Financial Recovery

So Treasury Secretary Timothy Geithner pitched his vision of ridding banks of their troubled assets on Monday (3-23-09).

In essence the Treasury will front some money, the FDIC will guarantee a whole lot more and the private sector partner will also provide a few percent of the total cost. This money will be used to bid for assets being shed by banks. If the trinity make successful bets, they will make a profit off their investments. Alternatively they will make a loss if their bets prove wrong. And since the federal government has fronted most of the cost, it will bear significant risk as well.

The problem assets are truly mind boggling especially for this feeble mind. You start off with homes Joe Schmoe's like us own which are packaged and re-packaged with a bunch of other homes and real estate investments into instuments that are sold and resold across the world. If this isn't a direct participation by Joe Schmoe in the global economy, nothing else is. So when a homeowner pays his mortgage, it trickles up into  the return on investment for a derivative.  It is no longer a bank holding a humble mortgage and using simple spreadsheets to track returns on a real asset.

But that apart, the whole notion of auctioning a banks bad assets leads to a few challenges. 

Firstly many banks are living in a state of denial not unlike us small shareholders who grimly hang on to some of our stocks that have declined precipitiously, hoping for an upswing. For banks, it is more than hope. By continuing to value assets at a higher price than they may fetch in the current market, they can show - on paper atleast - that they meet capital requirements.  So if they sell these assets via auction at reduced prices, they may need to shore up their capital using funds they may or may not have. This is another reason banks are fighting the mark to market rule because this rule forces institutions to value assets at current prices and not at the price of the transaction (buy or sell). By keeping inflated assets in their balance sheets banks can appear healthier than they are.

Secondly of course there has to be a market for the auction. The packaged derivatives may have prevented the Feds from attacking the problem from the bottom that is the individual homes. So they have approached the problem from the top in an all encompassing sweep including all asset classes including derivatives. But an opaque derivative means, the people bidding on the auctions are bidding blind using mathematical models. Remember these models were also used infamously to hike up the prices of the derivatives.

Thirdly, I am betting that the financial community will be happy about participating in the auctions. The financial institutions holding these assets may be more circumspect becauce it may lead to deterioration to their balance sheets, but the companies bidding on the assets are essentially betting on huge returns for an investment of only 6 cents to a dollar. Obviously the higher the bidding goes, the happier the banks will be. And we all know how Wall Street loves speculation.

Examined all together, we are talking of

1. Still a fundamental lack of knowledge of the assets being purchased
2. A potential for cleaning out balance sheets but conversely a hit to these.
3. Mathematical modeling
4. Large bets being placed  with little of one's own money.

Aren't at least three of these four factors what got us into this mess in the first place? Also, the government is hoping that once the assets are auctioned off, the successful bidder will keep these long term to enable stabilization of the assets, gradually expiring the derivatives and mortgages as people buy the assets and pay them off. However if the successful bidder resells the assets, they may further decline in value. Also, if the underlying asset fails to get new owners, they may deteriorate - e.g. a vacant home getting mold or getting vandalized. This would then further lower their value.

The feeble mind hopes that this strategy pays off. It wishes the government and participants all the luck. Otherwise the coming years will be very interesting and will make 2008 seem like a walk in the park.

The Law of the Jungle

David Roche in an article in the Wall Street Journal (1-22-09) says this:

It's natural for policy makers to say, "We know where the problem at the heart of the credit crisis is: it is a lack of lending and we must get credit flowing." If only it were that simple. What policy makers on both sides of the Atlantic desire is to sustain household leverage and consumption at any price, when the only exit from the credit crisis involves a return to thrift by the over leveraged. That cannot be achieved painlessly.


This paragraph succinctly captures the heart of the credit crisis and its aftermath for this feeble mind. Essentially governments want their citizens to splurge again and continue to rack up debt. They are operating under the mistaken belief that this is the only way to keep their economies healthy. They appear not to have learnt that poorly regulated and over abundant credit led to the problem in the first place, and, as the article points out - thrift - and a return to sanity in terms of personal consumption is the only way out.

The governments are caught in a vice. Through a series of developments spanning multiple decades, the share of manufacturing in the GDP has declined and services especially financial services have gained share.

