Wednesday, December 31, 2008

Happy New Year

Dear all,
I would like to wish everyone a very happy and safe new year

Monday, December 22, 2008

The Credit Crisis- Unplugged

Background: To understand the ongoing subprime mortgage and credit crisis, let’s go back a few years. The end of the Dot-Com Bubble was the start of another, even larger bubble: the housing bubble.

From 2000 to 2005, the median sales price of existing homes increased year over year and speculative investment in properties skyrocketed. "Flipping" or buying a house, doing some quick renovation or repair, then selling it for a handsome profit, became sort of a national pastime, with cable TV shows dedicated to it. In 2005 we saw the launch of not one but two shows, one called Flip This House and another - completely unrelated - called Flip That House.

When property values kept on increasing, home loans became very easy to get (after all, if the borrower defaulted on the mortgage, then the bank got the house - which value kept on increasing anyway!). New mortgage products became popular: subprime loans for borrowers who otherwise wouldn’t qualify for loans because of their lack of creditworthiness (hence the term "subprime") and adjustable-rate mortgage, which, as its name implies, have a variable interest rate. In addition to ARMs, there were also interest only loan - which let the borrower pay only the interest and not the principal on the loan for a period of time, and negative amortization loan (or NegAm) which let the borrower pay a portion of the monthly payment (the rest got added to the total amount borrowed - in this type of mortgage, the amount you owe gets larger year after year!).

How easy was it to get a mortgage? One mortgage provider, HCL Finance (motto: "Home of the ‘no doc’ loan" - no doc refers to no documentation of income required) had a product called the NINJA loan. It stood for No Income, No Job (and) no Assets! (Source)

In 2006, home prices started to go down and a year or so later, borrowers of subprime mortgages started to default on their loans. In 2007, almost 1.3 million properties were being foreclosed - a jump of 75% over the year before. (Source) As late as March 2008, it was estimated that 8.8 million homeowners (about 10.8% of total homeowners) have zero or negative equity in their homes, meaning they owe more than their houses are worth. (Source)

Had that been it, the crisis probably would’ve been isolated. Sure some banks would undoubtedly fail because they made bad loans, but the subprime crisis had since spread to the credit markets and created a massive credit crunch that is larger and far more dangerous than the subprime crisis.

Securitization: To understand the current credit crisis, it’s important to understand something called "securitization." Securitization is an old process by which an asset that generates a cash flow can be converted into a security (like a bond), that can then be bought and sold in the market just like any other security.

A great example is the Bowie Bond. In 1997, musician David Bowie issued a bond (basically a loan note) secured by the current and future royalty revenues of his first 25 albums (a total of 287 songs … here it was the "asset"). The 10-year Bowie Bonds were bought for $55 million by Prudential Insurance Company, who then would collect on the royalties for ten years. So David Bowie got $55 million up front, and Prudential could either keep the bond (and get the song royalties) or sell the bond for profit. (Source)

Back to the topic at hand. Traditionally, banks hold mortgages until maturity, with profits being interest of the loan. But Wall Street had an idea: why not do to mortgages what David Bowie did to songs? So they (and by they, I mean Freddie Mac, Fannie Mae, and 12 Federal Home Loan Banks) pooled together mortgages and bundled them up into asset-backed securities (ABSs) and sold the package to get up front money (the investor would get the monthly mortgage payments from all of the homeowners whose mortgages got bundled).

But wait - these mortgages all had different risks. Some were safe, stodgy 30-year mortgages whereas others were subprime loans that though were more risky, also had higher interest rates and thus were more profitable. Not to worry: Wall Street split the ABSs into "tranches" (just a fancy word meaning sections or classes): the safest were rated AAA (by rating agencies whose sole job was to gauge how risky something was … and got paid by those whom it rated - talk about a conflict of interest!), the rest were medium and low-rated tranches.

The logic was this: one borrower might default on his loan, but if you bundled them together, there’s safety in number: it’s unlikely that ALL borrowers would default all at once.

But wait - there’s more. The medium and low-rated tranches were riskier investments, but it’s unlikely that all of them would default at the same time. So let’s take all those medium-to-low rated ABSs and pool them together to create something called collateralized debt obligations (CDOs). And through the magic of rating, we once again could turn some of these risky securities into - tada! - A-rated securities fit for pension funds. Repackage these CDOs a few more times and pretty soon you wouldn’t know how much subprime loans were actually in them. (Source)

The Credit Crisis: So how did the housing downturn infect the credit markets? Well, when the housing price dropped, a large number of borrowers began to default on their mortgages. Suddenly, ABSs and CDOs looked very suspicious as no one knew how much exposure to the subprime mortgage mess these securities actually had. The market for ABSs and CDOs dried up and holders of these securities couldn’t sell them. In many cases, these companies leveraged their purchase of these securities, which really amplified their losses.

Just as the market worsened and investment firms and companies found that their holdings of ABSs and CDOs were worth far less than they had paid for them (and thus had to write off that loss in their books - causing a number of hedge funds to collapse), another domino fell: Credit-default Swaps (which took down AIG).

Credit-default Swap: Credit-default Swap (or CDS) is basically insurance on debt. Say that a bank buys a large amount of bonds from a company. As with any debt, there is a risk of the debtor fail to pay the money back. To protect against the company defaulting on its bond payments, the bank would buy CDS. In case of a default, the bank go to the insurer and cash in its CDS.

