I had written this article a few weeks back, things have changed somewhat since then but i have updated the same and am publishing my views on the issue. I had decided not to publish given the strong response to the revamped TARP and TALF, however given the fact that TALF has been a big failure in the first two months i decided to post it anyways.
All of us have followed with great interest and mostly dismay the happenings in the American, UK, Spain, etc economies over the last few months. The financial crisis whose origins as most commentators today believe lies in the Ronald Regan time policies of the US which promoted free markets, criticized the governments role in the economy and encouraged low levels of regulation have now come a full circle where greater government role, nationalization, Keynesian government stimulus’s are becoming the buzz word.
If we go back slightly in time the crisis started coming to light sometime in the middle of 2007 as housing prices started falling in the US and some European countries. This led to a wide swathe of financial derivative instruments based on US and European mortgages losing value and as risk aversion grew cost of capital increased and availability of capital reduced. A large number of people today ask me why is that all US Financial companies are facing problems and the simple answer to that is that everyone was doing the same thing by under pricing risk and booking paper profits as actual profits in their books. Short term quarterly results based evaluation cycles and greed were clearly behind this phenomenon.
A number of people also ask me how come the value of all the derivative instruments are as large as USD 62 trillion when the total global GDP is lesser than this. In order to explain the prevalence of these kinds of derivative instruments I will try to take a simplistic example. Let’s say that there is the stock price of reliance industries which is the largest component of the NIFTY index. The upward and downward movement of Reliance industries stock does not only impact itself but it also impacts the movement of the derivatives directly linked to Reliance like futures, put and call options etc. It also affects the movement of various indices in which Reliance is present like the NIFTY, Sensex, NIFTY futures, Put and call options related to NIFTY etc. Thus any movement in the underlying (which in this case is Reliance Industries) impacts the valuation of a large number of financial instruments where the value of those could be a multiple of tens of times the actual value and trading of Reliance Industries. Thus the pricing of the underlying asset can have a multiple impact of 50-100 x or even more on all the derivative instruments linked to that asset. Subsequently these instruments progressed to all kind of other loans like credit card out standings and all kind of other loan origination’s.
If we go back slightly in time the crisis started coming to light sometime in the middle of 2007 as housing prices started falling in the US and some European countries. This led to a wide swathe of financial derivative instruments based on US and European mortgages losing value and as risk aversion grew cost of capital increased and availability of capital reduced. A large number of people today ask me why is that all US Financial companies are facing problems and the simple answer to that is that everyone was doing the same thing by under pricing risk and booking paper profits as actual profits in their books. Short term quarterly results based evaluation cycles and greed were clearly behind this phenomenon.
A number of people also ask me how come the value of all the derivative instruments are as large as USD 62 trillion when the total global GDP is lesser than this. In order to explain the prevalence of these kinds of derivative instruments I will try to take a simplistic example. Let’s say that there is the stock price of reliance industries which is the largest component of the NIFTY index. The upward and downward movement of Reliance industries stock does not only impact itself but it also impacts the movement of the derivatives directly linked to Reliance like futures, put and call options etc. It also affects the movement of various indices in which Reliance is present like the NIFTY, Sensex, NIFTY futures, Put and call options related to NIFTY etc. Thus any movement in the underlying (which in this case is Reliance Industries) impacts the valuation of a large number of financial instruments where the value of those could be a multiple of tens of times the actual value and trading of Reliance Industries. Thus the pricing of the underlying asset can have a multiple impact of 50-100 x or even more on all the derivative instruments linked to that asset. Subsequently these instruments progressed to all kind of other loans like credit card out standings and all kind of other loan origination’s.
(Experts please pardon my simplistic explanation of the complex issue)
Similarly US residential mortgages had huge amounts of derivative instruments build around them and the game was that over a period of several years’ residential real estate prices only went up in not only the US but also most countries in Europe. This led to an excessive amount of leverage being build up around these mortgages where amounts were lend to unworthy borrowers, the profits due to increase in prices of real estate were used to further finance new real estate or consume paper profits. Today we have a reverse of that phenomenon where the value of these papers have come down substantially and are falling everyday mainly due to the fact that there are no buyers for these. This has led to the Financial institutions having to mark down the value of their instruments to as low as 10-20% of their original values. This has led to booking of huge amounts of losses due to the value of these papers falling rather than there being actual defaults. Actual foreclosures and defaults have picked up only over the last few months.
However the purpose of my article is not to repeat things that have been written N number of times, but to focus on the solutions. Hank Paulson the former Treasury Secretary in the Bush administration had suggested a solution six to eight months ago which was termed as TARP (Troubled Asset Repurchase Programme). The focus of this programme was to buyout illiquid papers from bank and other financial institution balance sheets as these had become so illiquid that proper pricing for these in a free market was just not possible. In my view this was a very good plan which got criticized so much that there was a rethink on the same. Most Financial institutions stopped selling their toxic assets in the markets expecting that the US government will buyout the same from them. However Mr. Gordon Brown, the UK Prime Minister came out with a fresh proposal which promoted direct injection of capital into banks in order to improve their capital adequacy and increase bank lending to improve economic growth. This was widely acclaimed and Mr. Brown became a big economist overnight who had come out with the solution to the problem. This was also adopted by the US which pumped in USD 350 billion into various US financial institutions. However given the magnitude of the derivative financial instruments on bank balance sheets and the fact that the value of these far exceeded whatever capital could be injected into banks, the value of these assets kept on falling resulting in more write-offs. Eventually whatever capital was being injected was simply getting written off as banks kept on writing off the value of various kinds of assets on their balance sheets and kept on selling them at a loss at values which were clearly not fundamental but deeply depressed values mainly due to the fact that there is no buyer for these instruments. (This is somewhat akin to mid cap stock prices today where prices of large number of scrips is depressed much below fundamental values due to a lack of liquidity).
