In my previous post, I had talked about the launch of a fund that will invest in different asset classes, with the dual objective of giving superior returns as compared to the benchmark Sensex and to expose the readers of this blog to the world of trading. It is with great pleasure that I announce the launch of Aadiyatna, our very own proprietary investment fund. Aadiyatna is a partnership between George, Prajjwal and me, with a pooled in capital. For the purpose of discussions on the activities of the fund, we have launched a blog dedicated to this fund www.aadiyatna.wordpress.com
I will also occasionally update the activities of the fund on this blog. But I would suggest you visit the aadiyatna blog for frequent and more detailed updates on the fund.
This post is a reply to a comment by Somya.
–
Dear Somya
You have touched on a very crucial point. For creating a class of informed investors, which this blog aims to do, we will now launch a dedicated investing section to help our readers make more informed investment decisions. For starters, we will be starting a fund which will invest in equities, so that readers of this blog can follow the trading history and see for themselves how different investment strategies play out in the real stock market. As responsible advisors, we obviously do not guarantee that the replication of our trading strategies will yield profits. However, the aim is more to educate readers about different investment options, strategies and asset classes. Through this experiment, our readers can get a feel of how it is to invest in the stock market, and for those who already invest, we can share our thoughts on the trading strategies.
The above is in the planning process and I will keep you informed about the same. Thank you for the invaluable feedback. And keep visiting informedinvestors 
Regards
Ravi
——-
Original comment by Somya
Time: Monday September 7, 2009 at 8:25 pm
IP Address: 122.164.185.165
Hi,
I am not an investor and know nothing about the stock market. Hence, I am not an informed investor at all. But of late I have realized the importance of having at least some amount of knowledge about the financial markets (I have started earning you see!). Hence, I have a sincere request to make.
I was watching BBC news today and they happened to present a report on the financial markets. After almost one year since the financial turmoil struck the U.S. having a ripple effect on the rest of the world, BBC report tried to analyze the situation in India. This got me very interested.
The benchmark index in India last year had fallen by almost 50% leading to investors loosing incomes in as much as seven figures. Industries which relied heavily on exports suffered immensely with demand falling drastically from the Europe and the U.S. FIIs pulled out all their money from our country leading to a bottleneck situation. Growth rates fell, inflation levels rose, rupee depreciated further due to FII pull outs, people lost jobs, stock market became all of a sudden a nightmarish dream for even the unaffected.
After a year has passed by, India seems to have recovered much faster that expected. Benchmark index has improved by almost 66% (not sure whether I have this correct) since then and a certain head of a magazine named Mint said that India was in many ways isolated from the crisis. After a year, inventories in the Europe and the U.S. have dried up because of which import demand is slowly picking up now, the obvious benefits reaped by industries like textiles in India. People seem to be investing again, though with a more cautious attitude now.
I sincerely request you to make your blog more lively and informative and talk about the current scenario. Now that considerable time has passed since the crisis, much can be concluded upon. You blog should be doing that. Also, BBC in this entire month will be talking about the fin crisis and I am sure will come up with very interesting observations and hypothesis to work upon. Please update your blog frequently so that uninformed investors like me could be more informed.
Thanks. Regards, Somya Sethuraman
Jawaharlal Nehru
Long years ago we made a tryst with destiny,
and now the time comes when we shall redeem our pledge,
not wholly or in full measure, but very substantially.
At the stroke of the midnight hour, when the world sleeps,
India will awake to life and freedom…….
–
After a hiatus of three months, I am updating my blog on the auspicious day of our independence. Vande Mataram.
–
The Wholesale Price Index (WPI) never fails to surprise. While my flatmate, Supari Gupta, cribs about increasing dal, moong and other prices (sugar prices are on such steroids that the fund managers of Smart Portfolio have lined up a battery of sugar stocks to invest in, from Andhra Sugar to Sakhti Sugar and god knows what not sugar), the WPI inflation continues to plunge deeper and deeper into negative territory. So much so, that commentators have now started criticizing the index as far fetched from ground realities and faulty. There is also a clamor to shift focus to Consumer Price Index (CPI) inflation.
WPI inflation for the week ended 2nd Aug 2009 stood at -1.74 per cent, down from -1.58 per cent in the preceding week. This was surprising as we are witnessing rising food prices on the fear of a drought. However, a closer analysis would tell us that the above figures can be explained and the wholesale price index is not so misleading as it is made out to be.
