Be a bank to be bailed out

One of my team members asked an intriguing question last week – why is the federal government bailout been given only to those Banks and Investment Banks, but not for automobiles sector? Sounds logical; if we look internally, both Banks and Auto companies are asking for bailout plans, not to offer new products or new system; they just want to pay off the debts and payments. GM alone needs $10 billion to pay for its bills and another $6 billion to run its plant.

Let’s have a countering view for Banks and Autos.

The banks have collapsed just because of the greedy Investment bankers, who engineered and re engineered the whole Sub Prime papers and are now highly paid in the system.

The Automobile makers did not do any bad investment, but was just hit by the lowered demand which can even be attributed to those Investment bankers, who literally drained up the money.

The Big Three automobile manufacturers (General Motors, Ford and Chrysler) directly employ about 240,000 people. But each car makers has their own suppliers and small component suppliers who supply parts only to these companies. (Recently you would have heard the news of suppliers also moved out of Singur, once TATAs pulled out.) A recent survey shows around 4000 medium or Tier 1 supplier units employ around 974,000 people.

Let’s have a quick economics here.

Total automobile & related activity workers – 1.2 million

Now to take care the needs of any individual the society needs Doctors, lawyers, Groceries, Shopping, Entertainment, hotels, tourism, FMCG, clothing companies and everything.

So, as a whole, indirectly another million people will be dependent on these 1.2 million workers.

Add to them their family members. As an average let us take there is at least one dependant on every employed person. (If it is India, it would be a huge multiple factorJ ), so we get another 2.4 million.

So if GM/Chrysler/Ford file for bankruptcy, around 5 million people will be left with no source of income.

But the same time, the Investment bankers are very less in number (might be, that’s what they make it their USP). Their bank going bankrupt and they getting their jobs axed will not affect a large group of people, and even schools have taught us that Thou sinners shall be punished. J

 

But on the other side, if banks collapse, the impact will be very high in all parts of the economy.

1)     First, the depositors/Investors will lose money.

2)     There will not be any source of lending for any company /Industry to run. It means all industries to get locked down and follow bankruptcy route along with banks.

Think of a situation, you need a lac of rupee for an urgent requirement, but there is no lender. Your stomach feels cramping? That is what will happen if banks are not saved from bankruptcy, in any economy and particularly in US where there is negligible household savings.

Yes, when, these automobile companies are filing for bankruptcy, there will be a huge blow on the salaried middle class sector, which forms huge proportions of the society, also the retirees of the auto companies. Their retirement benefits would go in for a toss from the contribution to be made by the companies (but would be covered by Pension Benefit Guarantee Corp).

Even if the government bails out the auto majors, they will still be forced to do the restructuring. Cutting down costs, shutting down few plants and lots of job losses. Also the bailout comes from none other than taxpayer’s money, which will be splashed at the cost of their prosperity. That’s why the government is still hesitant to bailout Auto mobile companies because spending Tax payers money for a bank will yield more productivity in terms of Money supply, industrial activity and in turn consumer spending. But putting taxpayer’s money into auto companies will not increase the demand of the cars nor will it boost the consumer spending and economic turnaround. It might save the jobs for another three or four months for the companies to restructure their plans and plants, but again for the automobile companies to flourish, there need to be a demand created in the market, which could only be driven by banks.

It is just like what Edward Lorentz[1] had perceived, the near bankruptcy levels of GM or Chrysler might have been caused by the guy who lived in the 3^rd street of a  remote area in San Antonio, and featured in the list of defaulters by WaMu bank[2].

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[1] Edward Lorentz- Father of Chaos Theory and Butterfly Effect.

[2] WaMu- Washington Mutual- A Leading Mortgage lender, and off late bailed out by JP Morgan Chase.

What holds true now? Classical economics or Keynesian economics

In the recent past there is high chances we all would have come across few words like classical economics and Keynesian economics.. Economics by itself can drive us away from classrooms and give a hallucinating effect, and added to that these terms are sure hangovers. Just tried to give a simpler version with a relevant example.

