In light of the fall of investment banks, I wanted to give you a glimpse of how it was during their glory days.
Here's a video about investment bankers and their heated rivalry with consultants.
http://www.youtube.com/watch?v=ROlDmux7Tk4
The only investment banks left standing are Goldman Sachs and Morgan Stanley. Although there's a lot of uncertainty about their role in the future, Goldman doesn't seem very concerned. It is the only investment bank that was able to withstand the storm and actually turn in a profit for the year as whole - although it did post its FIRST ever loss this past quarter (They're the cream of the crop of investment banks recruiting all the top MBA grads from Harvard, Pennsylvania, MIT, etc). As such, Goldman is paying its employees an average of $400,000 this year.
p.s. I work in consulting now. Good thing I didn't go into banking. Although I could probably never get in anyway.
- Sean
Showing posts with label financial crisis. Show all posts
Showing posts with label financial crisis. Show all posts
Wednesday, December 17, 2008
Tuesday, December 16, 2008
PONZI SCHEME! …or shall we now call it MADOFF scheme
If you don’t know who Madoff is, watch these videos:
http://www.youtube.com/watch?v=oNYCw3rK1m0
http://www.youtube.com/watch?v=JOjC7zTOIJA
Bernard Madoff was a well-respected, and well-liked man that ran a giant ponzi scheme through his investment firm Bernard L. Madoff Investment Securities LLC. The scam he committed was of epic proportions - estimates right now say it was around $50-55 billion dollars in lost investments.
I think, in this day and age, for a scam this big to not get exposed is really unacceptable. There were certain due diligence groups that discovered multiple red flags regarding Madoff’s investment practices (click link to see interview about one firm that discovered some red flags). They notified the primary regulator, the Securities and Exchange Commission regarding such matters but the agency never dug deep enough to discover the truth. Also, one of the main reasons he stayed under the radar was because of his reputation and career accolades. Before becoming a money manager several decades ago, he was the chairman of the NASDAQ, the US’ electronic stock exchange. Madoff was also part of a 25-member advisory committee for the SEC itself. I guess working with the regulatory agency helped him build the rapport and trust necessary to go through with this.
How did he get exposed?
In the end, what ultimately doomed him was the financial crisis. Essentially, he ran his investment group like a hedge fund. Naturally, all investments funds were doing bad this year so a lot of people wanted to pull their money out of investments funds. (Ironically, it goes against the adage of “buy low, sell high” huh?) So when investors want to pull out money, they usually have to inform him beforehand and he has some time before he has to provide them that money. The request is called a redemption and usually hedge funds and more risky firms are given more leeway in terms of the time-frame in which they have to give the money to the investor. Ultimately, Madoff had $7 billion in redemption requests and he didn’t have enough money to meet them so he basically gave up and told his sons that it was just a big giant lie, a Ponzi scheme.
Sadly, if the financial crisis did not happen, this scam would probably not have been exposed for a while.
Surprisingly, it appears as though he ran this whole scam operation by himself. Supposedly, neither his sons, family, friends, business partners nor auditors knew about this scam. As this story unfolds, we'll find out if it was really just him.
Who is affected by this scandal?
The list of victims is growing by the minute and it includes charities, hedge funds, fund of funds (“FOFs”), banks, rich investors and regular people like you and I.
Here's a list of who is exposed and the amount they invested:
Madoff's Victims
Will they get their money back?
Madoff said he’s broke, and selling his investment firm won't begin to cover any significant part of the losses. They'll most likely go after his property and all his other assets.
Unfortunately, a lot of the victims will not get a lot of money back. In fact, the people who cashed in and got out are not out of the woods either. They are probably going to have to return the profits they earned because the profits were not really realized and were part of a fraud.
This case will be intensely disputed in the court of law for years and the most likely candidates to give up some money are the FOFs right now. The FOFs are basically mutual funds that invest in hedge funds. What makes this ridiculous is that they charge fixed fees (usually 2%) to manage the fund and they also charge performance fees (usually 10%). This is crazy because they invest in hedge funds which already charge fixed and performance fees (usually 2% and 20% respectively). Therefore, people who invest in FOFs are getting charged double. Anyway, FOFs can be held accountable if they determine that the FOFs didn’t do their due diligence before they invested in hedge funds - FOFs are held to a higher standard and are supposed to research and make sure the hedge funds they invest in are good investments.
Well, luckily, ordinary investors that don’t have billions invested in Madoff may have some hope. We have this agency called the Securities Investor Protection Corporation (“SPIC”) that will cover up to a maximum of $500,000 for each customer in this case.
So How did he do it? How did he fool people?
It all comes down to human psychology.
Excerpt from WSJ Article:
"Robert Cialdini, a psychology professor at Arizona State University and author of "Influence: Science and Practice," calls this strategy "a triple-threat combination."
The "murkiness" of a hedge fund, he says, makes investors feel that it is "the inherent domain of people who know more than we do." This uncertainty leads us to look for social proof: evidence that other people we trust have already decided to invest. And by playing up how exclusive his funds were, Mr. Madoff shifted investors' fears from the risk that they might lose money to the risk they might lose out on making money.
- Sean
http://www.youtube.com/watch?v=oNYCw3rK1m0
http://www.youtube.com/watch?v=JOjC7zTOIJA
Bernard Madoff was a well-respected, and well-liked man that ran a giant ponzi scheme through his investment firm Bernard L. Madoff Investment Securities LLC. The scam he committed was of epic proportions - estimates right now say it was around $50-55 billion dollars in lost investments.
I think, in this day and age, for a scam this big to not get exposed is really unacceptable. There were certain due diligence groups that discovered multiple red flags regarding Madoff’s investment practices (click link to see interview about one firm that discovered some red flags). They notified the primary regulator, the Securities and Exchange Commission regarding such matters but the agency never dug deep enough to discover the truth. Also, one of the main reasons he stayed under the radar was because of his reputation and career accolades. Before becoming a money manager several decades ago, he was the chairman of the NASDAQ, the US’ electronic stock exchange. Madoff was also part of a 25-member advisory committee for the SEC itself. I guess working with the regulatory agency helped him build the rapport and trust necessary to go through with this.
How did he get exposed?
In the end, what ultimately doomed him was the financial crisis. Essentially, he ran his investment group like a hedge fund. Naturally, all investments funds were doing bad this year so a lot of people wanted to pull their money out of investments funds. (Ironically, it goes against the adage of “buy low, sell high” huh?) So when investors want to pull out money, they usually have to inform him beforehand and he has some time before he has to provide them that money. The request is called a redemption and usually hedge funds and more risky firms are given more leeway in terms of the time-frame in which they have to give the money to the investor. Ultimately, Madoff had $7 billion in redemption requests and he didn’t have enough money to meet them so he basically gave up and told his sons that it was just a big giant lie, a Ponzi scheme.
Sadly, if the financial crisis did not happen, this scam would probably not have been exposed for a while.
Surprisingly, it appears as though he ran this whole scam operation by himself. Supposedly, neither his sons, family, friends, business partners nor auditors knew about this scam. As this story unfolds, we'll find out if it was really just him.
Who is affected by this scandal?
The list of victims is growing by the minute and it includes charities, hedge funds, fund of funds (“FOFs”), banks, rich investors and regular people like you and I.
Here's a list of who is exposed and the amount they invested:
Madoff's Victims
Will they get their money back?
Madoff said he’s broke, and selling his investment firm won't begin to cover any significant part of the losses. They'll most likely go after his property and all his other assets.
Unfortunately, a lot of the victims will not get a lot of money back. In fact, the people who cashed in and got out are not out of the woods either. They are probably going to have to return the profits they earned because the profits were not really realized and were part of a fraud.
This case will be intensely disputed in the court of law for years and the most likely candidates to give up some money are the FOFs right now. The FOFs are basically mutual funds that invest in hedge funds. What makes this ridiculous is that they charge fixed fees (usually 2%) to manage the fund and they also charge performance fees (usually 10%). This is crazy because they invest in hedge funds which already charge fixed and performance fees (usually 2% and 20% respectively). Therefore, people who invest in FOFs are getting charged double. Anyway, FOFs can be held accountable if they determine that the FOFs didn’t do their due diligence before they invested in hedge funds - FOFs are held to a higher standard and are supposed to research and make sure the hedge funds they invest in are good investments.
Well, luckily, ordinary investors that don’t have billions invested in Madoff may have some hope. We have this agency called the Securities Investor Protection Corporation (“SPIC”) that will cover up to a maximum of $500,000 for each customer in this case.
So How did he do it? How did he fool people?
It all comes down to human psychology.
Excerpt from WSJ Article:
"Robert Cialdini, a psychology professor at Arizona State University and author of "Influence: Science and Practice," calls this strategy "a triple-threat combination."