At its very core, even the most sophisticated economy today is not very dissimilar to a primitive system of bartering. There exists a symbiotic relationship between the extractors (e.g. miners) to the producers (i.e. factories) to the consumers (i.e. us) to the providers (i.e. banks, retail etc.).
There is a give and take between these sectors and there is an intermingling of roles. In a global economy, these roles are not all represented equally in all economies as some (U.S.) consume more and take a hyper consumer/provider role, while some (China) take on the producer role. Granted this is an oversimplification, but this is all this feeble mind can grasp and it provides a framework for the money flow in societies.

A miner may sell his ore to a factory and buy a car from a dealer after taking a loan from a bank. When the extractor/producer sector is in decline in an economy, the provide/consumer sector races in to fill the void. However in the absence of the former, the latter turns to cannibalizing itself trying to create prosperity without offering any tangible goods or service but merely by manipulating its instruments - be they stocks or real estate or derivatives. This results in a bubble that inevitably bursts.

When we disturb the equilibrium by focusing one sector - finance - at the cost of another, a period of turmoil inevitably follows. This is not dissimilar to the law of the jungle. There exists an equilibrium between the predator and the hunted. However if due to some reason, the predators get an advantage that makes them multiply, they will exhaust the forest of its food and will be forced to dwindle to a more sustainable level.

As stated in the article, consumers have splurged. The predators have hunted and decimated the forest. To nurse the forest back to health, you do not send in helicopters to drop food to the predators to sustain their numbers, but you let the chips fall as they will so that the predators slowly dwindle and other animals make a comeback.

However as a developed and humane society, we help the citizens affected so that the recovery as it happens does not end up making them destitute and they emerge stronger in the future.

And the recovery has to bring about some sanity in sectors. If post recovery, the financial sector continues to dominate other sectors, the relief will only prove to be temporary and the precursor to a longer famine.

How the global economy recovers is anyone's guess. A painful scenario would be that a combination of lowered standard of living, fuel prices and credit tightening would result in manufacturing making a comeback. Another, more plausible scenario would be the recently talked about separation of toxic assets that would free up the good economy to return to business as usual. However, the toxic assets will cast a shadow and its effects may touch us all in terms of taxes and currency fluctuations. It would be a successful resolution however, if the private sector is allowed to thrive again without too much government intrusion because in the ultimate analysis, they are the only sector that has shown that it can consistently build wealth.

2009

So what will 2009 hold for us? In these early days we have

1. Fed interest rates at close to zero.
2. Fighting in Gaza/Israel.
3. Somalian pirates still holding a tanker and a few ships.
4. The DJIA around 8600, the S&P around 900 and the Nasdaq around 1600.
5. Scandals that are still brewing from Madoff to the Illinois senate seat controversy.
6. Gas at around $1.60.
7. Anticipation on Obama's inauguration.
8. Money, job and home value worries.
9. Uncertainty about the economy - will it get worse or will it get better?
10. Ongoing conflicts in Iraq and Afghanistan.

A lot depends on whether a person is an optimist or a pessimist.
And a person's optimism or pessimism really depends on whether he has an income coming in and if he/she can make ends meet.

This feeble mind this that, that is the key to success in 2009. It includes

• Live within your means.
• Pay off all your debts including mortgage.
• Save a year's worth of living expenses. This should include estimated Cobra payments, home, car, flood, umbrella insurance, car and mortgage payments, school/activity fees for children, any estimated co-payments, food and clothing allowances and up to $10K as an emergency reserve on top of the other estimates. This is a tough goal and may not be achieved in one year but we need to get realistic on what a year's living expense really means.
• Hold on to you job in any way possible.
• Don't cave in to impulses small ( a new cellphone) or large ( a car or a pool).
• Stop looking at ads. You are not helping the economy by spending, you are only hurting yourself. The economy will find ways to adapt.

I guess the above proves that I have a pessimistic view, and to be honest I suppose I do. I am not overly so but just like companies tighten their fiscal policies and curtail spending in tough times, so should you.