American International Group or AIG was the creator and the largest seller of CDS. It thought that CDS was an insurance product just like a homeowner’s policy, but obviously it was wrong. "Any one house burning down doesn’t increase the likelihood that lots of other houses will burn down," explained Adam Davidson of NPR, "That doesn’t apply to bond insurance." (Source)

In case of bonds, a default can create a domino effect: as investors lose confidence and sell, the price of bonds go down and the interest rates go up. Borrowers who can’t find capital to meet their obligations would start to default on their bonds and the cycle deepens. (Photo: Gone-Walkabout [Flickr])

To make sure that AIG would actually pony up and pay the CDS in case of a bond default, it had to post a collateral. This collateral depended on their credit ranking - as their credit was downgraded, it had to post more collateral. Because of its worthless mortgage-backed securities assets, AIG’s creditworthiness would be downgraded - which meant that it would need to post as much as $250 billion, which of course it didn’t have laying around, in collateral in a matter of weeks!

Why Bail Out AIG? Over the years, the CDS market has grown into a $70 trillion a year business. And since no one knew who has CDS from AIG, the failure of AIG would mean that a lot of companies are holding bonds that are significantly riskier than they first thought. Companies that had "hedged" their bets by buying CDS would find their books suddenly unbalanced, which means they have to sell off assets to cover their risks or they would become insolvent. This failure would propagate throughout the entire economy and create a "systemic failure." That, by the way, was what the government was trying to avoid by bailing out AIG. (Source)

The Credit Crunch: The basic essence of the credit crunch is this: banks won’t lend because they can’t be sure that they’ll be paid back. Companies with excellent credit ratings found themselves unable to get a loan (after all, all those ABSs and CDOs had excellent ratings, so who’s to say that the ratings are worth anything?). Even some banks find themselves unable to borrow money from other banks!

The Solution? As you well know by now, the White House requested, and the Congress passed a $700 billion bailout program. The idea is to for the government to buy distressed asset, especially mortgage-backed securities, from the nation’s banks, which would inspire banks to lend again. The bailout remains unpopular with the general public, who perceive it as bailing out Wall Street, who caused this mess in the first place.

Whether the bailout will work or not remains to be seen.

Sunday, December 21, 2008

typos

Sorry guys for the typos in my earlier post. It 2am and I have to wake up in 4 hours for work. Will try and prevent the typos from next post
Cheers and thank you
Kunal

The reincarnation

Dear all,
Its been a long time since I wrote about finance, that many of you may have actually forgotten about me.
Two major events have taken place since I last wrote, I moved in to another country and secondly the world has entered the worst depression since 1929.

In these grave times, as we are led to believe, I should not be loquacious and talk about myself, but comment on something I am really passionate about. I intend to make the common investor aware of the happenings in the financial world through a series a write-ups and how to deal with the recession.

The eternal question which everyone keeps asking is that is investing in the stocks equivalent to gambling. The answer is a yes and no. For the uninitiated, the answer is yes. It is also true that around 80% of the people loose money in the markets. So then why should one invest? Why dont we just put all our money in the banks and accept their measely returns under the pretext of security. Other options which people consider especially in Australia is to invest in property and buying houses or like most indians, buy Gold.

It has been a proven fact from the past that Gold is a favorite commodity to buy when the stocks are going down and recession loops large. But then, has anyone wondered that Indians buy gold under all circumstances and never sell? Its an investment which is passed on from generations to generations. If you compare a 20 year chart of stocks v/s gold, I think stocks would win.

Investing in real estate has been another favorite amongst the rich and the famous. The common man thought that it was the best way to make money. The banks and investment houses also helped to spread the myth. The outcome of this relentless onslaught of greed and poor information was the real estate prices kept zooming upwards leading to a big bubble. The only difference between the rich and the common man is that rich actually have the money and the common man is funded by the bank and he has to pay a chuck of his salary as interest.
I have seen people boast about the number of houses that they own. The forget to mention the debt component in their lives.

The outcome of this greed has been the dramatic burst of the real estate bubble. It has created a massive dent in our financial structure and has led to loss of millions of jobs and money worth nearly 1 trillion dollars and counting.

The effect of this bubble has been devastating on the stocks. Benchmark indexes have fallen over 50% and are trading at 4-5 year low. People have lost lot of money and the day traders have become bankrupt.

The confidence of the long term investor has been battered and bruised. So in the midst of this self created crisis, should the smart investor quit?

For the smart investor, this could not have been a better time to buy into the stocks. So many good companies are trading at P/E of 5-6. Do you think that the stock market will go to 0?
Markets are ruled by greed and fear. The smart investor needs to sense both these emotions and act to the contrary. We are in the midst of a massive fear factor and there could not be a better time to buy into the markets for the long term

For example, last week, Satyam Consultancy Services, one of the finest IT companies in India have a cash balance of around 1.2 billion dollars decided to use that money to diversify into infrastructure by buying into the company owned by the promoters. It was an eg of bad corporate governance and was rightly punised by the markets. 50% of the market value of Satyam was wiped off in a day. The promoters under huge pressure from the investors, called of the deal immediately. The stock was still down. Its market cap was 2 billion dollars. The company has 1.2 billion dollars in hand. It earns around 300-400 million dollars per year profits.

You dont have to be a rocket scientist to estimate that the company is worth buying into. There are issues about corporate governance for sure and i am sure the image of the company has been shattered. But then, these very chimps who are crying about corporate governance are responsible for the bubble which has burst.

If we come out of the recession soon, these very chimps will be crying out loud to buy the stock. Only then, it would have been much more expensive then it is now. This is a classical example of fear running deep into the markets.

So thats what has been happening currently in the financial world- Fear. In the next few write ups, I will try and explain in lucid language as to what exactly led to the bubble creation. Also depending on availibity of time, I would give some stock recomendations

Happy investing!
Kunal