar ‘Captain’ Vijaykanth.

    Coming back to the topic – GB, very well explained. I’m amazed at some of the ‘ulta chor kotwal ko daante’ posturing that is still being exhibited by Wall Street.

    For once I’m thankful that Indian banks & financial institutions have been ‘conservative’ in their liberalising over the last 15-20 years. Indeed, if come-March 2009, India can pull off the projected 8% growth rate – it would be an awesome achievement given the mayhem prevalent in the world markets.

  12. @ Atul – The Prophet is more like it.

    @ GB – Must say you have explained a very complicated issue in a very simple manner. With the normal brand of GB humor in between, Much like our films :))


  13. Pure Genius
    I’m speechless.
    My vote for you for RBI guv

  14. Wow! This was something.. GB Tussi Great (Bong) Ho

    @ Harshit…

    “On a more serious note, I think this is the best tutorial I have seen for a layman who does not understand the ABC of money markets/lending etc.”

    You could replace the word layman with Lehman in the line above and it will still make as much sense.

  15. Great post ………. Being in this mess myself, there is another very interesting tidbit as to why this CANNOT happen in India. Even in India, people were buying houses left, right and centre and were being funded by the banks but the biggest difference is the existence of the Black Market! Because of that every house you buy in India, you have to pay upfront at least 30 – 40% in black and only the rest white! So, even if the banks fund 60% completely, the value of the house would never get eroded so much that you would start defaulting. And interestingly, the credit agencies realize that and so they rate the Indian Mortgage related securities higher than the ones in US!!

  16. “.. brought about this economic cataclysm as a result of unbridled greed, was at a histoic high”

    shouldn’t it be “historic”?

    ps: Great Stuff as always..

  17. Your conclusion, which is open ended question, is scary real scary….

  18. very well explained. Thoroughly enjoyed reading both the posts.

    I think IT sector will definitely be impacted. Financial institutions were some of the biggest IT spenders.

  19. fish out of water October 6, 2008 — 10:22 am

    One problem with intervention in markets like the bailout package is that when you stop the markets from working their magic, destructive and productive, you might end up with a situation like Japan’s. Till the late 80’s early 90’s the Japanese were supposed to take over the world. They were buying trophy properties in the US(Pebble Beach golf course, hollywood studios, Rockfeller center etc) because the stock market was shooting for the moon. Of course, a lot of that was “backed” by rising real estate prices. When that bubble burst, the Japanese govt. intervened. The companies that should have died were kept alive, they sucked out precious capital that could have gone to start ups, more nimbler companies etc. Instead, what they got was a decade of low or no growth. Capital HAS to be put to work where it earns the most, and I am not sure if this bailout package does that.

    Also, more regulation is not the answer. Fannie and Freddie are extremely regulated. Hedge funds on the other hand are not so and while they are down the red ink in that industry is not flowing like the Kosi.

    Your post above is very well written and lucid (something my comment above is not!!)

  20. Yet another excellent post! You have a gift in explaining things simply but elegantly.

    Coming to the ideological and economical issues: Firstly, even though I oppose the bail-out as highly unethical (as one commentator elegantly opined, “privatization of profits and socialization of losses”), I do believe that some kind of major Govt. intervention is required for some sense and sanity to be restored into the financial markets. But I think that the U.S. Govt. must make participating firms strictly accountable to this bail-out package and must further transform the market-place from an instrument of unscientific and greedy speculation to an instrument of stable wealth creation.

    I do think that this entire financial fiasco makes a compelling case for government oversight and regulation. Capitalism in a pure, unfettered form is clearly unsustainable. I think this collapse signals the end of the free market as a completely ‘free’ and ‘pure’ concept. I do think that the free market henceforth would be one with significant supervision and regulation.

    There is significant evidence (in the form of frequently/regularly occurring speculative bubbles) that the free-markets often do not behave in accordance with sound economic laws/fundamentals of corporations and economies. It is clear that the stock markets and most speculative instruments are driven by word-of-mouth and mass-hysteria, than by the credentials of a country’s economy or a company’s economic portfolio. Such problems are only compounded when you have zero/little government oversight and as a consequence markets are permitted to first rise on the basis of hyper-exuberance and then fail spectacularly on the basis of large-scale paranoia and panic.

