Tuesday, September 30, 2008

Scenario : Passive Investor

" This DOES NOT apply to me because I am already doing GREAT with my Investment ! "

Not quite ....

A Good investor knows that A Good Investment is one that can continously compound return for you, but carry the risk of losing big time overnight, if not everything.

So if you are a Good and Rational investor, you WILL set aside some of the current return and practise like a Young Work Force.

That way, no matter what happens to your current investment, be it losing everything.  Its ok, because you have the capital to restart the legend again.

Scenario : Small Business Entrepreneur

Similar but different than Young Work Force, Small Business Entrepreneur may not have Consistent Income.  Therefore, instead of putting aside a fix percentage of your income, you just put aside a Fix Amount

However, don't forget that when you are self employ, your main goal is to Turn Your Business into AutoPilot !!  Meaning you HAVE TO come up with a SYSTEM that can run your business on its own.  Else you will always be self employ, which is Really not much different than a Job in personal finance terms.

Self Employ : You work for your self, you set your own rules but you still depends on your buyers to survive.  The day you stop finding buyers is the day your income stops.

Business : A system is in place so even if you take a 3 months holiday, the business runs as usual.

Investment : You dump your money in and you get back a larger sum after a period of time.

Scenario : Young Work Force

Scenarios for Young Work Force

1.  Get a job, earn some money.  ( Do something you like most and do it with persistency can earn you most in long run )
2.  Setup Standing Instruction to transfer 10%-30% from your income account to another dedicated saving account.
3.  When the saving account reaches 50% or the same amount of your Income account, save the extra to a 1 month Fix Deposit
4.  When the 1 month Fix Deposit is as much as 2-3x your monthly income, start another 3 months FD.
5.  Like wise you start keeping 3 months and 1 year FD.  Its totally up to you how much to put in each FD.  If you don't have patient, you may even choose not to start a 3 months FD.  But you HAVE TO do Steps 1-4 as minimum.  Else my guarantee to you is considered void.

( you can jump from 4 to 6, but you cannot skip 4 and 6 )

6a  Start putting money into Mutual Fund or Unit Trust ( for now, they are the same )
6b  The way you invest is like step 2, except it is not by percentage but a fix amount.
6c   Start a mutual fund with RM1,000 and automatically put in RM 100 every month. ( from saving account or income account ).  Make sure the automated systems runs for the next 3-10 years.

7a  Understand that stock market is a 'representative' of country's economy
7b  Select businesses that you like, have worked with and/of have high hopes in.
7c  Analyse the figures and management of the company to decide which business you would like to own too
7d  Buy that company shares ( if in doubts, just start with Blue Chips )

Results : If you start at age 22 with a monthly salary of RM 2,200

by only doing step 2, you will have more than RM 200,000 by age 52
by doing step 3, you will have an extra of RM 100,000
by doing step 6, you will have another extra of RM 120,000

So you have about half a million CASH by the time you are about 50.

It may not be a Huge Figure but don't forget, this half a million is by doing Nothing but only setup the initial steps.  It may take only the first 3 years to setup everything.

Monday, September 29, 2008

The Unraveling of the Money Markets: The Flip Side of Efficiency

To the uncritical mind of finance professors who see the markets with the eye of a P.R. agent, the changes that have taken place in the past thirty years in the financial markets were a series of inspired events brought about by visionary bankers, insightful academics and bold traders. The result, naturally, was “sophisticated” and “efficient” markets which benefited all.

In reality, finance is a dialectical discipline. Its development follows the logic of internal evolution of finance capital which turns the phenomena to their opposites – commerce to speculation, hedging to arbitrage, equilibrium to volatility, just to name a few. The most benign phenomena then reveal a hidden side that is in contrast to their docility. Such is the case with the “efficient” markets.

By efficient markets, the academics mean a market where, thanks to arbitrage, the borrowing costs are low and capital is allocated in the optimum way. In practice, this means markets in which capital never stands idle. It is employed at all times, earning however small a return. In a time of crisis, this constant engagement turns into entanglement. To free the capital then, it is necessary to unwind; mere selling would not do. Search for “unwind financial markets” in Google for various instances of unwinding.

In money markets, two areas oil the efficiency engine. One is the tri-party repo market which I described in Credit Woes. The other is the even larger securities lending market – called “sec lending” by everyone in the industry – whose size is well above the tri-party’s $4 trillion daily transactions.

The sec lending market is driven by short selling, or shorting, which is selling something you do not have. Outside the financial markets, the practice amounts to fraud; if you sell a house, or a car, or a farm you do not have, you would probably go to jail. In the financial markets, the practice is legal and very common. With the ownership requirement eliminated, the buy-sell sequence could be reversed; instead of buying first and selling later, you could sell first and buy later. So if we think that, IBM, for example, might fall, we call our broker and short 1000 IBM shares. We hope to buy them back later when the price falls.

For every seller, there is a buyer. Someone must have bought the 1000 shares we just sold. But we did not posses the shares. How are we going to deliver the shares to the buyer? That brings us to sec lending.

Take a large investor – a mutual fund, for example – that owns tens of billions of dollars worth of securities. In the modern financial markets, there is no physical certificate. All securities, rather, are held in street name, for the fund, by a custodian bank.