The "murkiness" of a hedge fund, he says, makes investors feel that it is "the inherent domain of people who know more than we do." This uncertainty leads us to look for social proof: evidence that other people we trust have already decided to invest. And by playing up how exclusive his funds were, Mr. Madoff shifted investors' fears from the risk that they might lose money to the risk they might lose out on making money.
If you did get invited in, then you were anointed a member of this particular club of "sophisticated investors." Once someone you respect went out of his way to grant you access, says Prof. Cialdini, it would seem almost an "insult" to do any further investigation. Mr. Madoff also was known to throw investors out of his funds for asking too many questions, so no one wanted to rock the boat.
This members-only feeling blinded many buyers of Mr. Madoff's funds to the numerous red flags fluttering around his operation. When you are in an exclusive private club, you do not go rummaging around in the kitchen to make sure that the health code is being followed.
Here we have the biggest dirty secret of the "sophisticated investor": Due diligence often goes undone. For a brief window in 2006, the Securities and Exchange Commission required hedge funds to file standardized disclosure forms. William Goetzmann, a finance professor at Yale School of Management, found that hedge funds disclosing legal or regulatory problems and conflicts of interest ended up with lower future performance. But the disclosure of these risks had no impact at all on how much money flowed into the hedge funds.
In other words, investors were getting useful information -- and paying no attention to it. Amaranth Advisors LLC, the commodity hedge fund that collapsed in 2006 with $6 billion in losses, did not even file the required SEC form at the beginning of that year, a clear signal that something might be wrong. Instead of standing pat or pulling money out, investors poured more money in.
Last year, the Greenwich Roundtable, a nonprofit that researches alternative investments, conducted a survey of consultants, pension plans, "family offices," funds of funds and other large investors who shop for hedge funds. It's hard to imagine a more sophisticated crowd.
Yet one out of five investors in the survey reported that they "always follow" not a formal checklist or analytical procedure, but rather "an informal process" of due diligence.
That's for sure. One out of four investors surveyed will write a check without having studied the financial statements of the fund. Nearly one in three will not always run a background check on fund managers; 6% may not even read the prospectus before ever committing money.
"Due diligence," says Stephen McMenamin of the Greenwich Roundtable, "is the art of asking good questions." It's also the art of not taking answers on faith.
If you invest with anyone who claims never to lose money, reports amazingly smooth returns, will not explain his strategy, refuses to disclose basic information or discuss potential risks, you're not sophisticated. You're an oxymoron."
- Sean
Saturday, December 13, 2008
A solution for the financial crisis
Alright, so the government has basically undergone a series of bailouts that has saved the financial sector. Yet, you may be asking yourself -- how come the economy looks just as bad, if not worse than a few months ago??
Other relevant, and good questions might be: Has the government implemented any long-term solutions? and.. Why can't we draw from prior experiences and adopt those solutions?
How come the economy looks just as bad, if not worse than a few months ago?
What the government has done so far is just help the financial sector in hopes that they'll continue ordinary business operations. Yet, they're being somewhat short-sighted and not looking at the source or origin of the issue. Bottom line, the economy is getting worse because the real estate sector is getting worse and people are not able to make their monthly payments.
Has the government implemented any long-term solutions?
No, the government hasn't really addressed the root of the problem; it has only responded by bailing out companies where the risk of failure has been greatest (ie AIG, Fannie/Freddie, Citigroup etc). None of these actions are solutions for the long-term. Put another way, they are merely bandages applied to a severe wound.
Why can't we draw from prior experiences and adopt those solutions?
Everybody compares this crisis to the Great Depression. First off, this comparison is somewhat warranted because of some similarities such as the stock market crash, large loss of consumer confidence, financial sector issues and high unemployment rate, but we shouldn't get carried away just yet. The extent of the issues I listed are not as severe as in the Great Depression and we now have policies and reforms specifically implemented during the Great Depression that have largely prevented the scenario from playing out the same way - ie Federal Deposit Insurance Corporation ("FDIC").
So with that in mind, why can't the government use prior experience, or more specifically, the Great Depression itself, to solve the current financial crisis? Well, the answer to this question is two-fold; First, Ben Bernanke is an expert on the Great Depression, and he has used his knowledge and expertise on that subject to his advantage. While this is certainly not a consensus, economists have generally attributed the length and severity of the Great Depression to the failure of the banks and the lack of money or liquidity in the economy. Ben Bernanke and the Treasury have done all they can in these areas; they have saved the banks and they have pumped a lot of money into the economy. So why hasn't it worked? Well, it may stop us from going into a depression so in that sense it will serve its purpose. But, essentially, the facts and circumstances are different this time.
Secondly, economics is an imperfect science, or what some may call a soft-science. What I mean by this is that you can't run experiments of countries and just throw in different factors (policies) to determine the net effect on the economy. The only data economists have is empirical, or from observation of past events. This is a problem, because not only are the facts and circumstances different, but our country has also only gone through 1 or 2 crises that are mildly comparable. The first was the Panic of 1893 which we don't have much data on, but our economy was a lot different so the data might be moot anyway. The second is the Great Depression. However, the issue with the Great Depression is not only that the facts are different, but that we do not really understand or know how we got out of that. There's a myth that people know for sure that Keynesian economics or large government spending brought us out of the that crisis. Others say the war and the large spending and employment during that period helped our economy recover. It may also be that the crisis was solved by time itself, but we will never know.
So we can't draw much out of the Great Depression because even if it is comparable, it is only one instance that we do not really grasp fully. (if you have one data point in statistics you know how unreliable that can be)
What is the solution?
I came upon the writings of professor Stephen Finglewsi, an NYU finance professor and his proposed solution to the financial crisis. His is the first reading I've found that I completely believe in because it makes economic sense and is very intuitive to understand; There's a clear goal and practical approach to solve the crisis.
So in his paper he provides a great analogy that I briefly referenced in my earlier post to describe the situation we have. Essentially, the financial sector troubles can be compared to what insurance companies experience with natural disasters.
So, let's say an insurance company offers insurance against hurricanes hitting homes. If hurricanes were to hit all the homes that the company provided insurance to, the company would have huge losses as it would use all its money (cash reserves) to cover the insurance policies . However, if everybody were to claim their insurance at the same time, the insurance company might not have enough cash to pay everybody so it goes into bankruptcy. At the same time, even if it were able to pay off all its claims, it would have problems running its business as it now has no money. It might have to lay off employees and it would need to raise more money to continue to issue new insurance contracts.
The same principle applies to the financial sector. Basically, they invested in the mortgages through securities and now have to bear the losses. For some companies, the losses were too much so they went into bankruptcy (see Lehman Brothers). Either that or they were bought out by another company or bailed out by the government (see AIG, Citigroup, Merrill Lynch, etc.)
The ones that could bear the losses, were crippled financially and do not have enough money to continue ordinary business. Also, they're scared that the companies they lend money to will go into bankruptcy as well so that limits business as well.
Alrite, so let's go onto what he proposes. (Sorry for the technical verbiage. It would be hard to describe in more simplistic terms)
Figlewski's plan:
The plan focuses on disconnecting the real estate sector from the financial sector: "When an electrical device catches fire, the first thing to do is to disconnect the power. The financial system is connected to the real estate sector by mortgage loans, and it is being severely damaged by the uncertainty over how many of those loans will default and how much the lenders will lose when defaults occur."
To accomplish this overarching goal he has several proposals for the Federal government to "step between the homeowner and the mortgage lender to remove the risk from the mortgage payments": (read his paper if you want to know more of the details)
Fairness: Is it fair to bailout homeowners that bought houses they could not afford and payments they could not meet? A lot of people feel the bailout of the banks was not fair, so are they willing to go along with this plan? If the government is changing the terms of the contracts, how is that fair for other homeowners?
Well, Figlewski's plan makes the government bear the immediate losses, and does not lower the total overall payment so in that sense it is fair. Plus, it would be beneficial overall to go through with this because everybody would be better off in the end.
As Figlewski's mentioned, the purview of his plan is not all encompassing - so it is not a panacea - but it ultimately stops the source of the problem and prevents our situation from getting significantly worse than it already is.
What will happen if we implement this plan? What other issues exist?
The US economy will continue to have problems after we implement this plan mainly because of US consumers and exports. Businesses need people to buy their products and services to make money. People will spend a lot less because of the economic crisis so that will keep GDP down for a while.
- Sean
Other relevant, and good questions might be: Has the government implemented any long-term solutions? and.. Why can't we draw from prior experiences and adopt those solutions?
How come the economy looks just as bad, if not worse than a few months ago?