 Economics- A ‘dismal’ social science that studies how individuals, governments, firms and nations make choices on allocating scarce resources to satisfy their unlimited wants is called economics.

The two major theories of economics are,

Classical Economics &

Keynesian Economics.

Classical economists believe that markets function very well, will quickly react to any changes in equilibrium and that a “laissez faire” government policy works best. Keynesian economists believe that markets react very slowly to changes in equilibrium (especial to changes in prices) and that active government intervention is sometimes the best method to get the economy back into equilibrium.

Take the Asian Financial crisis (should aptly be called as Currency crisis); what IMF declared and practiced in 1997 was a perfect example of Classical economic theory. IMF support was conditional on a series of drastic economic reforms influenced by neoliberal economic principles called a “structural adjustment package” (SAP). It instructed the governments and central banks of those economies, to cut back on government spending to reduce deficits, allow insolvent banks and financial institutions to fail, and aggressively raise interest rates. IMF thought, these measures along with the bailout package will help to restore the confidence in the country’s solvency as this will pave way for a more free market with lesser government intervention and will reflect the way the markets and financial institutions were managed in US and UK. Sounds rubbish in present conditions?? J  The same western free market theories which seemed to be so powerful and transparent in 1997, were the first culprit in the recent financial crisis and all the advocates of free market theories and classical “Laissez faire” were now desperately crying for the governments to bailout the markets. The pity is even IMF, which engineered the solution for Asian crisis with free market practices, was asking European Union to intervene and bailout not only markets but a nation called Iceland.

For some it may sound like classical economy speaks for a more capitalistic approach and the Keynesian economy proxies for a more Socialist economic environment. Both versions of economies are debatable since both has their pros and cons. In a perfect Socialist economy, there will be no room for free market and it will have the government intervene in day to day activities of the businesses, banks and it will mandate how everything should run in the state. This may give rise to bottlenecks in trade and economy since, the decision making lies in the hands of few, who might as well be insane politicians. They can support their ideas with the fact that government is run by people and the benefits of the business should be for the people and any mishaps in business should not affect the public. True, but there will be few good things which can be passed on to the masses and chances of missed opportunities in trade and commerce will be higher than conceived. Remember the situation which prevailed in India during Indira Gandhi’s rule, Banks were nationalized, Transportation were taken by government companies, License raj in each and every aspect of business. This might as well lead to Crony capitalism, in which Ambani’s could only be benefited.

On the other hand, the free market will make way for every Tom and Harry to run the business in their own ways and can take profits home. Sounds logical? They use their brain/ideas/efforts, and make profits. What’s wrong in that?, everything is fine, but the resources they use were from Public and the worst thing is that the products they produce will have a direct impact in the lives of millions and for every move of the business, people gets affected directly. Take the examples of Pharma and Banking industries and their implications our lives. The extreme effects of free market are yet to come and the recent Subprime crisis, where every other bank played with the home loans of millions is just the tip of the iceberg.

So what would be an ideal situation for any economy/government? It should be a directive approach, wherein the government should have the directive authority and have control over the essential commodities and industries and everything from price till market should be in the hands of government, and to have an efficient administration the governments can form a body comprising economists, Sociologists, NGO activists, policy makers and business men.

 

Sub Prime Crisis- Part 4

 

 

 

 

 

 

Now, fit all these incidents in one line,

 

 

 

 

House owner (Borrower) ——– Bank/Mortgage lender (e.g.; Fannie/Freddie) ———–sells loans———Investment Bank (e.g.: Lehman Bros) ——— Securitization——– Reengineered products——- MBS———Insurer (e.g.: AIG / other I banks) —————Credit Default Swaps————Investors (again Banks/HNI’s/Institutions)

 

So, as the real estate prices are dropping down and, when the home owner and his fellas stops paying their loan dues, the loans which they took are now worthless in the hands of the bank, and indirectly, the securitized MBS/ABS issued by I banks and the bonds issued by them from the pool of already junk bonds will be meaningless or in financial parlance, loses ground and depreciates in value overnight. Now, as we already saw, the leverage that the I Banks have taken, will bankrupt them once the bonds declines in value. Now the banks and HNI’s and other Institutions which has subscribed to the bonds issued by I Banks will approach the Insurer. The insurer also will not have enough assets to cover all the losses, since the CDS issued by him is also equally worthless. Now it’s their turn to file for chapter 11 or 7.