In the efficient capital markets, with the constant struggle by funds to improve their performance by even 1/100th of a percent, these securities are a potential source of addition income to the funds which own them. So as part of an active arbitrage strategy, the custodian bank approaches the fund and makes the following pitch:

We are holding large securities positions for you that currently sit idle. Through our sec lending program, we could lend all or part of them to short sellers. You need not worry about risk. Among various precautions, we indemnify the lent securities, so that should you suffer any loss, we would make you whole.

As collateral for the lent securities – you will even have the option of telling us whom not to lend to – we would receive cash collateral from the borrower (short seller). We would invest the cash and share the proceeds in some equitable manner, say 80-20, where you get 80% and we get 20% .
After the securities owner (the fund) agrees, the custodian bank inform short sellers that it is open for business.

Assuming the same 1000 IBM shares is trading at $120 per share, the following then takes place:

1. The custodian bank “delivers” 1000 shares, worth $120,000, from the fund’s account to the short seller, or the borrower (of stock)

2. The borrower posts cash collateral to the bank equal to $122,400, which is 102% of the value of the borrowed stock.

(Upon termination of the short sale, the securities are returned to the fund. The bank returns short seller’s $122,400, plus accrued interest calculated at the Fed Funds rate.)

3. The bank invests $122,400. If the spread between what the bank earns for this investment and the Fed Funds rate is 10 basis points, the interest income would be $122.50, which is split in a pre-agreed manner between the bank and the fund.

This is the most critical step. Since the interest income is the difference between what the bank can earn and the Fed Funds rate, there is a strong incentive for the bank to invest aggressively. In the mean time, short sellers do not sit on their positions for long, so the investment has to be short term, which is the realm of money markets.

There are two ways to increase – to enhance, in the language of marketing brochures – the return on a money market fund: to go down the credit ladder, or to extend the term. The first option exposes the fund to the risk of loss due to a downgrade. The second, in addition to a credit downgrade, locks up money for a period ranging from one week to just under one year.

Imagine now that the borrower of shares is Lehman Brothers. The owner of the shares – a mutual fund, in our example – becomes concerned about the health of the firm and instructs the bank not to deal with Lehman. The lent shares must now be recalled and $122,400 with the accrued interest returned to Lehman. If the bank has locked the money in a money market fund that has an as-yet-in-the-future maturity, it has to liquidate the position. If the money market fund is aggressive and has invested in junk mortgage securities that have dropped in price, the hit to the principal is even more pronounced. The custodian bank must then make up the shortfall, an act that requires an immediate infusion of cash. It is in this way that short term markets come under pressure, which is why the Treasury immediately responded by guaranteeing the principal in money market funds; large custodian banks with trillions of dollars in custodial accounts, not to mention many “boutique” firms, are actively engaged in sec lending. The efficiency of markets brought about by the sec lending business is one of the primary sources of disorder in money markets that is reflected in unprecedented Fed Funds/Libor/OIS spreads.

That is also why the stock price of custodian banks took a beating on September 18, a process that continues to date. Check State Street, for example, whose violent price swings on that day showed that traders were aware of the role of the “custody banks” and the vulnerability that follows from their business model.

All in all, the individual stock price changes, like today’s 700 plus point drop in the Dow Jones, are mere consequences. That index could rebound tomorrow – or the day after. The unraveling of the money markets, on the other hand, is here to stay – well beyond tomorrow and the day after.

Banks ...

The principle is .... Bank makes money from you. So if you think you can make money out of banks, then you must be more naive than the banks.

Having said that, it doesn't mean you cann't make money WITH the banks, together with them ...

Unfortunately due to banking history and its old pratices, they will hide everything they think is benefiting you.  ( btw, before there are moneys, there are already banks ).  Although they are regulated by goverment to protect you, but they still have the room "Not To Voluntarily Offer You Information".  

With Banks, if you don't ask the right question, you will NEVER get the right answer.

So all the traditional banking products including Saving Accounts and Fix Deposit just let you get by.  You don't really earn anything from there if you consider inflation.  In the past, Banks didn't want you to know about Mutual Funds and Insurance.  But now they don't have that choice anymore.

In short, you put your money in Saving Accounts and Fix Deposit when you don't know what else to do with them.  AND you think its higher risk to keep them in your own place.  If someone stole your money from your place, you lost them.  If someone stole your money from the bank you deposit into, usually you will still get your money back, thanks to legislation and laws.
Inflation => You Lose
(Saving Accounts + Fix Deposit) - Inflation -> You Lose LESS
But you still don't earn.

(don't assume yet, mutual fund and insurance aren't going to get you out of your rat race neither, if its that simple, I wouldn't need to start a blog at all)

some global Financial Tips ...

Just a short break to look at some tips what you can do for your own finance planning.


This link is from USA but nevertheless some concepts can be adopted here too.

Sunday, September 28, 2008

How about Insurance ?

Some may asked how come there isn't any insurance in your pyramid ?

That is the tricky part.  You see, insurance has come a long way and no one can deny it is one of the CORE financial tools.  Some may even think that IT is the Mother of all finance.  That is because you can literary start with Nothing and gain Everything by setting up an insurance business.