What the government has done so far is just help the financial sector in hopes that they'll continue ordinary business operations. Yet, they're being somewhat short-sighted and not looking at the source or origin of the issue. Bottom line, the economy is getting worse because the real estate sector is getting worse and people are not able to make their monthly payments.
Has the government implemented any long-term solutions?
No, the government hasn't really addressed the root of the problem; it has only responded by bailing out companies where the risk of failure has been greatest (ie AIG, Fannie/Freddie, Citigroup etc). None of these actions are solutions for the long-term. Put another way, they are merely bandages applied to a severe wound.
Why can't we draw from prior experiences and adopt those solutions?
Everybody compares this crisis to the Great Depression. First off, this comparison is somewhat warranted because of some similarities such as the stock market crash, large loss of consumer confidence, financial sector issues and high unemployment rate, but we shouldn't get carried away just yet. The extent of the issues I listed are not as severe as in the Great Depression and we now have policies and reforms specifically implemented during the Great Depression that have largely prevented the scenario from playing out the same way - ie Federal Deposit Insurance Corporation ("FDIC").
So with that in mind, why can't the government use prior experience, or more specifically, the Great Depression itself, to solve the current financial crisis? Well, the answer to this question is two-fold; First, Ben Bernanke is an expert on the Great Depression, and he has used his knowledge and expertise on that subject to his advantage. While this is certainly not a consensus, economists have generally attributed the length and severity of the Great Depression to the failure of the banks and the lack of money or liquidity in the economy. Ben Bernanke and the Treasury have done all they can in these areas; they have saved the banks and they have pumped a lot of money into the economy. So why hasn't it worked? Well, it may stop us from going into a depression so in that sense it will serve its purpose. But, essentially, the facts and circumstances are different this time.
Secondly, economics is an imperfect science, or what some may call a soft-science. What I mean by this is that you can't run experiments of countries and just throw in different factors (policies) to determine the net effect on the economy. The only data economists have is empirical, or from observation of past events. This is a problem, because not only are the facts and circumstances different, but our country has also only gone through 1 or 2 crises that are mildly comparable. The first was the Panic of 1893 which we don't have much data on, but our economy was a lot different so the data might be moot anyway. The second is the Great Depression. However, the issue with the Great Depression is not only that the facts are different, but that we do not really understand or know how we got out of that. There's a myth that people know for sure that Keynesian economics or large government spending brought us out of the that crisis. Others say the war and the large spending and employment during that period helped our economy recover. It may also be that the crisis was solved by time itself, but we will never know.
So we can't draw much out of the Great Depression because even if it is comparable, it is only one instance that we do not really grasp fully. (if you have one data point in statistics you know how unreliable that can be)
What is the solution?
I came upon the writings of professor Stephen Finglewsi, an NYU finance professor and his proposed solution to the financial crisis. His is the first reading I've found that I completely believe in because it makes economic sense and is very intuitive to understand; There's a clear goal and practical approach to solve the crisis.
- From an Approach to a Plan: The Key is Fairness (Full paper if you're willing to read it)
So in his paper he provides a great analogy that I briefly referenced in my earlier post to describe the situation we have. Essentially, the financial sector troubles can be compared to what insurance companies experience with natural disasters.
So, let's say an insurance company offers insurance against hurricanes hitting homes. If hurricanes were to hit all the homes that the company provided insurance to, the company would have huge losses as it would use all its money (cash reserves) to cover the insurance policies . However, if everybody were to claim their insurance at the same time, the insurance company might not have enough cash to pay everybody so it goes into bankruptcy. At the same time, even if it were able to pay off all its claims, it would have problems running its business as it now has no money. It might have to lay off employees and it would need to raise more money to continue to issue new insurance contracts.
The same principle applies to the financial sector. Basically, they invested in the mortgages through securities and now have to bear the losses. For some companies, the losses were too much so they went into bankruptcy (see Lehman Brothers). Either that or they were bought out by another company or bailed out by the government (see AIG, Citigroup, Merrill Lynch, etc.)
The ones that could bear the losses, were crippled financially and do not have enough money to continue ordinary business. Also, they're scared that the companies they lend money to will go into bankruptcy as well so that limits business as well.
Alrite, so let's go onto what he proposes. (Sorry for the technical verbiage. It would be hard to describe in more simplistic terms)
Figlewski's plan:
The plan focuses on disconnecting the real estate sector from the financial sector: "When an electrical device catches fire, the first thing to do is to disconnect the power. The financial system is connected to the real estate sector by mortgage loans, and it is being severely damaged by the uncertainty over how many of those loans will default and how much the lenders will lose when defaults occur."
To accomplish this overarching goal he has several proposals for the Federal government to "step between the homeowner and the mortgage lender to remove the risk from the mortgage payments": (read his paper if you want to know more of the details)
- "Government would eliminate risk of default and prepayment by guaranteeing all mortgage payments to be made in full and as scheduled."
- The main thing we need to do is to continue the mortgage payments - whether in full or at least a significant portion of it but that's all in the details.
- Why? Because these payments are crucial for the financial sector. The ultimate investors are financial institutions and because they're losing a lot of money from these investments so they cannot perform their functions as financial intermediaries.
- We cannot re-structure or change the investment terms to make the payments less because they are very complex and have a lot of moving parts.
- The main thing we need to do is to continue the mortgage payments - whether in full or at least a significant portion of it but that's all in the details.
- "Government would work with homeowners that are at risk of default to reschedule and reorganize loan size and payments. The objective is to keep as many families in homes as possible and to avoid the costly process of foreclosure, evictions and fire sales of repossessed properties."
- "The standard mortgage has a "level pay" structure, in which the monthly payment of interest and principal is constant over the life of the loan. For example, a 30 year conventional mortgage with an interest rate of 7% calls for a monthly payment of $1330."
- "But this is a little strange. No one renting a house or an apartment would expect to pay the same rent every month for the next 30 years. Simply allowing the monthly mortgage payment to grow in the future would make it possible to lower it substantially right now. We can restructure the payment schedule and still satisfy the principle that "A deal's a deal." As long as the loan is fully paid off over its lifetime and the agreed interest rate is always paid on the outstanding principal balance, the government intermediary would be receiving the same economic value from the borrower over time that it is paying to the lender."
- "For example, rescheduling the monthly payment in the first year to be just equal to the interest on the loan, but to grow at a rate of 1.3% a year thereafter, would reduce the payment on the 7% 30-year loan by $163, to $1167 in the first year. This simple change in the pattern of mortgage payments would represent no real cost to the taxpayers at all. But it could make it easier for many homeowners to meet their mortgage obligations."
- The government could go even further and make mortgage payments even lower with higher growth rates. "For example, with a growth rate of 3% or 5% a year, the first 5 year's payments go down to $974 or $769 per month, respectively. These schedules still represent fair exchanges, in that there is no reduction of principal or interest involved. However, because the government would continue to pay $1330 a month to the lender, the homeowner would be gradually building up a debt in the early years, which would be paid off over time."
- If the homeowner cannot meet the above mentioned restructured mortgage payments, the government could convert a house to a rental unit in the interim, allowing homeowners to stay in their homes until they are financially viable.
- This would lower mortgage payments to rental payments and would give the government temporary ownership of the house.
- So the government would pay the difference between the scheduled mortgage payments and the rental payments to satisfy the ultimate investors who are dependent on those cash flows.
- There is also the issue of "upside-down" or "underwater" homeowners whereby the current market value of the house is less than the outstanding mortgage loan they have. For instance, if you took out a loan for $250,000 in 2006 for your house that was worth $300,000 at the time: but now, the house is only worth $200,000, so you have an incentive to just default because even if you sell the house, you'll only get $200,000 and you'll still owe more money.
- This is more complicated because we do not know how each person will act, but presumably, homeowners bought a house because they liked it in the first place so they would continue to make payments if they could.
- Also, there's the cost of moving out of the house and to find another place to live
- Finally, a person's credit rating goes down the tubes if they default on a home.
Fairness: Is it fair to bailout homeowners that bought houses they could not afford and payments they could not meet? A lot of people feel the bailout of the banks was not fair, so are they willing to go along with this plan? If the government is changing the terms of the contracts, how is that fair for other homeowners?
Well, Figlewski's plan makes the government bear the immediate losses, and does not lower the total overall payment so in that sense it is fair. Plus, it would be beneficial overall to go through with this because everybody would be better off in the end.
As Figlewski's mentioned, the purview of his plan is not all encompassing - so it is not a panacea - but it ultimately stops the source of the problem and prevents our situation from getting significantly worse than it already is.
What will happen if we implement this plan? What other issues exist?
The US economy will continue to have problems after we implement this plan mainly because of US consumers and exports. Businesses need people to buy their products and services to make money. People will spend a lot less because of the economic crisis so that will keep GDP down for a while.