As the graph above suggests, the WPI inflation for food articles does capture the surge in food prices neatly. The WPI inflation for all commodities shows a fall because of two reasons- the weighting scheme and the high base effect. Primary articles gets a weight of 22.02 per cent, fuel, power, lights and lubricants 14.23 per cent and manufactured products 63.75 per cent. Thus, even with increasing food prices, a generally cooling manufacturing prices makes the overall inflation benign.
Another reason for the apparent contradiction of falling WPI numbers in the face of increasing prices is the high base effect. WPI inflation is constructed on a year on year basis. If a basket of goods costs Rs. 100 on 1st Aug 2008, and the same basket of goods costs Rs. 102 on 1st Aug 2009, then inflation on 1st Aug 2009 would be computed as 2 per cent, i.e., inflation is measured relative to prices existing in the preceding year. Thus, if prices was unusually higher for some weeks in the previous year, the inflation figures for the same weeks this year would be lower. This is exactly what has happened to the WPI inflation figures for the the week ended 2nd Aug 2009, as the graph below would testify. The wholesale price index showed a huge uptrend in August the previous year, contributing to the high base effect.
Because of the above factors, the latest WPI inflation figures may seem surprising, but they are certainly not reasons to doubt the ability of the index to capture price changes in the Indian economy.
I had touched on the concept of liquidity trap in my previous few posts. I am revisiting the concept here in this small post for the benefit of those who might not still be clear about it. Look at the graph below.
It basically plots the benchmark interest rate set by the major cental bankers against time. What do you see? The benchmark interest rates for US has hit the zero lower bound while for UK and EU, they are very close to zero. Obviously, interest rates cannot turn negative. Now look at the graph below-
The inflation rate in the US has turned negative at -0.38 per cent for the month of March 2009 after a continued and sharp fall since July 2008. Let us compute the real interest rate in March 2009 for the US, which is defined as nominal interest rate minus inflation-
Real Interest Rate = 0.00 – (-0.38) = 0.38 per cent
Definitely low by any standards. However, consider what the real interest rate would have been if the inflation was something like 3.85 per cent (the average inflation rate in the US for the year 2008),
Real Interest Rate = o.oo – 3.85 = -3.85 per cent
Yes, a negative real rate of interest, which would have offered a much larger boost to the economy and given greater traction to the monetray policy operations of the Federal Reserve. As the economy heads deeper into deflation, even with the benchmark interest rates kept at zero, the real rate of interest, reflecting the acutal cost of borrowing, will keep on rising. The above situation is referred to as a liquidity trap and it is easy to see that the monetray policy becomes completely ineffective in influencing the economy, with fiscal policy being the only tool in the hand of the government to bring the economy out of a recession.
Published by: Ravi Saraogi
From an inflation scare to a deflation scare, the wheel has come full circle. While the first half of 2008 was spent speculating how high inflation would go, the second half was spent wondering how low inflation would reach, and now, we are all spooked about the possibility of a deflationary spiral. The inflation, which peaked at 12.91 per cent in the second week of August 2008, has been declining since then at a rather alarming pace, plunging to 0.26 per cent in the second week of March 2009, before recovering a little to 0.30 percent in the third week of March 2009.
Source: Office of the Economic Adviser, Ministry of Commerce and Industry
Deflation is much feared in the developed world, as falling prices can quickly grow into a deflationary spiral. A deflationary spiral refers to a condition in which prices fall on account of low aggregate demand, and consumers, anticipating a further fall in prices, delay their consumption, leading to an additional fall in aggregate demand and another level of price reductions. A deflationary spiral also leads to excess capacity and a fall in investments. As was seen during the Great Depression of the 1930s, the problem of falling prices, if not checked, can cause an economy to slide into an extended phase of widespread recession.
A deflationary spiral is also feared because it can cause an economy to fall in a ‘liquidity trap’, in which, aggregate demand and investment remain low even though the nominal interest rate is near zero. This is because in a ‘liquidity trap’, though the nominal rates of interest are lowered by the central bank, the real interest rates remain high on account of falling prices. Real interest rate is obtained by subtracting from the nominal interest rate, the ongoing rate of inflation. For e.g, let the nominal interest rate in the economy be 2 per cent p.a. Now, if the rate of inflation in the economy is 1 per cent, the real interest rate works out to be a paltry 1 per cent p.a. If however, the economy is going through a deflation of 1 per cent (i.e., an inflation rate of negative 1 per cent), the real interest rate works out to be 3 per cent p.a., which is a lot higher than that for the inflationary economy.