However, the original intention of insurance is protection ( from the buyers point of view ).  And it is a game of statistic.  You contribute a small amount of money to a pool, if something unpredictable happened to you, you got compensated with a large sum of money from the pool.  Statistically less people will face unpredictable incidents than the total money contributed to the pool.  The remaining money left in the pool is what the insurance business earns. ( but don't kid yourself, its damn complicated in real life )

So from Personal Finance point of view, insurance is like a lottery.  You buy with a small amount of money, if you win, you got a lot of money back.  If you don't hit the jackpot, you lose the money you paid.  Then next month, you buy again if you want to continue playing. ( today its called Term Insurance )

Ofcourse the differences are :
1. Insurance is a proper contract, govern and regulated to protect your rights
2. Sometimes Insurance 'can be' a sure win lottery if you go with the contract that says 'Whole Life'
3. In normal circumstances, you Do Not Want To 'Win'

... and a few more technical stuff.
So its all about the 'jackpot'.  Or its all about the large sum of money you were hoping to win.  Why ?  Why do you need that sum of money ?  And why do you want to buy a lottery, take a chance to get that sum of money ?

Because you have a dream, a target, a goal.  Because you want to get that sum of money 'just in case'.

So in Good Finance Planning, you buy insurance when you have a Goal.  When you know exactly how much you need just in case you are not able to earn it if some unexpected happen to you.

That is why it does NOT fit into a Basic of Standard Finance Planning Pyramid.  You Don't Have to have an insurance in your finance planning.  But it will be a big plus if you do ... who wouldn't want to guarantee win a lottery eventually ? :)

So if you have goals in your life, you may need insurance.  For example :

You want to earn $100,000 to buy your dream car in 5 years time.  You may consider buying an insurance worth $100,000 just in case your plan is interrupted by some unexpected events (sickness, accident etc.) so you know no matter what, you are going to have your dream car !  And the best thing is, you don't have to lock down with your car, you can use that sum of money to buy other things you really want by that time.

Another common scenarios are dependant.  If someone depend on you for a living and you care about them, most probably you want to make sure their lives are substainable just in case.

So if you care about yourself or someone else, you may need insurance.  

But if you don't give a damn about everything, then insurance may not be the right finance tool for you.

Even if you don't care, you HAVE TO SAVE !  You may NOT regret NOT buying a lottery, but you WILL regret losing TIME - the only Golden Opportunity to Compound.  

Saturday, September 27, 2008

now Finance Planning starts ....

You already setup a Standing Instruction transfering a Fix Amount ( Percentage ) of monthly income into another Saving Account.  

Congratulation !  More than 90% of general population never survive till this stage.  Surprising or not, those who can make it to this stage are usually those non high flyers, the old guy next door or the geek who never leave his room etc.  And all of them became the millionaires next door that you never know.  ( Amazon agrees )

Basically what you have accomplished is managing your Cash Flow.  You have decided Future is Important and want to reserve some seeds instead of eating up all of them now.  Here onward is all about maximizing return of this Saving Account.

The key is Passive or Money Earns Money.  A way that the money grows by itself without you watching it, working on it ... if you are eager to talk about earning more money, goes back to the Income stage.  Increase all your want and explore all your wild ideas there ... here is about putting your wealth aside and comes back years later to wow yourself.

( The analytical part after Cash Flow is Asset and Liability but I leave this to later.  Lets stay on something simple and practical stuff first )

Basically you pile up your wealth pyramid like this ...

1. Bank Saving Account
2. Bank Fix Deposit
3. Bond Fund
4. Mutual Fund ( Balance Fund then followed by Equity Fund )
5. Stock Exchange

This is the part where challenges may come.  Different consultants share different approaches based on their own perspectives.  Not everyone pile up the pyramid bottoms up.  Not everyone draw the pyramid like that.

This is also the part there is no right and wrong answers.  Its all about how YOU want YOUR SAVING ACCOUNT to grow IN ANYWAY YOU WANT ...

So what should you do ?

If you are new to this and no other people is confusing you, just take this pyramid now.  Subsequent sharing will lead you to building your own pyramid.

If you already disagree with this pyramid or your existing consultants tell you otherwise, then this is a good time you take out a pen and draw your own pyramid now.  Whenever you have more than two ideas that cannot co-exist fully, then its time you pick the good from both and build your own.  Afterall, this is all about you yourself, not anybody else.

Friday, September 26, 2008

2nd, Save First ....

If you have any income or any return from you existing investment, the beginning of managing them is SAVE FIRST !

This may sounds old and boring to those who has heard it thousand times, but have you done it yet ? To add some spice to it, you should Save First Automatically !! Like a successful business, if you don't have a system that can run by itself, then you are most probably not having any business yet. So in Personal Finance Planning, if your Income Account is NOT Automatically SAVED into another Account, then you are most probably too dependant on self discipline that does not work in Most People ...

Wednesday, September 24, 2008

First .... Income !!

First, you should have some sort of INCOME first :)

You may work for someone, you may be your own boss, you may be a kid or you may be retire ... but still you should have some sort if income before you talk about Finance Planning.