- The unemployment rate is extremely high and will continue to rise. The unemployed will definitely cut back significantly and only stick to necessities. This is apparent.
- Unfortunately, the problem is magnified by the real estate and stock market crash. Economists have studied how price drops in both of these have decreased spending in the past. They measure this by a statistic called the Marginal Propensity to Consume (MPC).
- A MPC of 0.50 means, for every dollar drop in price, consumers will spend 50 cents less overall.
- An assistant NYU finance professor Stijn Van Nieuwebrugh shows the MPC for real estate is between 0.05 and 0.15 while the MPC for stocks is between 0.02 and 0.04.
These numbers may not seem that large, but given the crash that has occured, they will have a sizable effect on the overall economy. (read his article here) - Exports will also decrease because the dollar is strong right now, so for foreigners it costs them more now to buy goods from US companies.
- Sean
Friday, December 12, 2008
Bailout....fails?? What?
Oops. I guess I should've learned from the original TARP bill that Congress is pretty much autonomous and does not give into political pressures.
Days after news organizations promulgated that the Auto bailout bill was going to pass, Congress, or more appropriately, the Republican party, vehemently decried the terms of the Auto bailout bill and advised the Auto companies to pursue Chapter 11 Bankruptcy (Click link to read explanation).
The Republican party is a strong proponent of free-market economics and its ideology has been severely challenged by this crisis; It took major efforts to convince them to pass the TARP in the first place. Also, given how recent events have played out -- no real tangible signs of improvement or stabilization in the economy -- the party is hesitant to dole out more cash for companies that it feels are a lost cause.
The events are interesting because it is strange how people's views have changed so quickly. America, a country built on capitalism and free-market enterprise, has resorted to socialist measures to try and and solve its issues (bailing out companies and banks). Almost everyone is also endorsing this idea as if it is our only option and because we do not want to face the consequences of what makes capitalism work in the first place - sacrifice.
Maybe a silver lining in all this is that there is still a system of checks and balance among the government and I must say, it takes a lot of guts to stand firm on your ideas when you're going against the will of the people, the treasury secretary, the president and the president elect.
Alas, the Republican party's resistance will only delay the bill because right now, the treasury secretary, Henry Paulson, is considering using some of TARP's funds for the provision of the auto bailout. If that does not come to fruition, Obama's administration will do something. However, GM has already said that they may not survive this month without the money. I guess we'll just have to wait and see what happens.
Days after news organizations promulgated that the Auto bailout bill was going to pass, Congress, or more appropriately, the Republican party, vehemently decried the terms of the Auto bailout bill and advised the Auto companies to pursue Chapter 11 Bankruptcy (Click link to read explanation).
The Republican party is a strong proponent of free-market economics and its ideology has been severely challenged by this crisis; It took major efforts to convince them to pass the TARP in the first place. Also, given how recent events have played out -- no real tangible signs of improvement or stabilization in the economy -- the party is hesitant to dole out more cash for companies that it feels are a lost cause.
The events are interesting because it is strange how people's views have changed so quickly. America, a country built on capitalism and free-market enterprise, has resorted to socialist measures to try and and solve its issues (bailing out companies and banks). Almost everyone is also endorsing this idea as if it is our only option and because we do not want to face the consequences of what makes capitalism work in the first place - sacrifice.
Maybe a silver lining in all this is that there is still a system of checks and balance among the government and I must say, it takes a lot of guts to stand firm on your ideas when you're going against the will of the people, the treasury secretary, the president and the president elect.
Alas, the Republican party's resistance will only delay the bill because right now, the treasury secretary, Henry Paulson, is considering using some of TARP's funds for the provision of the auto bailout. If that does not come to fruition, Obama's administration will do something. However, GM has already said that they may not survive this month without the money. I guess we'll just have to wait and see what happens.
Sunday, December 7, 2008
Government Bailout
Hey all,
This post is somewhat of a follow-through on my previous post on the financial crisis. I hope people have read my previous post as it helps you to understand the origins of the financial crisis. This post will focus more on how the US government has responded to try and stymie a complete economic collapse. I understand that most of you will be bored out of your minds if I write an in-depth post because it will be super long. Thus, I will try to focus on the important details.
So, as you guys now know, the crisis originated from the housing market and the securitization of mortgages coupled with over-leverage (excess borrowing to make investments). (Please read my other post “financial fallout” if you don’t have a clue what I’m referring to). It’s important to understand that securitization and leverage are not a bad thing per se, as they help companies to spread risk and pursue viable investments, respectively. However, as I mentioned in the other post, it is when we take these measures to the extreme is when we expose ourselves to deep problems (As you guys all know, the idea of moderation applies to almost anything in life).
As the crisis unfolded, the US government responded in its customary slow fashion. Because they did not take serious action last year when the problem signs emerged, they have been forced to take unprecedented high-profile measures since. Here’s a synopsis of the major actions taken by the government:
Fannie Mae & Freddie Mac:
What they do: These are government sponsored enterprises (“GSEs”) that help fund mortgage loans by buying them from mortgage institutions. So, essentially, they give cash to a bank and in return they hold the mortgage loans and wait for all the payments to come in. In order to fund this operation, they package (securitize) the mortgage loans into MBS (Mortgage backed securities) that they sell in the secondary market.
What happened: As the housing market got worse, and prices continued to decline, the GSEs looked in trouble; Foreclosure and delinquency rates increased (less payments to Fannie Mae & Freddie Mac) so there was uncertainty about whether the GSEs could pay off the debt they owed their private investors. Private investors who bought MBS' from these two were guaranteed fixed payments from the entities. However, since these two companies were implicitly backed by the Government, nobody really knew if the government would step in to help pay off the debt that the GSEs owed. This concern and loss of confidence in the entities made their stock price go down drastically. Eventually, they were basically bankrupt.
Government Action: In early September, the Government rescued these two by placing them into what they call “conservatorship.” Basically, this means the government takes control of the operations of the firms, and most importantly, the US Treasury backs all the debt that the firms guarantee. Therefore, it reinstates the confidence that private investors have in the firms because it becomes an explicit rather than an implicit guarantee. The government had to bailout the GSEs because a lot of banks, foreign banks and other large influential firms were dependent on the GSEs. Had they gone bankrupt, it would have caused a huge ripple effect that would have put not only firms, but also countries in trouble.
Bear Stearns & JP Morgan:
What do these entities do: Bear Stearns and JP Morgan are investment banks – firms that sell investments such as stocks and bonds in the secondary market, as well as provide financial strategic consulting advice for mergers and acquisitions. Note: Some investment banks also do commercial banking (traditional bank function: take deposits, give out loans. Citigroup is an example). Investments banks such as Bear Sterns and JP Morgan form the storied quintessential Wall Street firms where bankers adorn $5,000 Armani suits and drive around Ferraris.
What Happened: Bear Stearns had a lot of losses related to its MBS' and eventually the losses were too significant for them to bear.
Government Action: The government felt that the collapse of Bear Stearns would be too catastrophic since it was interlinked with a lot of other big name firms. Therefore, the US government facilitated a deal whereby JP Morgan purchased Bear Stearns at 7% of its market value based on its closing stock price that day. Why sell Bear Stearns so cheap to JP Morgan? Well, the US government wanted to prevent other companies from wanting to follow Bear Stearns' path. That is, if companies knew they could sell themselves for a high price, they would give up on solving their investment problems.
Lehman Brothers:
What does this entity do: Lehman Brothers was an investment bank also.
What happened: Lehman Brothers had a lot of mortgage related investments that eventually bankrupted the company.
Government Action: The government decided not to help Lehman Brothers because they felt it wouldn’t have a drastic effect on the economy. As a result, Lehman filed for Chapter 11 bankruptcy resulting in the largest bankruptcy in US history.
The collapse of Lehman affected many companies as they invested money and lent money to Lehman. Many people believe that it was a big mistake that the US government did not step in to save Lehman. We won’t know for a while whether this is true or not. Since Lehman Brothers’ collapse, the US government has been a broker in making several merger and acquisition deals such as Bank of America’s purchase of Merrill Lynch, and Wells Fargo’s purchase of Wachovia. The banks that got acquired had a lot of mortgage write-downs related to their MBS' investments so their only choice was to sell the business.
Now, the only investment banks left on Wall Street are Goldman Sachs, and Morgan Stanley. Yet, it is not sure if their business model/structure will work in the future since a lot of their profits were derived from these credit derivatives. Both firms converted to commercial banks recently as this allows them to borrow short-term funds at the cheapest rate (the federal funds rate) from the Federal Reserve (“The Fed,” or the US Central Bank). In addition, Goldman Sachs’ desperation was further reinforced when it revealed its interest in pursuing online banking to get depository funds.