I am however hoping that the year turns for the better

• That the economy stabilizes after the job losses and contraction.
• The middle class get some safety net that prevents them from going destitute after a illness or job loss.
• The government goes after hedge funds and regulates them better rather than imposing more burden on a regular business a-la Sarbanes-Oxley.
• The big 3 automakers produce vehicles that people buy for their mechanical merits rather than for patriotic reasons.
• We get some closure of a successful nature in our overseas military undertakings.
• We end the year with cautious optimism.

So...happy new year!

Shopping Withdrawal

Faced with a faltering economy, the Feeblemind is trying to cut back on shopping as well. It is proving to be more difficult than thought.

A tradition is to look at the ads that are inserted into most weekend editions of newspapers. Typically in the Feeble house the conversation goes like this. The Feeble wife chimes up: "Wow, Macy's is really offering a discount on the 100 piece dinner set". Feeble would look wistfully at the chipped coffee mug he is drinking from and agree - how much nicer it would be to have a coordinated set for day to day living rather than to have a mishmash of remnants from the survivors of prior dinner sets.

But then the feeble mind gets a kick. Wait, didn't we plan not to buy a single thing this month other than the essentials. So we plan on sometime in the future when we will dump all our old crockery and replace them with a shining coordinated set. It makes sense to wait after all given that our kids have slippery fingers.

Then it is Feeble's turn. There are a couple of electronic retailers whose weekly offerings Feeble studiously pursues. The six year old computer is so slow and well overdue for an upgrade. But given that Feeble and his wife have a company issued laptop, should one splurge on a newer model just so that junior can access Nick Jr. faster?

The digital camera went on the blink and Feeble's eyes lit up. This would be a justified purchase. Since the old camera was toast anyway, Feeble decided to open it up to see how it looked inside. After opening the camera, he pressed the on button and lo and behold the camera started functioning again. Dejectedly, Feeble put the camera back together again.

The point is that we have become such a shopping driven culture. I can't help but notice that some houses in our neighborhood just don't get guests. It could be that they are transplants from far away places or just that they don't know anybody to call over for a drink or a meal. These homeowners are not reclusive. They are people who smile and have a conversation if you meet them walking the dog. But there is a distance they keep that prevents one from becoming friendlier. We find it happening a little for us too. In the weekend after the kids activities are done, Feeble or his wife sometimes wander off just to browse in a store or mall. More often than not this pleasurable interlude results in a purchase or two and a mild high.

Now that we are trying to curtail these ad-hoc shopping trips, we are realizing that the shopping high can result in withdrawals - especially when one tries to curtail it cold turkey.

Food for the people!

A great essay in the New Yorker addresses the recent spike in food grains and the impact a prolonged price increase would have had for the poorer people of the world.

It is a great concise essay, the type this feeble mind is more apt to follow....but to summarize it even further, its main points are

• The growth of global crop yields has slowed dramatically since the 1990s.
• Under the pressure of the IMF and the World Bank the various national Agricultural Control Boards (ACB) were done away with in the interest of free markets
• The demise of the ACBs lead to the decrease in the stockpiling of food grains by various countries making them susceptible to food shortages since they then depended on exports and did not have any internal reserves.
• The free market did not necessarily lead to increased production and when it did, it was more for cash crops rather than staples.
• Very few 3 - 5 countries supply most of the food exports and any shortages in any of these countries can dramatically drive up prices (note the recent draught in Australia)
• Reliability is key to food supply rather than efficiency and in a business as complex as agriculture, maybe redundancy and over production is a good thing.

Some of the other concerns this feeble mind may add include the dramatically growing population which when coupled with lowered yields could precipitate a food crisis.

This Thanksgiving though, lets us all appreciate the bounty we have on our tables and be grateful for it.

And look for long term investments in the agricultural sector ;-)

Random Thoughts

I was reading about Iceland in the European papers. This country has 300,000 people and some time ago it decided to de-regulate its banking industry. Banks in Iceland started offering great interest rates to European investors who deposited huge sums of cash. Now, the banks are in trouble and many European governments fearful of investor backlash have resorted to freezing the assets of the Iceland banks in their countries and guaranteeing the deposits - in a foreign country no less! Interesting times we live in.