Income can be active or passive, either way you NEED finance planning.

Lauch of another Personal Finance Blog in Malaysia

Lets see if this can become something you like ...

Before I post anything up yet, check out this web below. You can get a FREE crystal ball after filling up a very simple survey.


The web site expires and NO longer valid, sorry.

Tuesday, September 23, 2008

A Question for Secretary Paulson

I chose the wrong week to go on vacation and must now catch up with the unread papers of an eventful week.

The demise of broker-dealers was news only in the manner it played out. But the business model was doomed. I wrote on this blog that for broker-dealers “to function, the system has to be unstable”.

The wording was slightly imprecise. I meant that to function, the system needed to be balanced on a razor’s edge. And for over a decade it was. But the ongoing turmoil in money markets disrupted the shaky balance beyond any hope of restoration.

AIG, too, was an easy bet. You could see something was rotten in the state of the company from the vehemence that it attacked standard accounting principles.

What I did not know was the extent of AIG’s involvement in the troubled money market funds. Then, under the cover of arranging an $85 billion bail-out of AIG, the Treasury announced that it would also rescue money market funds regardless of their affiliation. This happened on Thursday, after several funds “broke the buck”, meaning that their investors would lose some portion of their principal.

The news came out on Friday and after a few comments about how unprecedented it was, disappeared. Count on the mainstream media to ignore important news.

Let us see now. The U.S. Treasury is handing out money to money market funds to ensure that these funds, many of them with absolutely no affiliation with banks, broker-dealers or other financial institution, would preserve their $1 net asset value. Why? Note that this is taking place in the midst of a blood bath that forced Merrill Lynch to sell some assets for as little as 22 cents on a dollar. Why would it matter then if a money market fund's NAV dropped by a penny, to 99 cents? And why would that concern the U.S. Treasury?

The answer is that money markets are the critical link between industrial and finance capital, or, as your economics professor would say, between the financial markets and the “real economy” – the “real economy” always in quotation marks because he cannot define the term but expects you to understand it, very much like pornography.

The relation between the industrial and finance capital is a chapter in Vol. 5 of Speculative Capital. Here, I will have to be brief.

Assume your business purchases a machine for $12,000. The machine has an average life of 5 years, after which you have to replace it due to either wear and tear or obsolescence.

It is an elementary principle of accounting and finance that, ignoring the price change due to innovation, you have to set aside $2,400 every year for 5 years to create a reserve fund for the replacement of the machine. It is this money – $2,400 the first year, $4,800 the second year, and so on – that is placed in money markets and never in capital markets, the latter having a completely different function.

Money markets provide an extra income to funds while funds are waiting to be employed. But that income is absolutely secondary to preserving the original sum. This sum, when called upon, must be available for turning into fixed assets. If it falls short, it could not purchase the assets and the process of industrial production would suffer. It might even come to a halt. That is how money market is “related” to the real economy.

One of the funds in trouble was the famed Reserve Fund. Here is its “inventor” in an August '07 interview with the Financial Times. The man must have seen what was coming.
Bruce Bent, the inventor of the money market fund, has criticised the “flagrant abuse” of the concept – which he introduced in 1970 – that has come to light in recent weeks.

Mr Bent, who established the world’s first money market fund, the Reserve Fund, says the original idea behind the fund is being ignored. His displeasure stems from a sense that many money market funds have exposure to sectors or securities they should not be in, claiming his original concept was not designed to give investors any headline risk and should give them immediate liquidity and safety above all else.

“The money market fund was created to provide effective cash management, to guarantee at least a dollar in and a dollar back and beyond that, a reasonable rate of return,” Mr Bent says.
Like all fund managers, old Bruce is a practical man and cannot exactly or convincingly explain the nature of the “flagrant abuse” he is complaining about; when it comes to matters of theory, the “sense” will take you only so far. But he is right on the mark in describing the characteristics of money market funds. All traders know that, which is why on Thursday, the rates on the 3-month T-bills dropped to 3 basis points, which is to say, zero. I even heard that the market ran out of the T-bills. Thus, through rates and prices, the only way they know how, traders defined money markets for us: a place where the safety of principal trumps the interest income at all costs.

What about the Treasury secretary? Does he know the relation between the money markets and the real economy?

I must say, Yes. His hurried response to the shortfall in the money market funds is not sufficient proof. You could argue that it was the practical reaction of officials deluged by panicked calls from bankers and fund managers; the back office of any clearing institution on that Thursday must have been a scene to behold.

So I have other evidence, thanks to Larry Summers whose picture made The New York Times the other day as a potential Treasury secretary in the Obama administration. I remember him speaking in his capacity as the Deputy Treasury Secretary (to Bob Rubin) of the “benefits” of the Southeast Asian financial crisis. The time was February 13, 1998. The Wall Street Journal reported it on page A2 under the heading “U.S. Presses Japan to Stimulate Economy”:
’There has been more progress in scaling back the industrial policy programs in these countries in the last several months than there has been in a decade or more of negotiations,’ Mr. Summer said.
So Larry Summers knows that a financial crisis can setback industrial output and boasts of having achieved just that in Southeast Asia. He no doubt passed this knowledge to the Treasury staff as part of the “knowledge transfer” initiative that any responsible technocrat would undertake.

