Wednesday, October 8, 2008

Boiled Frog

Well, this post is not about some exotic East Asian recipe. Rather, it is about economics. Yeh, you are right. Of late, it is only Economics books that have come up with really hot (literally!) titles. How about ‘More Sex Is Safer Sex’?

Now, the blood bath on Wall Street and its first-cousin Streets in Europe and second- and third-cousin Streets all around the globe is grabbing much of the TV minutes. So much so that even Headlines Today had to dump poor Koel and her couch to have a story on the mean money makers on the streets. Sex sells. But, it seems the smell of death sells even more. And while the governments in US/UK/Europe rushed over to put money into the banks, the Streets are not satisfied yet. Their ‘dils’ maange more!

Man is seldom rational. Or probably, he is, when alone. Markets, it seems, are even worse. It is more like the parable of the boiled frog in which a frog that is thrown into boiling water will promptly jump out, but a frog that is put into a pot of room temperature water which is slowly boiled will not ‘notice’ the small increases in temperature of the water and eventually, will boil to death. While the toxic excesses have been regularly pointed out by few wise like Buffett (“Derivatives: ticking time bombs”), the markets’ assumption seemed to be “It is different, this time!”

Much of this has its roots in hope (euphemism for greed). And hope, by definition, is divorced from reality. Too much of that apparently good thing called hope in realty led to subprime mess. But why banks lent to those who have low willingness/ability to repay? And how did they get so much money? MAGIC! Enter financial engineering. Probably, it was here that realty and reality parted ways. Thanks to loads of bright MBAs, banks were able to put their existing loans into new packages (MBS: mortgage backed securites) and sell them and get more money. With more money to lend and Wall Street demanding more profits, they needed to find more people to lend to. When they could not find trust-worthy ones, they T-I-G-ed like true Americans and lent to other American who too had T-I-G. All was well as long as the house prices kept rising. When the house prices started heading south, banks found the worth of their collateral was much below what they had loaned.

And there’s an even more bigger bomb called Credit Default Swaps (CDS), which are essentially bets on whether a company will fail to pay its debt obligations. Simply put, CDS is insurance on corporate bonds. And you can have the bond and go on to buy the insurance just to make sure that you are safe in case the company defaults, which is called hedging. Also, you can bet on the company’s staying power and sell/buy the insurance without owning the bond, which is called speculation. When the company, which you bet would keep its promise on repaying debt, breaks its promise, you are caught naked. When you don’t have the papers to cover your vitals, you panic. AIG might know better how scary these bets might get! You sell off your other assets to cover as much as your skin as possible. If you are big enough in the trade, rest assured it sends a jolt down the spines of other smaller rats in the market. End of faith. And everyone starts eyeing each other with heavy suspicion. With nobody to LEND a helping hand, the biggies drown, pulling as many others as possible with them.

Essentially, this is crisis of confidence, which results in choking credit, particularly the short-term money. With no money to pay now, trust falls further and the cycle goes on till those who have money get bored with its smell and decide to have some fresh air. So, can the bail-out funds from governments save the confidence and keep lenders from hoarding money?

Remember Red, hope is good thing, may be the best of things, and no good thing ever dies. Yeh, Andy, better it shouldn't. At the least, not until we all are dead.

3 comments:

R-ambam said...

Bail-out fund , yaanai pasikku soala pori (Pop-corn) nnu kaelvipattein....! Also adding petrol to the fire..

Ippavaavathu ungala mathiri aalunga saami gumbudaraangalaanu paarpom.

sk said...

Yeh, you are right. CDS market is about $62trn, MBS market about $6trn in 2006 and 2007 US GDP of $14trn. Now, the bailout for $700bn! But, this is essentially to lubricate the creaking machine called credit markets. And you normally don't drown the machine with lubricant. ;)

Neenga solratha paathaa kadavul ennamo kalla nottu adikkaraar nu solla varra mathiri irukkae! Btw, enakku kadavul nambikkai illa nu yaaru sonna? [Engeyo kettaa mathiri irukkae??!!]

Sathiyan said...

machi, nee ippadiye economics, gyaan nu pesittu iru...kandippa ponnu kedaikka poradu ille :) seriously, why are u taking up serious topics ?? what happened to ur so called " mokka " sense of humour da ?