    Like I said before, I do think that the current mess is a wake up call for the world’s market regulators and Govt. bodies – that financial markets around the world must be strictly monitored both for the amount/nature of risky investments and also for any ‘short-selling’ or any other activity that values assets not on the scientific basis of economic fundamentals.

    It is also in many ways highly ironic that the bastion of capitalism, the self-proclaimed ‘leader of the free world’, the self-proclaimed ‘proponent of free-market capitalism’ is itself indulging in socialism of the first order! Even the U.S.S.R. would have choked on the scale of this bail-out package! It also serves as a major loss of face for the United States, as it has often vehemently made a case for fiscal prudence in African economies. Like some comentator said on BBC World, the United States as a brand-value has been on the decline for sometime now, but this episode has shattered that brand completely.

  21. you spelled historic as ‘histoic’ somewhere. not picking on you, just one of those slip-ups 🙂

    great post! nothing my 400 level finance course taught me.

  22. Good, finally got an overall picture of the scenario for my project in ‘Fall out of the subprime crisis’ for financial management in my MBA .
    Will hopefully give the viva without freezing up 😉

    Now if only you could explain the fallout of this deal on the indian markets, the “are we insultated versus from U.S versus the teflon has run out debate”

    Notun article ta lekhar jonne aami aapna ke pujo tey ipod debo

    P.S could the new article be posted before October end please 😀

    Kidding, good post GB da

  23. Thank you for making me understand how this all works. The two part narration was quite enlightening.

    You have said
    “The Bill was then passed by the Senate and the President signed it into law.”
    however I guess, after the changes been made, it was first presented in Senate & then in the house before president’s sign…anyway just a nitpicking if you allow me to 🙂

  24. Rajiv, African economies do need fiscal prudence, transparency and accountability. You don’t need the Americans to state the obvious.

    Speculative bubbles aren’t necessarily a bad thing. Guess how the gigantic network of Indian railways was built in the 19th century?

    Purely on private speculative capital that was channeled into a railway construction because they thought it was the next big thing. Too bad the investors all lost money on the venture, but gave countries like India and the US their major freight transport infrastructure.

    I’m guessing you say “zero/little government oversight” merely as hyperbole.

    In some aspects the Americans are less regulated than others, in some a lot more. Americans have very stringent financial disclosure requirements and a very solid oversight administration for the commercial banking sector.

    In fact some foreign companies shy away from an ADR listing on the NYSE simply because of the rigorous financial disclosure requirements.

    And the housing speculative bubble is not exclusively an American problem. All of Europe has been hit badly as well, and Asia would soon follow. In fact, Spain was the first country where the housing bubble burst, and Spain is definitely a far more regulated economy.

    Here’s some Economist data on this. Note that Americans by far are not the worst offenders. Ireland, Britain, Spain, South Africa and Australia are all far worse than the US – and they are a diverse bunch – Ireland and Britain less regulated, Spain and South Africa a lot more.

    Also – “scientific basis of economic fundamentals”? I wonder if you’ve ever tried to do a valuation of a company based on fundamentals. You use discounted cash flows and growth rates based on any number of assumptions and depending on those assumptions you can get wildly varying values.

    Absolutely no commodity in this world has intrinsic value. It’s value only depends on what someone is willing to pay for it.

    And short-sellers are not trying to influence that market consensus of value, they are merely trying to predict and bet on this market consensus. If we are allowed to profit by guessing that markets go up, then why shouldn’t we profit by guessing right that markets will go down?

  25. Thanks for the great posts, GB. In the past, while reading some of your hilarious but essentially vacuous posts on bollywood and the likes, I have often felt that you do not do justice to your incisive and lucid story-telling faculties. This two-part primer on the current financial crisis that is rocking US (and will soon spread on a global scale) has been one of your best contributions since the inception of your blog. I look forward to find similar jewels among worthless pebbles in your blog in the future.

    My two-pence summary: whatever goes up must eventually come down; Viagra (read the bailout package) may keep “it” (read the US economy) up longer, but will not last forever.