That brings us to the question. If the Treasury secretary and his underlings knew of the relation between money funds and the “real economy”, why did he not interfere to prevent the perversion of money markets that I described in the Credit Woes series? The perversion was a long time in the making and took place in the plain view of everyone in the market.

For that matter, where was Larry Summers, as Deputy Treasury Secretary, as Harvard President, as an eminent Financial Times columnist, to raise the issue? After all, it was under his watch and that of his mentor, Consigliere Rubin, that the money markets began metamorphosing into trading places.

These are rhetorical questions; I gave the answer in Vol. 1 of Speculative Capital, in discussing the dynamics of speculative capital and the way it operates through human subjects. But they are still questions to ponder in the midst of this crisis where grave-looking men in dark suits who try to end it find themselves grossly out of their depth.

(The last entry on Lehman bankruptcy had several errors, typos and an incomplete sentence. Blame them on the slow and spotty Internet connection I was using at the time. All are corrected, with apologies.)

Wednesday, September 17, 2008

Lehman’s Bankruptcy: An Event to Remember

The most outstanding characteristic of the “pragmatic man” is lack of conviction. He believes in no ideology, honors no conventions, adheres to no principles, follows no set rules, finds nothing per se wrong and rules out nothing categorically.

This is neither criticism nor moral posturing. It is an elaboration of what logically follows from the word “pragmatist”, what it implies. A pragmatist is ruled by the exigencies of the moment. He is a compromiser, a deal maker, a justifier, a fixer.

Central bankers are a pragmatic lot.

The news of Lehman and Merrill reached me at sea, in Alaska’s Inside Passage, to be exact. Without the phone reception and the spotty and outrageously expensive access to the Internet in the glaciated valley, I do not know the details, but the details do not matter. There is only one central question. Why was Lehman allowed to fail after long words about the systemic implication of the failure of much smaller Bear Stearns– and, if you want to go further back, Long Term Capital?

The Fed’s decision to let Lehman go under will be explained by the usual hangers on in the media as a courageous call and a necessary message to the officers of private enterprises that they must face the consequences of their actions. This will be celebrated as the triumph of free market and the application of tough love that everyone agrees corporate America desperately needs.

But central bankers are a pragmatic bunch and the Federal Reserve is no exception. It is inconceivable that the Fed would force a major broker dealer whose CEO sat on the board of directors of the Federal Reserve into bankruptcy for the sake of making an ideological point. The Lehman failure is a defeat, a setback. The Fed would have done everything within its power to save the firm. That it did not, because it could not, is the central story behind Lehman’s failure. In the Lehman crisis, the Federal Reserve reached the limits of its omnipotence. It was rendered impotent because it did not have the financial wherewithal to intervene.

In several entries on this blog, I have pointed out how the Fed’s Term Auction Facility, like the Bank of England’s Special Liquidity Scheme, was being abused by banks and broker dealers, Lehman included.

These “facilities” were created as a temporary solution to the seizure in money markets. The institutions holding impaired mortgage-related securities could pledge them with the central bank and receive Treasuries in return.

The idea was a “pragmatic” one. The activities of broker-dealers, for example, fell outside the Federal Reserve jurisdiction, but the facility was extended to them any way. It was believed by men who know nothing of the fundamentals of finance capital and explain everything in terms of human behavior that the scheme would somehow jump start the markets.

It did not turn out that way. The financial institutions immediately began swapping their existing junk securities for Treasuries. As the junk ran out, they sought and created junk specifically for the purpose of swapping it with Treasuries. Junk trading was back, except that now the central banks – the Fed in the U.S., and the BoE and ECB in Europe – were on the receiving end.

As the central bankers tried to clamp down on the practice, the markets fell.

The Bank of England’s money-market “reforms” that is in the works is intended, gingerly and with extreme caution, to finally get the Bank out of junk trading business. Hence, the comments of the Mervin King, its governor that the bank “will not and cannot solve the shortage of funding to finance bank lending”.

It was against this backdrop that Lehman’s funding needs turned into a crisis. Every day, the bank had to finance some $600 billion securities in the tri-party market. The Federal Reserve, having destroyed its assets through its Facility, could no longer take on such crushing load. It had to stand aside and let Lehman go down.

I will have more on this topic when I return.

Monday, September 8, 2008

Secretary Paulson Jumps the Gun – and Fires His Bazooka

Treasury’s takeover of Fannie Mae and Freddie Mac over the weekend meant that Secretary Paulson’s bazooka strategy had failed – but only because he chose to fire without having to do so. Otherwise, following his own words that “government support needs to be either explicit or nonexistent,” he could have extended an explicit government guarantee to Fannie and Freddie and achieve the same results he got with the takeover with much less suspense and fanfare. But the point, of course, was not to save Freddie and Fannie, but to bury them.

The extensive coverage of the event that followed added nothing of substance to the subject. That was par for the course for the media, as the readers of this blog know from the Destruction of Fannie Mae and Freddie Mac. A few tidbits, though, I found interesting.