Bailout Plans:

·         As the US government has got the $700 billion bailout bill passed in the senate, the bill lets the government spend billions of dollars to buy bad mortgage-related securities and other devalued assets held by troubled financial institutions.

·         The institutions which got bailed out will get money for the bonds (MBS/ABS of Sub Prime Securities) of zero value which they hold now. So, from the money which they collected from Government, they can revive their business and can have a better liquidity.

·         The bailout plan passes the money to the Financial Institutions in trenches only.

·         The Bailout does not mean that the tax payer’s money is given free. The Federal Government will receive convertible warrants, which they can convert it to shares if the company is doing well or it can get the coupon back in the stipulated period of time.

·         Also the Bailout packages announced for AIG, will hand over the Controlling state with the government.

Alas, we forgot about the banks who has subscribed to the entire senior, mezzanine or any other superlatively nomenclature bonds. Now the only option or cushion left with them is to merge with the biggies at a throwaway price or can run behind the Fed’s secretaries and Congressmen to Bail them out and if they are lucky enough to have their ex-boss as the chairman of Treasury, They can survive. Back home in India, you can compare the miniscule losses of 0.1% in comparison with your total book size, in a press meet and assure the investors along with SEBI Chairman, just putting back the real value of that 0.1%  loss is equal to that of nearly 460 Crores of Public Money.

 

                                                           

-Desire is the root cause of all evil – Gautama Buddha, Founder, and Preacher-Buddhism.

 

Credit Default Swaps and the mess….

Credit default swaps are insurance-like contracts that promise to cover losses on certain securities in the event of a default. The buyer of the credit default insurance pays premiums over a period of time, knowing that losses will be covered if a default happens. It’s supposed to work similarly to someone taking out home insurance to protect against losses from fire and theft.

 So, when everything goes smooth, and every party stands to the true sense of integrity, credit default swaps are a wonderful product of financial re engineering.

What has happened now is that, the Investment Bankers, who has innovatively given birth to a  demon.a.k.a Sub Prime  MBS, (Mortgage Backed Securities), also created the Credit Default Swaps. I.e. they also act as Insurers  and as Insured. Confused, yeah. Its typically as ridiculous as karunanidhi is the editor for Murasoli and Namadhu MGR.

So, effectively for an Asset, which do not have any value, the I Banks securitized them, sold to those greedy lots  called Banks and HNI’s and they insured their own Securities. Indian Poiliticians are much better. They have got Arcot Veerasami’s  to beat the drum for their Kids.

 

So, for example, I Bank A has issued MBS, gets insured with insurer B. Now the Insurer B should have enough Assets to cover if there is any loss due to A.

Now the I Bank A also starts selling its MBS,  and the Insurance Guy B will also be trading the swaps( which has the insurance backup for A). what goes worse is when, the IBank A, withholds the third rated securities with themselves, and Insurer B, with the same amount of Asset, insures another Company or another instrument of B. Now, our sweet borrower, says he cannot payback, and I bank A’s Securities are worthless. Meanwhile, B would also be bankrupt, since he don’t have the assets to backup all the losses from A. ( there are high chances that B might be another I Banker….), they both can file for Chapter 11/7 or even Federal Govt can Bail them out, but the investors…???????( Damn that fellow, shouts a former I banker….. he says he had asked the investor to read the Offer documents and warned him of the risks in Securities Market…..)… what say….