  26. @Thalassa:
    Firstly, I am not of a financial background (I am a Computer Engineer wishing to pursue higher education), but I have over the past couple of years been very inquisitive into the working of macro-economic structures and global trade. So, in that sense, my opinions are formed more out of an enthusiasm than a solid grounding in Economics. If you indeed are of a financial background (a strong education in finance/economics), then I suppose you would be more experienced in these regards and hence I would submit more readily to your views. However, for the sake of this current argument, I am assuming you are not and so lemme put up some defenses. And my apologies for its length!(Brevity is not my cup of tea!)

    Fiscal Prudence: I am all for fiscal prudence and the proper management of government funds. I am not for a minute suggesting that we treat government financial excesses lightly or leniently. I am merely lamenting upon the irony and hypocrisy of the situation today – the United States of America, which as for so long been absolutely vehement either directly (via its own trade delegations) or indirectly (arm-twisting via WTO, World Bank, etc.) come down hard upon the importance of fiscal responsibility is today having no qualms about writing off 1 trillion $ of bad debt by corporations and entities!! American debt has mounted upto 11.5 trillion $ with this ‘rescue’ package. I was only noting the remarkable irony of it all.

    Sepculative Bubbles: General opinion (by a wide variety of economists) on the internet show that bubbles have mostly negative impacts, as it tends to divert large sums of money into ultimately worthless assets. Your example of the Indian Railways (which I didn’t cross-check with the assumption that it is true) does demonstrate that bubbles may have positive effects for nation-building in the long-term (long-term here defined as a period of several decades). But the fact still remains – hundreds of investors (individuals and institutions) put their money into extremely over-valued assets (which was no doubt a result of mass-exuberance and hyper-positivity, coupled with a lack of ‘grounding’ this exuberance by govt. authorities). The consequence may be perceived as positive by you (heck! it gave us national rail infrastructure!), but what cannot be ignored is the cost paid for it. Say this national rail originally was worth say X bucks, but was perceived by investors to be X Y (where Y is some insanely high amount) and the bubble finally crashed. When the bubble burst, it took away trillions of dollars along with it, as all this money was tied down to this extremely over-valued, but currently severely devalued asset. Thus, bubbles by their very definition, are a bad thing.

    Govt. Regulations/Stringency: I concede to your argument that the United States has one of the most stringent systems in place to check financial mischief. However, my argument is that if such a massive failure occurred, clearly this stringent system is NOT stringent enough! How can a system be deemed ‘fit’ or ‘stringent’ when CEO’s of failed institutions and bankrupt corporations are taking ‘severance packages’ worth 50 million $ a piece?! Aren’t these CEO’s reponsible in someway as they sought to underplay the exposure their bank had all along trying to sell a non-existent utopia to doe-eyed (and greedy) investors?! Clearly, the credit rating agencies had a serious conflict of interest – they were supposed to rate banks/corps who were funding them in the first place!! How could such conflicts of interests be ignored over by regulators? Clearly, the entire regulatory and supervisory mechanism had failed both at a functional and a moral level. The U.S. may have strong laws in place and their courts ensure that culprits are booked (as happened in Enron with the indictment of Kenneth Lay and finally the granting of 7.2 bn $ to Enron share-holders), but most of it guards the stables AFTER the horse have flown. Again, as far as several countries being affected and the quantum of bad assets being more in other countries – I am assuming these to be true. But even so, it can’t be denied that a lot of bad investments were simply not shown on the accounts of major investment banks and financial institutions. This combined with credit rating agencies being in cohorts with these same troubled financial corps precipitated this disaster.

    In hindsight, I can say that I am arguing not as much for regulation, as much as a zero-tolerance policy on bubbles. If that can be achieved with less regulation, then so be it. But, economic bubbles of this magnitude should never be permitted to grow unchecked and unfettered. It may seem extremely lucrative initially, but it will only end up in a lot of financial chaos and turmoil in the long run (and whats more?! the rich upper mgmt. would earn astronomically high paycheques leaving the govt. exchequer to pick up the pieces of an economy ruined by a severe liquidity crisis, credit squeeze and the prospect of hyper-inflation!)

    PS: I would be happy to obtain a response from you and seek to argue the merits/demerits of my and your arguments.

  27. nice to have the knowlegde reinforced that the politicians are venal everywhere.