One was Secretary Paulson’s using a secure video link from a bunker to brief the president. I understand the show-off, the ego trip: look Ma, I am talking to the president from a bunker. But there could not have been anything confidential about the plan that required secure communications. The Treasury’s plan was a rehash of the “prescription” – castration, really – that The Wall Street Journal presented on its July 10 editorial. I quoted it in the Destruction series. So, a few lines on any message board, with a link perhaps to the Journal article, would have sufficed.

As if to confirm this point, the New York Times reported that Mr. Paulson had also briefed Warren Buffet. No explanation was offered for this private briefing of a private investor by the U.S. Treasury secretary – doubly inappropriate because it took place in the context of an issue that involved, as per Secretary Paulson himself, a “conflict between public and private purposes”.

The Sage of Omaha then had this to say:
Secretary Paulson has made exactly the right decision for the country. He is minimizing the problem of moral hazard and maximizing the benefits for the housing market and for the smooth functioning of financial markets.
And you thought drivel – pure, unadulterated, absolute drivel – was the purview of politicians only.

I also learned that Fannie Mae CEO, Daniel Mudd had pleaded with Paulson to spare his institution. He pointed to his success in raising capital and emphasized that Fannie was in much better shape than Freddie Mac. He must have been certain that Fannie Mae could survive on its own, else he would not have dared to press the point in an atmosphere of the crisis. But his reasoning went nowhere. Paulson told him that “Freddie was nearing a crisis and that, in the eyes of the markets, the companies were joined at the hip”.

And why was Freddie Mac nearing a crisis?

It needed capital. When the CEO, Richard Syron went to New York to seek investors, The New York Times reported, “potential investors told Mr. Syron there was too much uncertainty around the Treasury’s intentions; if investors acted now, and Freddie was later seized by regulators, they would lose everything they had invested.”

So the reason Freddie Mac could not get capital was the uncertainty about the actions of Treasury. And that – Freddie’s inability to raise capital because investors were unsure about the Treasury's actions – was the reason that Fannie Mae also had to go.

None of this is will surprise the readers of this blog who read the Destruction series. Unbeknown to the CEOs, the fate of Fannie Mae and Freddie Mac was sealed long before the first weekend in September 08. That is why the Treasury’s rescue plan now “bans [Fannie/Freddie] from lobbying the government, putting an end to their ability to use their political machine on Capitol Hill.”

This is the equivalent of creating a “no fly zone”, proof that opponents are in the driver's seat and the sign that they are planning to have their way with you.

A matter of a small indignity remained. The New York Times said:
The seizure of Fannie and Freddie is all the more surprising because, as recently as late March, Washington viewed the companies as saviors of the housing market and the economy, rather than as risks to them. Instead of requiring Fannie and Freddie to scale back, regulators gave then a green light to buy and guarantee more and bigger mortgages.

On March 19, James B. Lockhart, their chief regulator, dismissed swirling rumors about their financial health. “The actions we’re taking today,” Mr. Lockhart declared, referring to a decision to ease restrictions on how much capital they were required to hold, “make the idea of a bailout nonsense in my mind. The companies are safe and sound, and they will continue to be safe and sound.
This remembrance of the events past is hard on Paulson and Lockhart. It makes them look like fools who misread the situation even after the collapse of Bear Stearns.

Such characterization would be fine with both men, certainly with Lockhart. That is because the real story is even more damning.

The plan, you recall from the Destruction series, was to take out the agencies. The job had to be done in a “clean” and controlled manner; it would be foolish to do otherwise. But in the midst of the plot, the unpredictable intervened: the credit market froze. After the collapse of Bear Stearns in March, panic set in. In desperation, the attention turned to two healthy institutions that, up to that point, had been incessantly maligned. Suddenly, the tune changed, hence Lockhart's passionate declaration that “the companies are safe and sound, and they will continue to be safe and sound”. The second half of the statement is a wishful thinking, almost like a promise you know you could not keep. Anyway, by then it was too late.

I will have more to say on this subject in Vol. 5 of Speculative Capital.

Sunday, September 7, 2008

The Critical Role of Interest Rate Swaps in Financial Markets and the Real Economy

Sometime in the fall of 1990, during a lunch conversation with colleagues in what was then Credit Lyonnais, I brought up the idea of writing a book on swaps. The head of HR who had some knowledge of the publishing industry thought I was setting myself up for disappointment. Publishers would not accept a book proposal without an introducing agent, and no agent would take a writer as a client who was not already a published author. Like first jobs and the experience requirement, it was one of those well-known catch-22s, he said.

The same evening – it was on a Thursday – I wrote a 4-page proposal and sent it to Dow Jones Irwin. On Monday they called and offered a contract.

Valuation, Trading and Processing Interest Rate Swaps came out in 1993 under the imprint of Business One Irwin – even then the publishing industry was in turmoil – and, according to the statistics of the legendary McGraw Hill bookstore in New York anyway, became an “industry bestseller”; industry meant technical books in finance. I received a princely sum of $7,500 and many compliments. One mildly critical comment stood above the rest. An academic reviewer wrote: “The chapter on operations is interesting in that it addresses issues not discussed elsewhere but I doubt many people would be interested in how it works”.