I have a fascination with small successful countries. Iceland was not in my radar until now but I was always a fan of Israel and its people. But Iceland is inching up my popularity index. Not because it defrauded a bunch of Europeans - I have sympathy for the people who invested - but because as I learn about this country I seem to like it more. They seem to be a tough resourceful and resilient people who cheerfully survive months of near darkness.

So I searched the web for Icelandic newspapers and came across this article. I appreciate them even more.

Another country that evokes admiration is Sweden. My fascination stems partly because many of these countries have populations that are smaller than some of the world's major megapolises. But their innate decency, concern for their people's welfare, industriousness and entrepreneurship has contributed greatly to a prosperous society in their countries.

If only many of the other countries with a wealth or resources and talent could try and replicate their models.


Stock Market

Since this is a random post, on a different topic, the stock market is not doing too well these days. So the newspapers and news sites have taken to showing the faces of traders in the floor of the stock exchange. More often than not the faces paint a picture of hyper misery, dejection worthy of the most melodramatic of Mexican soap operas.

Though I am hurting as much from the crash of the market as the next person, I can't but smile every time I see one of these images. We get it. The news is bad. Thanks for the open jawed, eyes raised toward the ticker, hand on head image to really drive home the point. I really wanted to post some of my favorite images, but did not want to run into copyright issues.
At least I have something to laugh about in the current mess.

But I am still Bullish on America!

Big Numbers

Anybody following the financial crisis unfolding would be shell shocked by the huge numbers being thrown around. A $100billion here or a $700billion there or maybe a couple of trillion.

The feeble mind begs to understand where the government is going to come by with this money. From what it understands, the feeble mind knows that:
There is a budget deficit
There is a trade deficit

A budget deficit means that tax revenues are not enough to fund current government spending.

A trade deficit means that imports are way more than export. While a trade deficit might result in currency valuation issues, it is inherently a private figure - that is it is comprised of the import and export totals for private company activity. It is not public money.

So with a budget deficit, spending the trillion dollars means
borrowing some more - by selling more treasuries and other bonds
printing more money eventually paying back the money through that most steady stream of government revenues – taxes.

I suppose in the scheme of things, greater minds can wrap themselves around these huge numbers and the miracle of the American economy can resurge and pay itself out of debt. One hopes that the preceding statement is true.

To a certain extent, tracing the current crisis, one gets the feeling that many people managed to dig themselves out of the tech bubble by creating a real-estate bubble. And people thought that there might be another bubble around the corner to salvage a real-estate bust. Unfortunately no build up immediately followed real-estate to take over where it left off. But given the huge amounts of liquidity being pumped in, which is not to say that there is not another bubble in the making?

As the economy gets more financial services oriented, companies will try harder to make money without really offering a tangible product. The current crisis is just a manifestation of that. What boggles the mind however is the number of people asleep at the wheel.

Companies start issuing sub-standard debt instruments.

Companies get away with giving the highest ratings to these instruments.

Companies insure this debt, but they label this insurance as credit default swaps so that they
don't fall under the insurance industries regulatory purview. Ironically some of the largest insurance companies offer these swaps.

Companies actively trade in the sub-standard debt instruments and swap without really understanding the mathematical models that define them - sort of reminds me when I started trading stocks and literally chose them on a whim (not that I am doing much better now).

To fuel this destructive model, more money is made available to mortgage brokers who happily sell mortgages to Joe Schmoe public. Joe Schmoe public conveniently ignores any nagging worries on affordability. And Joe Schmoe's mortgage gets lumped into a sub-prime Collaterized Debt Obligation which gets gets a great "AAA" rating and gets "insured" with a credit default swap and gets sold to a mutual fund. Joe Schmoe buys the mutual fund since it has a spectacular return for some inexplicable reason which he does not bother to understand or reason out. So in a way Joe Schmoe finacially cannibalizes himself.

Everybody is happy until it all breaks apart. Joe Schmoe can’t pay his mortgage. The Credit Default Swap cannot pay the “insurance” because –since it was outside insurance regulations- it did not have the capital to “insure”. Banks go psycho and stop lending. And the economy which has become dependent on financial services comes to a standstill.

And the Government HAS to step in.

And we pay "no" new taxes through our nose while the creative types devise another plan for another ponzi scheme wrapped around an algorithm.