An economy caught in the vortex of a liquidity trap will find itself incapable of conducting monetary policy operations as further lowering of nominal interest rates when they are already near the zero-lower bound is not possible. Getting out of a liquidity trap involves managing inflationary expectations in an economy, which can be difficult as the Japanese case would suggest, which kept its policy rates close to zero for most of 1990s, trying to break from a liquidity trap like condition.
Should India be worried? Several factors suggest that the Indian economy is in no immediate danger of a deflationary spiral and its negative effects. What India is going through at the present is more of disinflation rather than deflation. While deflation is defined as negative growth in prices (inflation based on WPI, though near zero, has not turned negative yet), disinflation refers to a continued fall in the rate of inflation.
Moreover, even if WPI inflation is expected to turn negative in months ahead, inflation based on Consumer Price Index (CPI) for industrial workers, the most widely tracked CPI index, was still at double digit level for the month of Jan 2009 (CPI is computed every month, as opposed to WPI, which is a weekly series) at 10.44 per cent, showing a little dip to 9.6 per cent only in February 2009. The CPI data for the month of March 2009 will be released on 30th April and before that, it is too early to say whether the dip in February 2009 will be continued. 
Source: Labour Bureau, Government of India
India is also far from the scare of a liquidity trap as the RBI has enough room to cut policy rates in order to lower borrowing cost in the economy. The repo rate (the rate at which the central bank lends) presently stands at 5 per cent and the reverse repo (the rate at which funds can be parked with the RBI) at 3.5 per cent. The cash reserve ratio stands at 5 per cent. Thus the key policy rates have still a long way to go before they hit the zero lower bound constraint where the monetary policy becomes ineffective.
Thus, the Indian economy, which is expected to grow at over 5 per cent this fiscal, is far from a deflationary spiral. What the current fall in inflation does is offer room to the RBI to further decrease key policy rates in order to lower lending rates in the economy. Such a move would not only give a monetary push to the economy but will also lay to rest any danger of a deflationary spiral in the future.
Published by: Ravi Saraogi
Glancing through Mankiw’s blog, I came across a startling fact- the US govt is expected to cumulatively borrow $9.3 trillion over the next decade. To put that into perspective, India’s GDP stands at about a trillion USD. Roughly thus, the US govt will borrow an amount equal to one India GDP every year.
US Fiscal Deficit
The Congressional Budget Office, an independent body which has a mandate to provide the congress with “objective, nonpartisan, and timely analyses to aid in economic and budgetary decisions on the wide array of programs covered by the federal budget”, also estimates that the national debt to GDP ratio in the US would exceed 82 per cent by 2019, which is double the last year’s level.
National Debt to GDP
The US fiscal deficit is expected to be $1.85 trillion in the present fiscal. The US GDP approximately stands at $14 trillion. That would put the current fiscal deficit at about 13 per cent of the GDP. The only time the US government ran a deficit as large as this was before World War II.
The situation is startling indeed. And has resulted in some very uncomfortable questions doing the rounds. The venerable US govt treasury bills, branded the ’safest asset in the world’, suddenly does not seem so safe now. The possibility of the US govt defaulting on its debt is now at least being considered if not expected.
The foreign holding of US treasuries has throw in another aspect. Look at the pie chart below-
Foreign Ownership of US Treasuries
Around 28 per cent of the outstanding US treasuries is owned by “Foreign and International” entities – read this as the central banks of countries like Japan, China and India. And the spiraling US debt has made at least one creditor nation wary of the “safe investment” branding. China, which recently surpassed Japan as US’s largest creditor (China holds $696 billion in U.S. treasury debt, more than Japan’s holdings of $578 billion. Foreign holdings of U.S. Treasury debt in the previous year stood at $3.1 trillion), expressed concerns regarding the ability of the US government in meeting it’s debt obligations. Wen Jiabo, the Chinese premier, recently said that China is “worried” about its holdings of US treasuries and wants assurances from the US that the investment is safe. “I request the U.S. to maintain its good credit, to honor its promises and to guarantee the safety of China’s assets,” Wen said at a press briefing in Beijing.