I had almost forgotten the book until a friend recently suggested adding it to the list of the books on the blog as a part of the blog’s (very) gradual overhaul.

Interest Rate Swaps has been out of print for a long time. But interest rate swaps are going strong as ever. In fact, though I did not know it then, the spectacular growth of the swap market in the 80s was the driver and the resultant of the rise of speculative capital.

An interest rate swap is simple in concept. Two sides agree to the exchange of interest payments based on a notional amount. (“Notional” because it does not change hands and merely serves as the reference for the calculation of interest amount.) One party pays fixed rate; the other, variable. The variable index is generally the London Interbank Offered Rate, or Libor (pronounced like MY DOOR.) It typically resets every quarter.

Operational issues aside, there is little to add to this description. But nothing exists out of context. Taken into capital markets for which it was designed, the swap structure proved quite revolutionary. It made possible arbitraging corporate credit and interbank lending markets.

The clue to this critical function is in the Libor index, which pertains to the rate banks charge one another. Interest rate swaps enable corporations to borrow cheaper in the variable rate Eurobond market and swap it to a fixed rate.

The quantitative impact of this funding mechanism was phenomenal. Twenty years ago, 80% of the corporate borrowing was through bank financing and 20% through bond market. Today, the ratio is reversed; it is 80% through capital markets and only 20% through bank financing.

Far more important, however, was the qualitative transformation of the markets. You see, if you could use swaps to arbitrage the cheaper inter-bank lending market and the long-term capital market rates, why stop at corporation? Why not bring in municipalities to the game as well, to take advantage of the “efficiencies” of the modern financial markets and collecting no so insignificant fees and bonuses in the process?

That is precisely what transpired. Hence, the rise of auction-rate securities (ARS) and the option tender bonds (OTBs). Under the relentless pressure of speculative capital which aims to shorten the trade horizons, the Libor reset was also reduced to its irreducible overnight frequency. In this way, the overnight swap index (OSI) was born.

Note here that OSI and the Fed Funds rate serve the same exact purpose. They are the rates that banks can borrow overnight from each other (OSI) and the Fed (Fed Funds). Hence, it stands to reason that the difference between them should only be a few basis points (accounting for the higher credit quality of the Fed). That was indeed how it was until summer '07. Since then, the persistently large spread between OSI and FF, over 60 basis points, has provided one of the most compelling signs of continued malaise in the markets.

If you sleep with dogs, you wake up with fleas. If the corporate and municipal bond market are linked to the interbank lending market through swaps, then they are bound to suffer the consequences of any dislocation in the financial markets. Somehow the top central bankers and top economist and top fund managers in Jackson Hole did not seem to grasp this obvious link between the financial markets and what they call – always in quotation marks – the “real economy”.

In Vol. 5 of Speculative Capital, I will show the exact manner in which crises in the financial sector impact the industrial production and service activities. In the mean time, read the following news stories that provide useful background material on auction-rate securities, option tender bonds and the role of interest rate swaps.

The last one is the most entertaining. It deals with the question of the “reliability” of Libor because the index did not behave the way college textbooks and the learned professors had said it should. There were serious and protracted discussion about reforming or replacing the Libor until the discussion slowly faded away, one hopes from embarrassment. There never was a more egregiously foolish shooting of the messenger.

Sense of crisis growing over interbank deals (FT, September 5, '07)

In particular, the cost of borrowing funds in the three-month markets – as illustrated by measures such as sterling Libor or Euribor – is continuing to rise, suggesting a frantic scramble for liquidity among financial groups. This trend is deeply unnerving for policymakers and investors alike, not least because it is occurring even though the European Central Bank and the US Federal Reserve have taken repeated steps in recent weeks to calm down the money markets. Or as UniCredit analysts say: “The interbank lending business has broken down completely … it is a global phenomena and not restricted to just the euro and dollar markets.”

Strategies reborn and lessons learnt – hopefully (FT, October 8, '07)

The TOB programme is a trust that borrows short-term money to buy US municipal bonds. The people setting it up ... buy long-dated US munis with money borrowed at Libor. After paying for a hedge against a rise in Libor, they might net 30 to 50 basis points, but they can leverage that trust up perhaps 12 to 14 times ... The managers have the option of liquidating the trust in case things go against them in some way, or if they decide they want to wind up the business. What they had not counted on was, of course, what happened. In the summer crunch, Libor blew out as banks became suspicious of each other. At the same time, like all non-sovereign bonds, US munis came under suspicion.

Global funding pressures intensify (FT, April 15, '08)

Strains across money markets intensified yesterday and are approaching levels last seen in mid-December ... This was illustrated by higher swaps rates, which compare the difference between overnight lending rates set by central banks and three-month Libor, the rate at which banks lend to each other. In the UK, this spread known as the overnight index swaps (OIS) rate, rose above 100 basis points yesterday and in the US increased to 80.6bp. … These are highly elevated levels and compare with swap rates of around 15bp before the credit crunch emerged last year.

