My understanding of current economy #3

Credit crunch

So what happened in summer last year? House prices began to fall, the collaterals which support the MBS depreciated, sub-prime mortgage payers struggled to make the payments (Reason? May be because they didn’t have a job?), values of MBS dropped dramatically (because they are leveraged products).

How US house prices dropped

So we saw the first tide of “write-downs”. What it means is: Bank B had $3 trillion worth of assets, or at least thought they had. The value is calculated using latest trading prices. But suddenly the trading prices dropped, and some of them even disappeared (depending on individual product, some MBS may cease to exist when many of the mortgage payer defaults), Bank B’s assets suddenly dropped in value. They had to fill the hole in the balance sheets (accounting regulations), they had to report losses to shareholders, they had to announce: I need to move $30 million to fill the hole left by sub-prime MBS which disappeared.



Biggest recession since great depression?

Since the credit crunch started last summer, when lots of well-known banks have multi-million dollars write-downs, a lot more have happened. It’s because in a free market, everything flows together. In a chain of implications, it looks like:
- banks have multi-million dollars write-down
- some banks realise the problem and sell all mortgage-related assets (e.g. JP Morgan)
- prices go down further
- more write-downs
- people lose confidence on economy, house prices, creditability, government, basically everything
- job losses
- more defaults because people cannot afford mortgage interests, forced to foreclosure
- more write-downs
- banks have no assets, no cash, cannot run business as usual by lending money to other banks and ordinary people; businesses don’t have operating cash, one falls after another
- etc..

In between, Fannie Mae and Freddie Mac lost so much that the US government had to tell the world – “don’t worry about the MBS in your portfolio sold by these two guys, we’ll back them up”. And there is no more major independent Wall Street investment bank:
- Bear Sterns went broke and bought by JP Morgan
- Merrill Lynch was acquired by Bank of America
- In the same weekend, the 158 year-old Lehman Brothers filed for bankruptcy. You should remember how its share prices dropped by 80% each trading day before its doomsday.
- Morgan Stanley and Goldman Sachs transited from investment banks to bank holding companies

Why people say that this recession would last longer than the ones before, and can be compared to great depression in the 1930s? I don’t know why they say that obviously, but I will guess.

From the beginning of my long entry, you can see that I deliberately started with investment banks. One of the reasons for the crisis we have today is little regulations in the world of financial product trading, and individual’s greed can be fulfilled in this world. The greed has previously built up the property bubbles, equity bubbles, FX bubbles and among others, and it has finally bitten back – the banks lost. But of course similar to previous bubble bursts, ordinary people lost more.

So the lesson to all governments is: you have to control your financial market tighter, in one way or another. Nationalisation of banks (e.g. Northern Rock, Fortis, all the big ones in Iceland, and so on) is not a good and final solution, but it was the only thing that those governments had to do and could do. The way that Chinese and Russian governments control their banks may also be too extreme. So another model needs to be found, different from all capitalism, socialism and communism.

During the transition stage from traditional banking to the next model, perhaps everyone will suffer a little – recession and slow growth. Simply because most businesses rely on banks nowadays. As of today, there doesn’t seem to be a solution to end the credit crisis which sees very little and strict lending from banks.

How does it affect you?

Since the problem began, many people has lost their jobs and savings. If you live in the UK, you must know about ICE Save. Iceland has done tremendously well as a country with fewer than 300,000 people (that’s about the same as population in Tin Shui Wai, see here) in the past few years. They had good business models, and attracted a lot of European countries to put their people’s savings in Iceland. At some point they were taking over Premier League football clubs in England e.g. West Ham.

Now, we all know that they made their money by spending UK residents’ savings on fancy financial products. When the stock market and other things go the other way (in fact, when everything like equity prices and property prices is shooting up, no body really thinks they’d ever go down), they lost all the money. They were on the brink of going bankrupt, as a country.