I am still finding it difficult to digest the above. Nobody questions the safety of US treasuries. Or so I believed. The situation has come to this pass that a developing nation, one-fifth the size of the US economy, is counseling the US administration to honor it’s debt obligations!! The future holds very important questions in light of the above. Is the appetite for US treasuries falling? If yes, what implications does this hold for the US government in raising finance to get it’s economy out of recession? What are the implications for the value of the dollar-the world currency? And lastly, which asset will now take the place as the “safest asset in the world”? Questions worth pondering on…
Published by Ravi Saraogi
The race for the Lok Sabha elections is heating up… Which basically means that you can treat yourselves to some awesome one liners that will make you marvel at the creativity of our politicians…. Some really nice ones have started filtering in.. Check them out
“Kamal ho ya Haathi, bhai behen ka sathi…. “
Amar Singh, General Secteray, Samajwadi Party, on the possibility that Advani might choose Mayawati as his Deputy if he happens to be the Prime Minister. Kamal = Lotus (BJP’s mascot), Haathi = Elephant (BSP’s mascot)
“Chadh gundon ki chathi par, mohar lagao hathi par”
Bahujan Samaj Party’s (BSP) election signature
To which, it’s principal opponent, Samajwadi Party (SP) replies,
“Gunde chadh gaye hathi par, goli lagegi chhati par”
Really nice. And to imagine this is only the beginning
From theoretical curiosity to a practical reality, liquidity trap has come to haunt the world’s largest economy with questions being raised as to whether US will also experience a “lost decade”, much like the Japanese, before things turn normal again. So while the specter of the liquidity trap is raging high, let’s try and understand what this phenomenon is all about.
With the Fed lowering the benchmark federal funds rate to nearly zero, you must have increasingly come across the term ‘liquidity trap’, describing the present economic condition in the US. In this article, we set the record straight and explain in lucid terms what liquidity trap is all about. If you really want to hear from the horse’s mouth what a liquidity trap is, then you should talk to John, (that would be John Maynard Keynes). Keynes had introduced the concept of liquidity trap in his description of the conditions prevailing in the US in the 1930s (the era of the Great Depression). Since a high tea with Keynes would not be possible, you could probably talk to some Japanese central bankers. After all, the Japanese economy has been diagnosed with a liquidity trap condition since the mid 1990s.
Japan has been a depressing yet fascinating story. Since 1990, the Japanese economy has been characterized by a secular recession. Economists of different clan, ranging from classical to Keynesians to neo classical, have studied the Japanese economy and have prescribed remedial measures, but to no avail. Lars E.O. Svensson (2003) in his paper Escaping From A Liquidity Trap And Deflation: The Foolproof Way And Others writes,
Expansive fiscal policy, with a big fiscal deficit, has not ended stagnation in Japan but has lead to huge national debt, close to 150 percent of GDP at the end of 2001 and still increasing. With regard to monetary policy, Bank of Japan lowered the interest rate to zero and kept it there from February 1999 to August 2000, and again from March 2001 until now. From March 2001, after long indecisiveness, it also attempted a so-called “quantitative easing,” a substantial expansion of the monetary base. During two years up to the spring of 2003, the monetary base was increased by about 50 percent. But these steps were not sufficient to induce a recovery.
So, what exactly is a liquidity trap? In a nutshell, liquidity trap refers to a condition when the monetary policy (policies which affect the money supply in an economy) becomes completely ineffective. Let us picture an economy suffering from stagnation in its GDP growth with deflating prices. To stimulate the economy, the central bank lowers the nominal interest rates in the economy. Lower interest rates will lead to cheaper credit, which will boost aggregate demand via increased investment demand and consumer spending. Let’s say the nominal interest rate was initially at 4 per cent which is then gradually reduced. The severe recessionary tendencies prompt the central bank in reducing the nominal interest rates all the way to zero per cent. A further reduction in the interest rates would imply a negative nominal interest rate, which violates the assumption of time preference of money, and hence is not a practical possibility. (Simply put, the nominal interest rate cannot be negative as that would mean that if you borrow Rs.100, at maturity, you would have to return back less than Rs.100, so, no sane lender will lend when interest rates are negative.) Thus, zero acts as a zero lower bound (ZLB) constraint for nominal interest rates.
If you would notice, we have used the word “nominal” to describe the interest rates. Though the nominal interest rates cannot be negative, the real rate of interest can be negative. Real interest rate is defined as,
Real Interest Rate = Nominal Interest Rate – Inflation
So if the nominal interest rate is say 5 per cent and the inflation rate is around 7 per cent, then the real interest rate will be -2. It should be noted that consumption and investment decisions are a function of the real interest rates and not nominal interest rates.