AIG:
What do this entity do: AIG is insurance company that offers traditional insurance but also decided to offer insurance in the credit derivatives market.
What Happened: AIG sold a lot of Credit Default Swaps (CDS'). CDS' if you remember are basically insurance contracts. As part of these contracts, the counterparty (insurance holder) can ask for more money (collateral) from the insurance provider (AIG in this case) if the insurance provider is downgraded (resulting from financial problems). This is exactly what happened in the case of AIG as a lot of the CDS holders asked for more money from AIG and eventually the company ran out of money. An analogous situation would be if everybody suddenly crashed their car and went to the insurance company. The company would not have enough money to cover everybody.
Government Action: The government bailed out AIG because too many people had these insurance contracts. AIG has to pay back the loan within 5 years with relatively low interest rate. The company is safe for now however.
Troubled Asset Relief Program (TARP):
This is the so-called $700 billion dollar bailout bill that Henry Paulson, US treasury secretary, and Ben Bernanke, the Fed chairman, vehemently endorsed. Initially, the money was supposed to be used to purchase “toxic assets” from the banks, basically all these risky investments that nobody wanted to buy. However, with strong opposition and outrage from the people, economists, and politicians, Henry Paulson and co. decided to make capital infusions (give banks money) into the banks. The banks that the government decided to sponsor, Goldman Sachs, Morgan Stanley, Citigroup, Wells Fargo, Bank of America, and JP Morgan are the biggest banks in the US. By giving them money, the government wanted to try and encourage banks to lend again - what the press has called “un-freezing the credit markets.” Economic indicators have shown that this process is occurring slowly but surely.
The government also ended up giving Citigroup, one of the investment banks, additional funds when the bank was in trouble. One week, investors suddenly lost confidence in Citigroup and there was basically a “run” on the bank as its stock price was plummeting. The government had no choice but to give Citigroup more money to stay alive.
The US treasury has spent about half of the $700 billion so far. Note: Had the government pursued the original plan, it would have been basically impossible to implement and would just be a drop in the bucket. The amount of these troubled assets are so large that $700 billion would not do much to shore up the banks’ balance sheets. The banks are hoping that these assets will be worth more when the housing market recovers.
Why bailout banks: Although the government would prefer not to interfere with what is happening in the markets, banks are so intertwined with the rest of the economy that they were left with no choice. Not only do they have countless investors that they owe money to, but they also are responsible for providing companies with short-term loans to cover costs. The majority of firms in the US are small firms that borrow money from banks to pay wages and operating costs to keep their businesses open. As the banks run into trouble and have less money, they refuse to lend money out to these small businesses because they need it for themselves. This causes a huge problem where businesses across the US have to go bankrupt as a result. Therefore, the US government has been trying to encourage the banks to lend out money to help business to continue.
Is their approach the best or correct way: Honestly, we do not know. What the government is doing now is not in any economics textbook. They’re basically doing everything on the fly so that’s not very reassuring. A prime example of the government’s uncertainty is the TARP and how its purpose changed. Originally, Henry Paulson and Ben Bernanke (Fed chief) said that buying the toxic assets is our only and best option. Yet, a couple weeks later they used the money not to buy the toxic assets but to give the banks capital. The truth is, Ben Bernanke and Henry Paulson do not fully grasp these mortgage securities (MBS', CDOs). The people who really understand how they work and the best way to deal with them are not the CEOs, or the people high in government, it’s the statisticians, geeks and mathematicians that are buried within the corporate firms.
It’s true that ex-ante, choosing Ben Bernanke and Henry Paulson to deal with this crisis would probably be our best option. However, in reality, things do not play out as we expect. Ben Bernanke is an expert on the Great Depression and he’s written many papers on how government could have prevented that crisis. Yet, he’s implemented all his solutions and the results are not what he expected. Henry Paulson used to be the CEO of Goldman Sachs, he understands the investment banks inside out. He should know how to get banks to lend and help the economy. Yet, despite all these problems, the economy is not as bad as everybody’s making it out to be. The Great Depression was MUCH MUCH worse.
The Big 3 Auto Companies (Ford, GM, Crystler):
I’m sure you guys have all heard about how the Big 3 have gone to Congress trying ask for money. What should Congress do? Well, in my opinion, the best option would be to let GM and Chrysler file for Chapter 11 Bankruptcy protection. However, I feel it is inevitable that the government will give them money sooner or later. If they do not grant it now, Obama will make sure they do. There’s a lot of politics at play here.
Fundamentally, the Big 3 are structurally unsound and they have a business model that does not work - too many brands, and too many SUVs and gas-guzzlers. They have a competitive disadvantage in that they are binded by the United Auto Workers (UAW) union in terms of pay scale, pension, and health costs. I feel that giving them money will only prolong the inevitable. In their plan to Congress they proposed certain measures to help cut costs by $4 billion a quarter, yet their costs are still in excess of $14 billion a quarter. You don’t need a PhD to figure out that the math does not work out. They have to file for bankruptcy so they can change those contracts and figure out a better business model. Also, the jobs that would be lost from their bankruptcy would be partially offset by the other carmakers in the industry.
What has happened globally?
Europe:
In Europe, there’s been a similar response to the US whereby a lot of banks, especially in the UK, have been given capital infusions. There has also been a fair number of bankruptcies. The European and US economy continue to be closely intertwined.
Asia:
Asia also has been greatly affected by what has been happening in the US. China’s growth rate has slowed considerably. They have mandated two economic stimulus packages to try and sustain an 8-9% growth rate.
What’s in store for the future?
Obama has done all the right things so far. He’s assembled an extremely skilled economic team comprised of both experienced economists and knowledgeable academics. (The team understands both bureaucracy and economics, because you need both to get things done in Washington). Yet, they have a tough task ahead of them and choosing the right team ex-ante does not guarantee results. Obama is planning a large stimulus plan coupled with several projects to increase jobs (he promised 2.5 million new jobs by 2011?): Obama's stimulus package
The government has also started to try and address the housing issues: US Eyes Plan To Life Home Sales. They’re lowering mortgage rates in an attempt to increase demand for houses and in turn, increasing house prices. There are still a lot of proposals floating around with respect to addressing the housing market. As we now know, stabilizing the housing market is a key to stabilizing the economy.
In the past, consumer spending was the driver of 60-70% of GDP. Now that consumer confidence is at an all-time low, consumer spending has been cut back drastically. Somehow Obama has to figure out how to get Americans to start spending their money again.
Also, exports are going to decrease substantially now because the dollar is strong (foreign investors are buying a lot of US treasuries, sold in US dollars and the closest thing to a risk-free asset, so there’s a high demand for US dollars => appreciating/strong dollar). But a shortcoming of this is that US goods are more expensive since a unit of foreign currency has less purchasing power now. This will hurt the US as well.
Well, that was a longer than expected post. I’m sorry for the lengthiness and don’t know if anybody’s going to read all of this. Haha.
- Sean
Sources:
http://knowledge.emory.edu/article.cfm?articleid=1178
http://en.wikipedia.org/wiki/Economic_crisis_of_2008
http://en.wikipedia.org/wiki/Global_financial_crisis_of_2008
http://en.wikipedia.org/wiki/Financial_crisis_of_2007-2008
http://www.nytimes.com/2008/03/16/business/16cnd-bear.html
http://online.wsj.com/article/SB122833771718976731.html?mod=article-outset-box
Good article if you want more technical in-depth reading on securitization:
http://economistsview.typepad.com/economistsview/2007/10/the-role-of-sec.html
This post is somewhat of a follow-through on my previous post on the financial crisis. I hope people have read my previous post as it helps you to understand the origins of the financial crisis. This post will focus more on how the US government has responded to try and stymie a complete economic collapse. I understand that most of you will be bored out of your minds if I write an in-depth post because it will be super long. Thus, I will try to focus on the important details.
So, as you guys now know, the crisis originated from the housing market and the securitization of mortgages coupled with over-leverage (excess borrowing to make investments). (Please read my other post “financial fallout” if you don’t have a clue what I’m referring to). It’s important to understand that securitization and leverage are not a bad thing per se, as they help companies to spread risk and pursue viable investments, respectively. However, as I mentioned in the other post, it is when we take these measures to the extreme is when we expose ourselves to deep problems (As you guys all know, the idea of moderation applies to almost anything in life).
As the crisis unfolded, the US government responded in its customary slow fashion. Because they did not take serious action last year when the problem signs emerged, they have been forced to take unprecedented high-profile measures since. Here’s a synopsis of the major actions taken by the government:
Fannie Mae & Freddie Mac:
What they do: These are government sponsored enterprises (“GSEs”) that help fund mortgage loans by buying them from mortgage institutions. So, essentially, they give cash to a bank and in return they hold the mortgage loans and wait for all the payments to come in. In order to fund this operation, they package (securitize) the mortgage loans into MBS (Mortgage backed securities) that they sell in the secondary market.