Under the circumstances there should be a two step solution in my view that is workable. One the original proposal gets followed and the governments buy out Troubled Assets from Financial institutions. This will not only help those who are actually able to sell off these assets but also others as the value of the assets moves up due to their being an actual buyer for the same. Western Governments should buyout these assets at values that are higher than current stressed valuations. This will move up values across the curve and automatically eliminate mark to market losses. This will be the first levels of stability for these banks and financial institutions.
However the purpose of my article is not to repeat things that have been written N number of times, but to focus on the solutions. Hank Paulson the former Treasury Secretary in the Bush administration had suggested a solution six to eight months ago which was termed as TARP (Troubled Asset Repurchase Programme). The focus of this programme was to buyout illiquid papers from bank and other financial institution balance sheets as these had become so illiquid that proper pricing for these in a free market was just not possible. In my view this was a very good plan which got criticized so much that there was a rethink on the same. Most Financial institutions stopped selling their toxic assets in the markets expecting that the US government will buyout the same from them. However Mr. Gordon Brown, the UK Prime Minister came out with a fresh proposal which promoted direct injection of capital into banks in order to improve their capital adequacy and increase bank lending to improve economic growth. This was widely acclaimed and Mr. Brown became a big economist overnight who had come out with the solution to the problem. This was also adopted by the US which pumped in USD 350 billion into various US financial institutions. However given the magnitude of the derivative financial instruments on bank balance sheets and the fact that the value of these far exceeded whatever capital could be injected into banks, the value of these assets kept on falling resulting in more write-offs. Eventually whatever capital was being injected was simply getting written off as banks kept on writing off the value of various kinds of assets on their balance sheets and kept on selling them at a loss at values which were clearly not fundamental but deeply depressed values mainly due to the fact that there is no buyer for these instruments. (This is somewhat akin to mid cap stock prices today where prices of large number of scrips is depressed much below fundamental values due to a lack of liquidity).
Under the circumstances there should be a two step solution in my view that is workable. One the original proposal gets followed and the governments buy out Troubled Assets from Financial institutions. This will not only help those who are actually able to sell off these assets but also others as the value of the assets moves up due to their being an actual buyer for the same. Western Governments should buyout these assets at values that are higher than current stressed valuations. This will move up values across the curve and automatically eliminate mark to market losses. This will be the first levels of stability for these banks and financial institutions.
The current proposal which has been put up a few days back which encourages private sector to participate to the extent of 90% and with loans from the US Government and US Fed with all kind of downside protections being built in for the private sector will most likely lead to the formation of another kind of bubble as tax payers will take a greater risk and private investors will make greater return. There will be conflicts between the institutions which hold these loans and securities and those who seek to buy them. Instead the government should step in, buy some of these loans and securities and be a buyer of last resort at a reasonable price that is higher than the current mark to market prices on a broad basis. Since fundamentals seem to be bottoming out across economies this sort of procedure which does not a trillion dollars is much better as it will set up a valuation floor with lesser amount of money and subsequently as markets improve the rest of the toxic securities will get absorbed in the market through market clearing rather than government intervention.
The second step should be that instead of putting money into a large number of banks and institutions like AIG in the form of equity capital which is finally paper and as we have seen can fall to any kind of value in the market. (Citigroup from USD 50 TO USD 1 in less than two years) governments should directly start buying various kinds of real estate which includes residential and commercial directly. This will stabilize the underlying markets and stop the free fall in prices. As prices here stabilize and start moving up the value of derivative instruments linked to these will start moving up automaticall
y and given the leverage involved in these instruments the actual impact of the same will be magnified in a similar manner as losses have got magnified in the fall. A deployment of USD 200-300 billion will be enough to stabilize these markets.
The second step should be that instead of putting money into a large number of banks and institutions like AIG in the form of equity capital which is finally paper and as we have seen can fall to any kind of value in the market. (Citigroup from USD 50 TO USD 1 in less than two years) governments should directly start buying various kinds of real estate which includes residential and commercial directly. This will stabilize the underlying markets and stop the free fall in prices. As prices here stabilize and start moving up the value of derivative instruments linked to these will start moving up automaticall
y and given the leverage involved in these instruments the actual impact of the same will be magnified in a similar manner as losses have got magnified in the fall. A deployment of USD 200-300 billion will be enough to stabilize these markets.
This two step process in my view will be much better than the current proposals which will involve huge amount of monetization ,which will ultimately lead to runaway inflation.