With the above base, let’s delve deeper into the world of liquidity trap. A liquidity trap situation is characterized when the nominal interest rate hits the zero lower bound constraint, and yet the real interest rate remains high. This happens when the economy is suffering from deflation which is not expected to change in the near term. Even if the nominal interest rate is held at zero, in case the price level in the economy is falling at the rate of 2 per cent, the real interest rate works out to be,
Real Interest Rate = 0 – (-2) = 2 per cent
So the catch is that it may appear that the interest rate in the economy is very low, but because of deflationary expectations in the economy, the perceived real interest rate is still high, and thus even a zero nominal interest rate may fail to stimulate aggregate demand in the economy via increased investments and consumer spending. This is why in a liquidity trap, monetary policy becomes ineffective and even a zero interest rate policy (ZIRP) is ineffective in gaining traction on the economy.
It would be interesting to note that in a liquidity trap, with very low nominal interest rates, open market operations, perhaps the most important tool for conducting monetary policy, itself breaks down. Open market operation refers to the buying and selling of government bonds by the central bank of a country. When the central bank buys government bonds in the market, it increases the money supply in the economy (as money is put into the hands of the people previously holding the bonds), and when it sells government bonds, it reduces the money supply (as people previously holding money exchange it for bonds). Now, when interest rates are zero, people would prefer to hold money (which has the added advantage of liquidity) over bonds. Thus open market operations emerge as a very important tool for changing the money supply and hence conducting monetary policy. In a liquidity trap however, the demand for money becomes infinite, i.e. money demand becomes perfectly elastic, and hence come what may, people will only prefer to hold money and not bonds. Thus the policy of trading in bonds to influence money supply breaks down.
(The discerning might question the above logic saying that even if the nominal interest rates are zero, there might still be some demand for bonds because real interest rate is strictly positive. A valid point. However, even if the real interest rates are positive, investing in bonds in a liquidity trap will entail a capital loss as going forward, because of the zero lower bound constraint, the only movement future nominal interest rates will show is up, and given the inverse relationship between bond prices and interest rates, bond prices will fall in future.)
A liquidity trap is potentially dangerous as it leads to a breakdown in the transmission mechanism. Generally, a lower signaling interest rate set by the central bank lowers the overall level of interest rate in the economy. Banks lend more on the back of increased demand for credit, both for investment purposes and for consumer spending (like home loans, car loans, etc), which leads to increased aggregate demand. This is how monetary policy works. In a liquidity trap however, the story is different. Recall that a liquidity trap occurs in a situation of recession in GDP growth and deflation, when interest rates are lowered to fight the slowdown. The depressing economic scenario in which a liquidity trap occurs is also accompanied by negative business and consumer sentiments. At such times, which is generally a fall out of some economic crisis, even if liquidity is made available, economic agents may be too risk averse to use the liquidity and may simply sit on such liquidity (i.e. hoard money). Banks may refuse to lend, either on account of increased risk aversion or on account of reduced incentive to lend as interest rates are near zero. Even if credit is supplied, with prices showing a downturn, entrepreneurs will refuse to invest in production. Even if the government increases the money supply through deficit financing (printing of money), people just sit on reserves of money and hoard it. This led Milton Friedman to suggest that a way out of a liquidity trap would be to stash money in the hands of the people and ask them to spend it. Such an approach is called ‘helicopter money’ as it brings up images of the central banker flying in the air and dropping bundles of cash at the people (see image below).
Central bankers are petrified of a liquidity trap as shooing it away requires managing expectations in an economy. If we recall the root cause of a liquidity trap, it is high real interest rates in the face of zero nominal interest rates. Lowering the real interest rate in the economy when the nominal interest rate has already hit the zero lower bound would require stoking up inflationary expectations in the economy. It is only when sufficient inflationary expectations in the economy have been generated that the perceived real interest rate will come down and the transmission mechanism will work. This is not an easy task for a central bank which has throughout its history sought to build a strong reputation for fighting inflation in order to enhance its credibility, and certainly not an easy task for ‘inflation hawks’ like the Japanese Central Bank and the Federal Reserve.
Economists have come up with different suggestions for stoking inflationary expectations in the economy, like following a price target path, commitment to inflation, increasing money supply further, currency depreciation, aggressive fiscal policy through government borrowing, etc.
However, as the Japanese case would suggest, shaping expectations in an economy is not an easy task as it would depend on the credibility of any announcement coming from the central bank. If people believe that as soon as inflation rears it ugly head and the recession tendencies wane, the accommodating monetary policy will be reversed by the central bank, then the remedial measures to escape from a liquidity trap will be ineffective. Only when the central bank declares that monetary easing will persist in the near future, even if inflation turns positive, and people believe in the declaration, will the policy be effective in defeating a liquidity trap. Declaring is easy. Making people believe is the difficult part.