If you live in Hong Kong, you must have heard about Lehman Brother mini bonds. The fact is, Lehman Brothers had a lot of products in the market e.g. warrants, structured products, Credit Default Swaps, and others. So when they go bankrupt, many of these products became junk.

Just imagine that you’ve paid HKD $5,000 to a fruit shop owner, and in a contract that you both signed it says the owner will provide you fruits every day for 3 years (good deal, eh? Just under $5 a day). Now the fruit shop has disappeared. You won’t get your money back. You can file complaints to the party who made you sign the contract. But it could be your wife who convinced you, or your greed in your mind.

When will the story end?

I don’t know. As I said before, the world now needs to come up with a new and better model for banks to operate properly. No more business as usual, because it will be different.

I’d say, as a risk management consultant as Thomson Reuters, banks need to look at their risks PROPERLY. Not just spend some money on software and have fancy reports, but really look into it to analyse what risks they are exposed to, and take actions to hedge them, not hide them.

What can we do now?

Observe and learn. Similar to all lectures, there will be costs e.g. the money you lose when participating in the market. But this could be once in a life time event.

Some ripples in the financial world, high unemployment won’t kill the world. Nuclear war and/or global warming will. You still live, so enjoy it.

My understanding of current economy #2

1. What happened?

Investment banks (or the so-called Wall Street banks, but actually it should include the I-Bank departments of universal banks too) have been taking care of people's money for years (about 150), that include different corporations, rich men, pension funds, and so on. By looking after their wealth and make good returns for people, they've gradually earned good reputations.

- Top graduates want to join I-Banks, because it's "cool" and more importantly they pay handsomely;

- they have been the biggest buyers of financial services and technology, and many other things (like cars, real estate, etc..);

- people in general pay more respects to bankers, compare to other professionals.

Fast forward to the 21st century, banks and investors rely on a lot of these investment banks to trade with and invest on. For example, when an investor want to invest on high return securities, a bond issued by Lehman Brothers would be a save and good option.

Inside the banks, traders would look for all possible ways to increase their rate of return with the massive capital they have, which in turns of course will give them higher bonuses.

I got this from a CNN article:

“Wall Street is a most unforgiving place to do business. Blood in the water will attract sharks, competitors will quickly build up trades against a debilitated foe, and a panic can accelerate a downward spiral. That's why institutions like E.F. Hutton, Barings, and Long-Term Capital--names that once conveyed soundness and permanence--vanished almost overnight.” (source: see here)

Different innovative financial products then started to appear in the market, and many of them are complicated derivatives and structured products which I can tell you, only a small group of people on the planet really know what they are, how they behave and most importantly what risks are involved. Still, every trading day billions of dollars are involved in trading of those.

Sub-prime mortgage and MBS

One of these structured products is called MBS, Mortgage Backed Securities. It’s still a general term for different varieties of MBS. But in short, mortgage companies (like building societies) and banks who lend mortgages, sell their mortgages to Bank A. Then Bank A put different mortgages together (structure and package) and sell them in the same way as a normal security (for example, the description would say it gives you quarterly coupons of 13%). It offers higher return than risk free products, and attracts a lot of buyers.

The arranger can bring the MBS that they package, to a credit rating agency e.g. Moody’s, Standard and Poor’s, pay them service fee and ask them to give their products a rating. The agencies are independent firms, so they won’t deliberately give good ratings. But they don’t actually have a good model to see the risks of these products. So many of these MBS have good ratings, even though the actual risks (which you only see after you are hurt by them) are high.

In the past few years, the house prices in the US have been rising dramatically, in the same time interest rates have been low. With very little control on mortgage application (unlike Hong Kong, where any mortgage more than 70% would need special application and addition insurance cost, thanks to 1997 local housing bubble), mortgage companies lend money to jobless homeowners to buy houses, sometimes even with cash backs. (Can you imagine that?! You walk into a mortgage company branch, 30 minutes after you walk away with a 3000 sq. feet house and cash to spend!) Because they see the house prices would rise and not afraid of the borrower failure to pay. That resulted in a massive amount of so-called “Sub-prime mortgage”.

