About Me

My photo
SME, RISK AND TRADING SYSTEMS, PhD [Operations Research]. I had interesting journey from small pahadi town in Uttrakhand to today (probably inspired by Phanisher Nath “Renu”’s Atho Ghumkaddo zigyasa), both in space and in time. The journey has made me a queer mix of contradictory extremes (points). I am caught up between and swing from one extreme to other, striking balance between Small town values and Big City Values, between experiences of bought up in socialistic environment and working in capitalistic environment (reaping benefits of!!), between Hindi medium schooling and English medium higher studies, between ease in connecting to small town values and issues and big city mores and list goes on…

Thursday, October 30, 2008

CURRENT FINANCIAL CRISIS – HOW WE SCREWED UP

It’s tale worth telling. The whole affair ended in recession of a scale unheard in human history. So, how it started? Who is to blame? What now?
I think there were two stories that ran in parallel, and they met to form an epic. Or shall we say two sides of a coin? It is an age-old story pertaining to human greed. But, then greed is also the stepmother of innovations (euphemism??) in trading. On one side are the investors across the world flushed with ready cash who were not too happy with the returns offered by the investment avenues available in the market. Investors realized that the available options like investing in developing countries are not as promising as they initially sounded; also lock in period was too long (kaun jeeta hai tere julf kesar ho jane tak). We want instant gratification!!! They were looking for the avenues, which can provide greater returns (easy target??). So, the only choice left was the great USA economy; and as always happens, everybody jumped to bandwagon. Now lets see what USA has to offer. It is a developed country; how come one can get greater returns out of it? Obviously it needed a booming sector; which came in the guise of real state (as the generation of baby boomers retired). Which in turn allowed Wall Street whiz kids to do wizardry and attract larger amount of funds from across the world.
Where did it start? It started when banks in USA started betting on real state boom. Banks pushed their sales teams by setting blue-sky targets. Sales guys in turn were driven by their commissions; so they hardly cared who got the mortgages. Result was a hoard of sub prime customers (whose credit rating is below par) got the housing loans. Banks turned blind eye to whole affair as they were expecting real state boom and thought if anyone defaults than they can recover more than their investments by selling of the property. But banks faced the issues of bad credits in their balance sheets and higher capital requirements due to regulations (as required capital is tied up to credit rating of the counter party). Here came in the Wall Street whiz kids they have on one-side investors looking for higher returns and other side banks flushed with bad credits in their balance sheets. They offered a trick in the guise of CDO where by forming a SPV banks can offload the bad credits from their balance sheets and convert them in bonds. CDO is essentially a mechanism of pooling up debts and then dividing them into tranches; where each tranche size is a fraction of the pool (tranches sum up to total pool size). The pool receives the monthly mortgage payments and distributes it to different tranches on priority basis. Lets take an example of simple CDO structuring; suppose the size of pool is $100 M. And we divide it in three tranches A, B, and C. Where tranches A, B, and C’s sizes are $30M, $30M, and $40M respectively. Now we say that mortgage payments will be distributed in the priority of A to C; so, tranche A has highest priority. The defaults have reverse priority so defaults will be borne by C first, then B, and A at last. One can see that each tranche is very similar to a corporate bond; where A is least risky, B is riskier, and C is very risky. Also, if SPV buys insurance for tranches he can get AAA rating for tranche A, and may be BBB for tranche B; which means your returns are guaranteed if you invest in tranche A. In other words CDO is able to convert a fraction of bad loans (the pool) into a real good loan J. Now Wall Street dudes sell these bonds (tranches) to different customers and keeping tranche C with them, as it is difficult to sell (though provide very high returns). Investors buy different tranches based on their risk preference. A municipality in USA may buy tranche A if it is looking for safer and better returns.

As expected many of mortgage owners defaulted and unfortunately real state went down. Banks were flooded with bad loans and due to real state bust recovery goes very bad. Lets see what is happening with CDO; pool is flooded with defaults. Even tranche A guy is not receiving his monthly coupons. He calls up the Wall Street guy who tells him that its real bad they did not expect so many defaults and as real state has gone down so they can’t recover the money. The investor questions but my tranche have AAA rating; Wall Street guy says rating agency screwed up too. Then he pleads my tranche is insured; “are you kidding me, no way insurance companies have this much money, they screwed up too” says the Wall Street dude.
Morale of the story “ crap will remain crap no matter how you package it” and “ There is no difference between a real smart gambler and real stupid gambler”

Where did the money go? Whose failure is this? Left to reader.

1 comment:

Unknown said...

It cannot be explained any better..
Keep writting trib..