  28. @Thalassa: Oh! And one more thing: I again concede to you on your point about the lack of intrinsic value to pretty much anything. By its very nature/defintion, money (in any form) is the result of speculation/perception. But what I mean by scientific conformity to economic fundamentals is the absence of either a false sense of optimism or pessimism, as we see in markets today. An asset’s value must be based on objective analysis and scientifically predicted trends, and not on mass-hysteria in either the positive or negative direction.

    But I grant that what I am saying is somewhat of a philosophical conundrum of sorts – the value of an asset can never be truly scientifically established.

    That said, the quantum of the subsequent market crash is in many cases unjustifiably negative. There were stocks who had little/no exposure and not much connection (other than at a macro level) that plummeted completely. This is something which I feel needs to be addressed.

  29. Rajiv – Thank you for your detailed comments. Pardon me if I’m a bit zippy, got to rush off so will comment in brief.

    1. The US Federal government is not writing off any bad loans (that’s what the Indian government used to specialize in with its hare-brained bank nationalization schemes). It is merely trying to stabilize the market for mortgage backed securities (a measure that I do not necessarily agree with).

    2. Every investment in an untested, untried technology is necessarily speculative. If we take your argument to a logical extreme, no one would ever do any oil exploration – because exploration is necessarily expensive, overly optimistic and extremely uncertain.

    As for bubbles, who is to decide when something is really a bubble and needs regulation? People have been calling China’s economy a bubble for nearly a decade now – following your argument we should have tried to cap its growth a long time ago.

    Microsoft used to trade at $5 a share at one time – it must have seemed like a bubble stock at $20 – should we have tried to regulate its price down?

    3. As for asset price, let me give you an example. It is fairly straight forward to value commercial or industrial real estate because they are income generating properties and you can use the discounted cash flow or income multiple to value the property.

    However, how do you even begin valuing residential property? A 100 years ago, no one wanted to live on the coastline because our defenses against storms, sea water damage and hurricanes was so poor. Now, beachfront property commands a hefty premium.

    The way residential property is generally valued is by comparison with similar properties in the same neighbourhood. So what kind of objective analysis is used in this process? None whatsoever – simple supply and demand. If someone wants to pay $1 million for a cubbyhole apartment in Manhattan, no amount of objective analysis can explain that.

  30. first?

  31. Bhai.. Phadoo hai tu..:-)..mast post hai..
    kabhi naa samjha mai je story(not that I understand it “fully” now).. par abhi 4 logo ke beech baith ke bahut phek sakta hu mai..(a reasonable part of it will be correct also)..

    PS: This post has made u a “GREATER” bong..hehe..

  32. Arnab Da.. great set of posts. :bow:
    Many think the reason Lehmann was allowed to go belly up while AIG was not was that Goldman Sacchs had about $20 billion in AIG and if AIG went belly up – next in line would be GS.

    Also the reason for govt taking over Fannie and Freddie could be the pressure from China. They (the chinese) had invested enormous amounts into the Fannie / Freddie MBSs and were not very subtle in their threats to release the forex they had in case US govt did not work to rescue their investments.

  33. Bong,
    your ganguly is retiring.. any comments on that?? Surely this must be a bigger crisis than the wall street thingie?

  34. Wonderful post I must say. As someone said, please run for president.. if they allow non US people to vote – mine is all for you!

  35. It is all the result of greedy capitalism

    Priciple of Capitalism
    ” When there is a loss it is private
    and it is public when there is loss”

  36. GB : In your shortselling example the profit should be 900$.Btw, good anaysis of the current crisis.

  37. No one has understood Gunda better than you. I did enjoy visualizing Bulla and Co and Wall Street. Yesterday when the Executives of AIG were in the spa spending the ‘rescue’ money it was very Gunda like situation. Bulla, Chutiya involved in ‘disco’ ‘kushti’….

  38. Very well-researched and well-written. Kudos for making a “what is finance” kinda person like me understand. 🙂

  39. Amazing article to say the least

    expecting few more from u ……

  40. Nice article….. Great and Amazing stuff from
    you to show the transparency of the Opaque financial

  41. Hey GB,

    This is the first time I’ve read anything written by you!
    Excellent penmanship indeed! The pain is you might have had to type all of this and other than educating us mere mortals; it’s not going to have any effect!

    Great read though!! Keep it up!

  42. Ah’ whatever happenned to Sachin’s all time best ODI batting side, all of a sudden today? Ryder got 3 wickets?

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