Combine with many more reasons, such as the general spending habits of US people (last year, the total expenditure was about 6% more than US total GDP, where did they get the money from? Look at the trillions of US bonds and notes owned by Chinese and Japanese government), the price of these MBS and other similar products then rose and rose.

Big bubble -> big trouble

People seem to have forgotten one thing: these products offer higher return rate because they are risky. The most obvious risks are:

- Credit risk - underneath the security is a group of mortgages, with home owners who have to pay the mortgage company every month. If they default (go bankrupt, or fail to pay), it affects the coupon payments of the MBS, and hence the value of the MBS should go down.

- Interest rate risk - Interest rate may go up, which means the gap between risk free products and these MBS would become smaller, and therefore the value of the MBS should reduce.

- Counterparty risk – What if the bank who arranges the MBS go bankrupt itself? No one will pay any coupon anymore for these outstanding contracts.
Of course there are many more risks to these products, similar to any other investments.

The now-nationalised mortgage giants Fannie Mae and Freddie Mac were active players in the MBS market (see here). Originally they were not. They saw a lot of investment banks making profits from trading these products. But as market participants, they knew the risks. But in a Bull market, how can you justify to your management and shareholders of making such less profit compare to others?

So they were "forced" to play the game as well, even in their risk management system, everything is in red alert because of the high risk exposure. "Never mind, you make the money and you walk away with the bonus." Sounds like Homer, duh!

You can in fact buy or implement the best risk management software available, but if the management chooses to ignore it, due to human judgements, greeds, etc.., the results we see today are inevitable.

More to come...

It's our day today

Today marks a special day. Manyee and I have so far travelled together 9 years of our lives. There is still a long way to go, but looking back my path it has certainly been much brighter and better because of you. Thank you bobo.

Candle lit dinner at the best restaurant in Hong Kong

My understanding of current economy #1

While a lot of people may be suffering from the recent events in the financial markets and economies, people should still have some fun.

(thanks Gigi for forwarding these fantastic British humour to me)

Q: What's the difference between Investment Bankers and London Pigeons?
A: The Pigeons are still capable of making deposits on new BMWs.

Q: What's the difference between an investment banker and a large pizza?
A: A large pizza can feed a family of four.

I had a cheque returned by the bank recently.
It was marked 'Insufficient Funds'
Mine or the banks?

For Geography students Only:
Q: What's the capital of Iceland?
A: Three Pounds Fifty...

Latest news,
the Isle of Dogs Building Society has collapsed.
They've called in the retrievers.

Quote of the day (from a trader):
'This is worse than a divorce.
I've lost half my net worth and I still have a wife.'

I talked to my bank manager the other day and he said he was going to concentrate on the big issues from now on.
He sold me one outside Boots yesterday!

Q: How do you define optimism?
A: A banker who irons 5 shirts on a Sunday.

An elderly lady receives an e-mail from the son of a deceased (but wealthy) African general, asking whether he could transfer millions of pounds into her bank account in return for a 20% cut. All the son needs is the sort code and account number.
Not realising she is the victim of a Nigerian 419 fraud, she e-mails back the details.
A couple of minutes later she receives an e-mail back from the general's son: 'Icesave?!' What is this, some sort of scam?'




But still, because of burst of bubbles, many people have lost their jobs and life savings. Has it affected you? If so, do you really know what happened and what affected you?

Last week in Tokyo, we had a long discussion on what happened and what changes we can expect in the system. It lasted until 2am in the morning, so some of the contents may not really make sense. But I still think during the course of explanations and discussions, we are pretty sure with what went happened, what went wrong, how it affected us and how it could be solved.

Some pictures taken during our discussion of the credit crisis.

Is that a big bottle of JD, or I have lost some weight?
JD maniacs