What happened: As the housing market got worse, and prices continued to decline, the GSEs looked in trouble; Foreclosure and delinquency rates increased (less payments to Fannie Mae & Freddie Mac) so there was uncertainty about whether the GSEs could pay off the debt they owed their private investors. Private investors who bought MBS' from these two were guaranteed fixed payments from the entities. However, since these two companies were implicitly backed by the Government, nobody really knew if the government would step in to help pay off the debt that the GSEs owed. This concern and loss of confidence in the entities made their stock price go down drastically. Eventually, they were basically bankrupt.
Government Action: In early September, the Government rescued these two by placing them into what they call “conservatorship.” Basically, this means the government takes control of the operations of the firms, and most importantly, the US Treasury backs all the debt that the firms guarantee. Therefore, it reinstates the confidence that private investors have in the firms because it becomes an explicit rather than an implicit guarantee. The government had to bailout the GSEs because a lot of banks, foreign banks and other large influential firms were dependent on the GSEs. Had they gone bankrupt, it would have caused a huge ripple effect that would have put not only firms, but also countries in trouble.
Bear Stearns & JP Morgan:
What do these entities do: Bear Stearns and JP Morgan are investment banks – firms that sell investments such as stocks and bonds in the secondary market, as well as provide financial strategic consulting advice for mergers and acquisitions. Note: Some investment banks also do commercial banking (traditional bank function: take deposits, give out loans. Citigroup is an example). Investments banks such as Bear Sterns and JP Morgan form the storied quintessential Wall Street firms where bankers adorn $5,000 Armani suits and drive around Ferraris.
What Happened: Bear Stearns had a lot of losses related to its MBS' and eventually the losses were too significant for them to bear.
Government Action: The government felt that the collapse of Bear Stearns would be too catastrophic since it was interlinked with a lot of other big name firms. Therefore, the US government facilitated a deal whereby JP Morgan purchased Bear Stearns at 7% of its market value based on its closing stock price that day. Why sell Bear Stearns so cheap to JP Morgan? Well, the US government wanted to prevent other companies from wanting to follow Bear Stearns' path. That is, if companies knew they could sell themselves for a high price, they would give up on solving their investment problems.
Lehman Brothers:
What does this entity do: Lehman Brothers was an investment bank also.
What happened: Lehman Brothers had a lot of mortgage related investments that eventually bankrupted the company.
Government Action: The government decided not to help Lehman Brothers because they felt it wouldn’t have a drastic effect on the economy. As a result, Lehman filed for Chapter 11 bankruptcy resulting in the largest bankruptcy in US history.
The collapse of Lehman affected many companies as they invested money and lent money to Lehman. Many people believe that it was a big mistake that the US government did not step in to save Lehman. We won’t know for a while whether this is true or not. Since Lehman Brothers’ collapse, the US government has been a broker in making several merger and acquisition deals such as Bank of America’s purchase of Merrill Lynch, and Wells Fargo’s purchase of Wachovia. The banks that got acquired had a lot of mortgage write-downs related to their MBS' investments so their only choice was to sell the business.
Now, the only investment banks left on Wall Street are Goldman Sachs, and Morgan Stanley. Yet, it is not sure if their business model/structure will work in the future since a lot of their profits were derived from these credit derivatives. Both firms converted to commercial banks recently as this allows them to borrow short-term funds at the cheapest rate (the federal funds rate) from the Federal Reserve (“The Fed,” or the US Central Bank). In addition, Goldman Sachs’ desperation was further reinforced when it revealed its interest in pursuing online banking to get depository funds.
AIG:
What do this entity do: AIG is insurance company that offers traditional insurance but also decided to offer insurance in the credit derivatives market.
What Happened: AIG sold a lot of Credit Default Swaps (CDS'). CDS' if you remember are basically insurance contracts. As part of these contracts, the counterparty (insurance holder) can ask for more money (collateral) from the insurance provider (AIG in this case) if the insurance provider is downgraded (resulting from financial problems). This is exactly what happened in the case of AIG as a lot of the CDS holders asked for more money from AIG and eventually the company ran out of money. An analogous situation would be if everybody suddenly crashed their car and went to the insurance company. The company would not have enough money to cover everybody.
Government Action: The government bailed out AIG because too many people had these insurance contracts. AIG has to pay back the loan within 5 years with relatively low interest rate. The company is safe for now however.
Troubled Asset Relief Program (TARP):
This is the so-called $700 billion dollar bailout bill that Henry Paulson, US treasury secretary, and Ben Bernanke, the Fed chairman, vehemently endorsed. Initially, the money was supposed to be used to purchase “toxic assets” from the banks, basically all these risky investments that nobody wanted to buy. However, with strong opposition and outrage from the people, economists, and politicians, Henry Paulson and co. decided to make capital infusions (give banks money) into the banks. The banks that the government decided to sponsor, Goldman Sachs, Morgan Stanley, Citigroup, Wells Fargo, Bank of America, and JP Morgan are the biggest banks in the US. By giving them money, the government wanted to try and encourage banks to lend again - what the press has called “un-freezing the credit markets.” Economic indicators have shown that this process is occurring slowly but surely.
The government also ended up giving Citigroup, one of the investment banks, additional funds when the bank was in trouble. One week, investors suddenly lost confidence in Citigroup and there was basically a “run” on the bank as its stock price was plummeting. The government had no choice but to give Citigroup more money to stay alive.
The US treasury has spent about half of the $700 billion so far. Note: Had the government pursued the original plan, it would have been basically impossible to implement and would just be a drop in the bucket. The amount of these troubled assets are so large that $700 billion would not do much to shore up the banks’ balance sheets. The banks are hoping that these assets will be worth more when the housing market recovers.
Why bailout banks: Although the government would prefer not to interfere with what is happening in the markets, banks are so intertwined with the rest of the economy that they were left with no choice. Not only do they have countless investors that they owe money to, but they also are responsible for providing companies with short-term loans to cover costs. The majority of firms in the US are small firms that borrow money from banks to pay wages and operating costs to keep their businesses open. As the banks run into trouble and have less money, they refuse to lend money out to these small businesses because they need it for themselves. This causes a huge problem where businesses across the US have to go bankrupt as a result. Therefore, the US government has been trying to encourage the banks to lend out money to help business to continue.
Is their approach the best or correct way: Honestly, we do not know. What the government is doing now is not in any economics textbook. They’re basically doing everything on the fly so that’s not very reassuring. A prime example of the government’s uncertainty is the TARP and how its purpose changed. Originally, Henry Paulson and Ben Bernanke (Fed chief) said that buying the toxic assets is our only and best option. Yet, a couple weeks later they used the money not to buy the toxic assets but to give the banks capital. The truth is, Ben Bernanke and Henry Paulson do not fully grasp these mortgage securities (MBS', CDOs). The people who really understand how they work and the best way to deal with them are not the CEOs, or the people high in government, it’s the statisticians, geeks and mathematicians that are buried within the corporate firms.
It’s true that ex-ante, choosing Ben Bernanke and Henry Paulson to deal with this crisis would probably be our best option. However, in reality, things do not play out as we expect. Ben Bernanke is an expert on the Great Depression and he’s written many papers on how government could have prevented that crisis. Yet, he’s implemented all his solutions and the results are not what he expected. Henry Paulson used to be the CEO of Goldman Sachs, he understands the investment banks inside out. He should know how to get banks to lend and help the economy. Yet, despite all these problems, the economy is not as bad as everybody’s making it out to be. The Great Depression was MUCH MUCH worse.
The Big 3 Auto Companies (Ford, GM, Crystler):
I’m sure you guys have all heard about how the Big 3 have gone to Congress trying ask for money. What should Congress do? Well, in my opinion, the best option would be to let GM and Chrysler file for Chapter 11 Bankruptcy protection. However, I feel it is inevitable that the government will give them money sooner or later. If they do not grant it now, Obama will make sure they do. There’s a lot of politics at play here.
Fundamentally, the Big 3 are structurally unsound and they have a business model that does not work - too many brands, and too many SUVs and gas-guzzlers. They have a competitive disadvantage in that they are binded by the United Auto Workers (UAW) union in terms of pay scale, pension, and health costs. I feel that giving them money will only prolong the inevitable. In their plan to Congress they proposed certain measures to help cut costs by $4 billion a quarter, yet their costs are still in excess of $14 billion a quarter. You don’t need a PhD to figure out that the math does not work out. They have to file for bankruptcy so they can change those contracts and figure out a better business model. Also, the jobs that would be lost from their bankruptcy would be partially offset by the other carmakers in the industry.