Slowly does it, as calls grow for Libor shake-up (FT, April 22, '08)

The British Bankers’ Association has opened the door to “evolutionary change” in how it calculates London Interbank Offered Rate – Libor – in response to growing criticism about the accuracy of the global benchmark for borrowing costs … The rate has traditionally been considered a key barometer of financial stress and swings in Libor can have big economic implications since many loan and derivatives contracts are based on it ... However, bankers fear the index has become distorted in recent months, particularly in dollar markets, because it is calculated according to bank’s perceived funding costs rather than actual trades.

The emphasis on Libor, OTB and ARS in these stories tends to obscure the central role of interest rate swaps. But that role is ever-present; it is central to the stories. No student of finance can afford to be in the dark about these critical tools of arbitrage. Good finance teachers will see to that.

Monday, September 1, 2008

(What Lies Behind) The Descent of Man

I had planned to write about this story earlier but got distracted by the events in the financial markets.

On August 6 this year, 11 climbers died on the “K2”, the world’s second tallest mountain.

Maurcie Isserman wrote an insightful Op-Ed piece in the New York Times in which he faulted the every-man-for-himself attitude of the climbers and contrasted it with the more chivalrous conduct of bygone years. I am quoting select passages here, but you should read the piece in its entirety.
WILCO VAN ROOIJEN, a Dutch mountain climber, managed to survive the debacle this week that took the lives of 11 others in Pakistan on K2, the world’s second-highest peak. Describing the chaotic events that ensued when a pinnacle of ice collapsed and swept away fixed ropes that climbers from several expeditions high on the mountain had counted on to aid their descent from the summit, Mr. van Rooijen lamented: “Everybody was fighting for himself, and I still do not understand why everybody were leaving each other.”

Fifty-five years ago this month, Dr. Charles S. Houston, America’s premier Himalayan mountaineer, led a team of seven Americans and one British climber attempting a first ascent on K2. They made steady progress up the mountain, and by Aug. 1 all eight climbers had reached a campsite at 25,300 feet. From there, given good weather, they expected to reach the 28,251 foot summit in two days.

Instead, they were pinned down by a blizzard in their high camp for the next week. And one member of the team, Art Gilkey, who was on his first Himalayan venture, was struck down by a case of thrombophlebitis, a clotting in the veins, in his left leg. It left him unable to walk and in danger of death if a blood clot were to reach his lungs. Houston and the others knew that there was little chance that they could carry an incapacitated man 9,000 feet down treacherous slopes to the safety of base camp. But they did not for a minute consider leaving their teammate behind.
Isserman ended the essay by comparing the conduct of climbers then and now:
Houston himself summed up the highest ideals of expeditionary culture when he wrote of his K2 comrades: “We entered the mountains as strangers, but we left as brothers.” Today in contrast, as was evident last week on K2, climbers enter the mountains as strangers and tend to leave the same way.
This ending suffers from a triple fault. It is didactic. It is nostalgic. And it stops where it must begin.

Why did the spirit of cooperation decline so drastically in the past 55 years to the point of nonexistence? What explains this descent of man?

The answer is the ascent of “economic man”.

Economic man is the driver of the Western economic theories. He is a constantly calculating machine ruled solely by the considerations of personal profit and loss, pleasure and pain avoidance, risk and reward. By virtue of this characteristic, he is labeled “rational”. This rationality is not in the Kantian, but the Shylockian, sense; the economic man is “rational” because he strives to maximize his profits without regard to others.

After WWII, with the influence of the US reaching beyond economics and into the cultural and social landscape, the “ethics” of economic man gradually worked their way into the psyche of the Western public. Still, the “progress” was slow and the economic man mostly remained confined to college textbooks and academic settings. The watershed event was the collapse of the Bretton Woods system that, in giving rise to speculative capital, created the perfect milieu for the coming-out of the economic man. He came out all right, in-your-face and even belligerent, not only in academic theories but also in the media, movies and books. Milton Friedman was his most fanatic advocate; he strove to create a social-moral system to always put the economic man on the right.

Here is this “father of monetarism” in a June 5, 2005 interview with the San Francisco Chronicle. The subject of the interview was Friedman’s “bold” idea of privatizing the Social Security that, the paper claimed, was becoming “mainstream”:
“I have always been opposed to social security,” Milton Friedman said in a recent interview at his home in San Francisco. “I think it is a very unethical program” … What about the fact that Social Security has reduced poverty among the elderly? “Well,” he replied, “what it has done is transfer a lot of income from the young to the old. It is certainly true it has made the old people of the United States the best treated old people in the world”. But why is that a bad thing? “Oh,” he replied. “It is not a bad thing for them, but what about the young?”
I quoted this interview in Vol. 3 of Speculative Capital and commented:
The “bold” economist reverses the meaning of ethical by changing its reference from others to the self: every man for himself and may the devil take the hindmost. To the intellectual architects of the particular brand of economics practiced in the U.S., every man is on a desert island.
The climbers who died or abandoned their friends on the K2 were the climbers of our time. They were taught – conditioned, really – to maximize their own self interest. In the chaos of an accident on the mountaintop, immediately running for cover must have seemed as the most rational course of action. It was in keeping with the ethics of the time.

Maximizing one’s interest, however, is not always the “optimum” course of action. You do not need to be a follower of Rumi to understand that. The chaos in the financial markets which I described in the 10-part Credit Woes series offers ample evidence of that universal truth.