What has happened globally?
Europe:
In Europe, there’s been a similar response to the US whereby a lot of banks, especially in the UK, have been given capital infusions. There has also been a fair number of bankruptcies. The European and US economy continue to be closely intertwined.
Asia:
Asia also has been greatly affected by what has been happening in the US. China’s growth rate has slowed considerably. They have mandated two economic stimulus packages to try and sustain an 8-9% growth rate.
What’s in store for the future?
Obama has done all the right things so far. He’s assembled an extremely skilled economic team comprised of both experienced economists and knowledgeable academics. (The team understands both bureaucracy and economics, because you need both to get things done in Washington). Yet, they have a tough task ahead of them and choosing the right team ex-ante does not guarantee results. Obama is planning a large stimulus plan coupled with several projects to increase jobs (he promised 2.5 million new jobs by 2011?): Obama's stimulus package
The government has also started to try and address the housing issues: US Eyes Plan To Life Home Sales. They’re lowering mortgage rates in an attempt to increase demand for houses and in turn, increasing house prices. There are still a lot of proposals floating around with respect to addressing the housing market. As we now know, stabilizing the housing market is a key to stabilizing the economy.
In the past, consumer spending was the driver of 60-70% of GDP. Now that consumer confidence is at an all-time low, consumer spending has been cut back drastically. Somehow Obama has to figure out how to get Americans to start spending their money again.
Also, exports are going to decrease substantially now because the dollar is strong (foreign investors are buying a lot of US treasuries, sold in US dollars and the closest thing to a risk-free asset, so there’s a high demand for US dollars => appreciating/strong dollar). But a shortcoming of this is that US goods are more expensive since a unit of foreign currency has less purchasing power now. This will hurt the US as well.
Well, that was a longer than expected post. I’m sorry for the lengthiness and don’t know if anybody’s going to read all of this. Haha.
- Sean
Sources:
http://knowledge.emory.edu/article.cfm?articleid=1178
http://en.wikipedia.org/wiki/Economic_crisis_of_2008
http://en.wikipedia.org/wiki/Global_financial_crisis_of_2008
http://en.wikipedia.org/wiki/Financial_crisis_of_2007-2008
http://www.nytimes.com/2008/03/16/business/16cnd-bear.html
http://online.wsj.com/article/SB122833771718976731.html?mod=article-outset-box
Good article if you want more technical in-depth reading on securitization:
http://economistsview.typepad.com/economistsview/2007/10/the-role-of-sec.html
Monday, December 1, 2008
DROPPED! But no worries...
OH crazy babies!!
Whole stock Market dropped today. But no worries, now is a good time to see if there is anything you want to buy. As for those of us who are losing money, NO WORRIES! Things will turn out ok. I know you guys know that already, but yea, just a reminder. Thanks again Sean for the information. It's a nice crash course.
And to all you new authors. You can post stuff whenever you want. Don't just sit there, ok? Haha. Cheers.
Saturday, November 29, 2008
The Financial Fallout
Hello there,
Hope you guys all had a great thanksgiving. As promised, I will try to provide an overview of the financial meltdown that has led the government to pursue unprecedented measures to prevent the second Great Depression.
First and foremost, you do not need to have a background in finance or economics to understand the underlying problems that created this whole mess. In fact, despite all the technical jargon that investment managers and other financial experts use, there are simple concepts that help explain the heart of the issue.
The First Stage: The Subprime Mortgage Crisis
First, we all know that in the past decade, America's housing market was booming. House prices were skyrocketing and everybody was trying to buy a home quickly because they believed prices would continue on that trend. Furthermore, the government has always encouraged home ownership and has instituted the policy of increasing home ownership.
(This is not a bad thing, quite the contrary, it is actually good to have people in homes because they are "investing," and because it is the ideal of society. A problem is created when we take it to the extreme and this is what happened.)
To increase home ownership, mortgage institutions have made it easier for people to get funds. On a simplistic level, they have done so by either decreasing down payments or decreasing credit rating requirements. However, a problem arose when the requirements became too lax and mortgage institutions started lending money to individuals that could not afford homes. In particular, the Clinton Administration pressured Fannie Mae, a government sponsored enterprise (GSE) to provide funds for sub-prime borrowers - borrowers that have a higher risk of default because they have a history of either: a) history of loan delinquency or default, b) history of recorded bankruptcy or c) those with limited debt experience. Fannie Mae's problem was compounded by its shareholders that wanted the entity to maintain its profits.
Many of these sub-prime borrowers entered into contracts with initial low payments -payments they could afford -but the contracts would later inflate to larger payments - which they could not. Yet, most, if not all borrowers, were also informed that house prices will go up, so borrowers could refinance at more favorable terms, or worse yet, just sell the house for a higher price. This was a significant misconception that most people had. From 2000-2005, house prices were rising and no real apparent problem surfaced in the sub-prime market. However, in 2007, the sub-prime crisis manifested itself when house prices started declining precipitously. While historically, it is true that house prices do increase over time, in the short run, prices can decline significantly as evidenced by the recent occurings. Thus, many home owners were left with payments they could not meet and the foreclosing avalanche ensued.
What has made the sub-prime crisis worse is the fact that many borrowers that already owned homes were baited into sub-prime loans through the refinancing process. Predatory lenders persuaded them into subprime contract terms that many did not understand. As a result, many home owners that would have been okay, are now in trouble as well. Additionally, the situation has gotten so bad that prime rate borrowers are starting to have problems meeting their payments as well.
The Second Stage: Securitization and Leveraging Activities Within the Shadow Banking System
While the sub-prime crisis itself has created a myriad of economic problems for the nation to deal with, it is the packaging and creation of complex derivatives or investments that have magnified the issue to a near catastrophic state.
The main culprits to this financial fallout have become part of a lexicon of financial terms that you may have heard of in the news this past few months:
Why 'Fallout' for the financial crisis? from Marketplace on Vimeo.
So hopefully you watched the video and now understand the investments conceptually. Essentially, the ABS, MBS, CDO, CLO, and CMO are all just invesments in fixed income securities backed by some type of asset, whether it be a mortgage loan, a car loan etc. These investments have been rated by rating agencies and priced using complex models. CDOs are the most risky because they evolved into CDO^2, CDO^3, whereby investors in the riskiest tranche (slice) are most likely not paid at all given current market conditions.
Despite the riskiness of all these investments, rating agencies made the mistake of relying upon "experts" and rating the securities based on limited knowledge.
The firms themselves also made a mistake by mis-pricing all these investments using PhD economists to build complex models. In essence, they tried to put numbers on their investments that account for human behavior and obviously their models did not work. Most of the documents trying to describe the mathematical derivation of these securities were 200 pages long that many doctorates working at these companies could not even fully understand. For instance, Blinder, the former Fed vice chairman, holds a doctorate in economics from the Massachusetts Institute of Technology but said that he had only a "modest understanding" of complex derivatives. "I know the basic understanding of how they work," he said, "but if you presented me with one and asked me to put a market value on it, I'd be guessing."
The main players engaged in the trading of these credit derivatives are part of the shadow banking system - A community that includes Wall Street firms such as hedge funds, investment banks, money market funds, and other financial institutions that perform functions beyond that of a regular commercial bank. Basically, all these firms just followed the crowd and didn't want to miss out on the exorbitant amount of profits these investments provided. Moreover, they leveraged, or borrowed so much money to make these investments that once the economy turned bad, they could not cover the claims or losses these investments incurred.
What makes these investments dangerous is that they are traded in the over-the-counter market ("OTC") - A market that is not regulated like the stock market, the bond market or the futures market. Therefore, we do not know who is trading with whom, or even the amount of money that is involved. A recent voluntary survey valued the total credit default swap ("CDS") market at approximately $60 trillion dollars. Yep, that's right, $60 trillion, about 6 times the US budget deficit. This does not include the asset backed securities market that in and of itself is tens of trillions of dollars.
Note: Companies are not disclosing the values of their asset/mortgage backed securities on their balance sheets. They are not required to since they bought it in the OTC market. That was why there was huge sell-off on banks in the past couple weeks. In particular, there were huge concerns over Citigroup because investors were worried about their access to short-term cash since they have less depository institutions than its competitors.
Furthermore, although CDS' are essentially "insurance," the financial institutions issuing them have not been calling it "insurance," because, calling it such, would result in meeting certain requirements. One important requirement that has to be met by an insurance issuer is that the entity has to have sufficient capital reserves to be able to pay off insurance claims. The issuers of the swaps, or CDS', did not have adaquete reserves to cover these claims and thats why they're in trouble. American Insurance Group or AIG is a prominent culprit of this phenomenon.
There are so many questions that remain as we are still in a precarious economic environment. Are the governments actions enough to thwart a global economic collapse? Probably, but we may still suffer a severe recession. One thing's for sure, the Obama administration will enact new regulatory measures to improve transparency and oversight of the credit derivatives market.
I firmly believe that it is important for every one of us to be competent in investing and in managing one's own money. In the past few decades, people have relied upon investing experts to perform this task for them. This has mostly come about because individuals are intimidated by the investments available to them; whether it is the stock market, the bond market, the futures market, or even a retirement fund such as the 401k, most people mismanaged their investments because they did not understand the inherent risk involved.
There are plenty of resources out there for you to learn and equip yourself with the right tools to handle these investments wisely. So many people have been burned this past year because they did not know how to mitigate their risk exposure. We are lucky because we did not have to suffer these massive losses that have compromised our future. However, we must learn from others' mistakes in order to avoid a similar fate. To do this, we must empower ourselves with the knowledge of prudent investment strategies and I hope this can be a forum that will help us to do that.
In Him,
Sean
sources:
The credit crisis as Antarctic expedition from Marketplace on Vimeo.
Margin calls and the financial market’s decline from Marketplace on Vimeo.
Hope you guys all had a great thanksgiving. As promised, I will try to provide an overview of the financial meltdown that has led the government to pursue unprecedented measures to prevent the second Great Depression.
First and foremost, you do not need to have a background in finance or economics to understand the underlying problems that created this whole mess. In fact, despite all the technical jargon that investment managers and other financial experts use, there are simple concepts that help explain the heart of the issue.
The First Stage: The Subprime Mortgage Crisis
First, we all know that in the past decade, America's housing market was booming. House prices were skyrocketing and everybody was trying to buy a home quickly because they believed prices would continue on that trend. Furthermore, the government has always encouraged home ownership and has instituted the policy of increasing home ownership.
(This is not a bad thing, quite the contrary, it is actually good to have people in homes because they are "investing," and because it is the ideal of society. A problem is created when we take it to the extreme and this is what happened.)
To increase home ownership, mortgage institutions have made it easier for people to get funds. On a simplistic level, they have done so by either decreasing down payments or decreasing credit rating requirements. However, a problem arose when the requirements became too lax and mortgage institutions started lending money to individuals that could not afford homes. In particular, the Clinton Administration pressured Fannie Mae, a government sponsored enterprise (GSE) to provide funds for sub-prime borrowers - borrowers that have a higher risk of default because they have a history of either: a) history of loan delinquency or default, b) history of recorded bankruptcy or c) those with limited debt experience. Fannie Mae's problem was compounded by its shareholders that wanted the entity to maintain its profits.
Many of these sub-prime borrowers entered into contracts with initial low payments -payments they could afford -but the contracts would later inflate to larger payments - which they could not. Yet, most, if not all borrowers, were also informed that house prices will go up, so borrowers could refinance at more favorable terms, or worse yet, just sell the house for a higher price. This was a significant misconception that most people had. From 2000-2005, house prices were rising and no real apparent problem surfaced in the sub-prime market. However, in 2007, the sub-prime crisis manifested itself when house prices started declining precipitously. While historically, it is true that house prices do increase over time, in the short run, prices can decline significantly as evidenced by the recent occurings. Thus, many home owners were left with payments they could not meet and the foreclosing avalanche ensued.
What has made the sub-prime crisis worse is the fact that many borrowers that already owned homes were baited into sub-prime loans through the refinancing process. Predatory lenders persuaded them into subprime contract terms that many did not understand. As a result, many home owners that would have been okay, are now in trouble as well. Additionally, the situation has gotten so bad that prime rate borrowers are starting to have problems meeting their payments as well.
The Second Stage: Securitization and Leveraging Activities Within the Shadow Banking System
While the sub-prime crisis itself has created a myriad of economic problems for the nation to deal with, it is the packaging and creation of complex derivatives or investments that have magnified the issue to a near catastrophic state.
The main culprits to this financial fallout have become part of a lexicon of financial terms that you may have heard of in the news this past few months:
- Asset Backed Securities ("ABS")
- Mortgage Backed Securities ("MBS")
- Collaterialized Loan Obligations ("CLO")
- Collaterialized Mortgage Obligation ("CMO")
- Collaterialized Debt Obligations ("CDO")
- Credit Default Swaps ("CDS")
Why 'Fallout' for the financial crisis? from Marketplace on Vimeo.
So hopefully you watched the video and now understand the investments conceptually. Essentially, the ABS, MBS, CDO, CLO, and CMO are all just invesments in fixed income securities backed by some type of asset, whether it be a mortgage loan, a car loan etc. These investments have been rated by rating agencies and priced using complex models. CDOs are the most risky because they evolved into CDO^2, CDO^3, whereby investors in the riskiest tranche (slice) are most likely not paid at all given current market conditions.
Despite the riskiness of all these investments, rating agencies made the mistake of relying upon "experts" and rating the securities based on limited knowledge.
The firms themselves also made a mistake by mis-pricing all these investments using PhD economists to build complex models. In essence, they tried to put numbers on their investments that account for human behavior and obviously their models did not work. Most of the documents trying to describe the mathematical derivation of these securities were 200 pages long that many doctorates working at these companies could not even fully understand. For instance, Blinder, the former Fed vice chairman, holds a doctorate in economics from the Massachusetts Institute of Technology but said that he had only a "modest understanding" of complex derivatives. "I know the basic understanding of how they work," he said, "but if you presented me with one and asked me to put a market value on it, I'd be guessing."
The main players engaged in the trading of these credit derivatives are part of the shadow banking system - A community that includes Wall Street firms such as hedge funds, investment banks, money market funds, and other financial institutions that perform functions beyond that of a regular commercial bank. Basically, all these firms just followed the crowd and didn't want to miss out on the exorbitant amount of profits these investments provided. Moreover, they leveraged, or borrowed so much money to make these investments that once the economy turned bad, they could not cover the claims or losses these investments incurred.
What makes these investments dangerous is that they are traded in the over-the-counter market ("OTC") - A market that is not regulated like the stock market, the bond market or the futures market. Therefore, we do not know who is trading with whom, or even the amount of money that is involved. A recent voluntary survey valued the total credit default swap ("CDS") market at approximately $60 trillion dollars. Yep, that's right, $60 trillion, about 6 times the US budget deficit. This does not include the asset backed securities market that in and of itself is tens of trillions of dollars.
Note: Companies are not disclosing the values of their asset/mortgage backed securities on their balance sheets. They are not required to since they bought it in the OTC market. That was why there was huge sell-off on banks in the past couple weeks. In particular, there were huge concerns over Citigroup because investors were worried about their access to short-term cash since they have less depository institutions than its competitors.
Furthermore, although CDS' are essentially "insurance," the financial institutions issuing them have not been calling it "insurance," because, calling it such, would result in meeting certain requirements. One important requirement that has to be met by an insurance issuer is that the entity has to have sufficient capital reserves to be able to pay off insurance claims. The issuers of the swaps, or CDS', did not have adaquete reserves to cover these claims and thats why they're in trouble. American Insurance Group or AIG is a prominent culprit of this phenomenon.
There are so many questions that remain as we are still in a precarious economic environment. Are the governments actions enough to thwart a global economic collapse? Probably, but we may still suffer a severe recession. One thing's for sure, the Obama administration will enact new regulatory measures to improve transparency and oversight of the credit derivatives market.
I firmly believe that it is important for every one of us to be competent in investing and in managing one's own money. In the past few decades, people have relied upon investing experts to perform this task for them. This has mostly come about because individuals are intimidated by the investments available to them; whether it is the stock market, the bond market, the futures market, or even a retirement fund such as the 401k, most people mismanaged their investments because they did not understand the inherent risk involved.
There are plenty of resources out there for you to learn and equip yourself with the right tools to handle these investments wisely. So many people have been burned this past year because they did not know how to mitigate their risk exposure. We are lucky because we did not have to suffer these massive losses that have compromised our future. However, we must learn from others' mistakes in order to avoid a similar fate. To do this, we must empower ourselves with the knowledge of prudent investment strategies and I hope this can be a forum that will help us to do that.
In Him,
Sean
sources:
- http://articles.latimes.com/2008/jul/05/business/fi-refi5
- http://www.nytimes.com/2008/02/12/business/12credit.html
- http://en.wikipedia.org/wiki/Subprime_mortgage_crisis
- http://www.ft.com/cms/s/0/622acc9e-87f1-11dd-b114-0000779fd18c.html
The credit crisis as Antarctic expedition from Marketplace on Vimeo.
Margin calls and the financial market’s decline from Marketplace on Vimeo.
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