In the Japanese case, the loose monetary policy directed towards generating inflationary expectations was ineffective as the exchange rate was not allowed to depreciate simultaneously (an inflationary policy should manifest itself in an exchange rate depreciation as it lowers the value of the domestic currency). A depreciating yen along with monetary easing would have given much more credibility to the policy for stoking inflationary expectations in the Japanese economy. However, the lack of depreciation in the domestic exchange rate gave away the fact that the Japanese central bank was still apprehensive of giving inflation a free hand in the economy over a medium term.
According to Paul Krugman, a central bank caught in the vortex of a liquidity trap has to have an explicit mandate to behave ‘irresponsibly’ by generating inflation in the economy. And it should take all steps necessary to prove the point that it is irresponsible. Guess it’s time to add a new chapter on the functions of a central bank…
Published by Ravi Saraogi
Reading about Warren Buffet’s biography The Snowball, by Alice Schroeder here, I came across something interesting,
“In 1940, a stockbroker from the Midwest took his ten-year-old son on a trip to New York City. They dropped in at the office of Sidney Weinberg, who was trying to restore the reputation of Goldman Sachs, the investment bank that had been disgraced during the great crash of 1929. Weinberg took the time to chat to the precocious youngster, even asking the name of his favourite stock.”
The stockbroker mentioned above was Buffet’s father Howard Buffet. The “ten year old son” obviously refers to the Sage of Omaha himself and Sidney Weinberg, was the head of Goldman between 1930 and 1969. Who would have guessed that after 68 years, the same “ten year old” will come to the rescue of Goldman by investing USD 5 billion in the erstwhile investment bank?
Published by Ravi Saraogi
Lloyd Blankfein, CEO, Goldman Sachs
One after the other they keep falling. Yet Goldman stands tall. Was it pure genius or luck. Or was it fraud? To understand why Goldman emerged unscathed (till now at least), we need to brush up on certain concepts and discuss it’s operations.
Lets start with the basics. An investment bank has two operations, the “buy side” and the “sell side”. For an excellent description of buy and sell side, make your way here. For the lazy, I will try and sum it up in a few lines.
The sell side would refer to any activity of the bank relating to market making (i.e. facilitating transaction of financial assets through activities such as research reports, buy/sell calls, acting as broker or agent, etc) or creation of financial assets (such as conducting an IPO, underwriting, engineering private placements of equity or debt, helping a company raise capital from the market, etc). So the two key words are “market making” and “creation of financial assets”. Both activities, sort of, take care of the supply side of financial securities. The research reports and buy/sell calls (which are made public), acting as a broker or agent, helps in the smooth circulation of the already available securities in the financial markets. Moreover, new securities are added to the existing pool by activities such as helping a company to raise capital by engineering an IPO, issue of corporate debt papers, underwriting, etc.
The buy side of an investment bank refers to activities it undertakes in managing other people’s money. These services are rendered to high net worth individuals, pension funds, etc. Basically, anybody who has loads of money and wants advise on how to invest it, can approach Goldman. These activities are of the nature of wealth, portfolio and risk management. The research undertaken by the buy side wing is private and is available only to the clients the investment bank services.
If you would notice, there is a problem here. Say Reliance Industries approaches Goldman and asks it to help it in raising additional capital. The sell side springs to action and helps Reliance issue some securities to raise capital. The job on hand is to ensure that all the issued securities are subscribed and Reliance is successful in raising the amount of capital it requires. Now, what better way to ensure that the securities are fully subscribed than simply directing the buy side to pour the client’s money on the Reliance securities. The sell side is salesmanship, where the primary job is to push the Reliance securities and ensure full subscription. What return these securities generate to the investors is secondary to their concern, whereas, the buy side has to ensure maximum return for it’s clients. Clearly then, the operations of the sell side and the buy side has to be kept separate to take care of the interests of the buy side clients.
So, the two activities of an investment bank is kept separate by a “chinese wall”.
The sell side wing of Goldman was a major player in issuing mortgage backed securities in the US financial markets. Mortgage lenders and banks had huge home loans that they had issued to borrowers with shaky backgrounds. To get rid of the junk on their balance sheets, they approached investment banks like Goldman, Lehman, Morgan, etc to package the loans on their balance sheets as mortgage backed securities and offload in the market. This way, the banks got their money back and investment banks earned a commission. If things stayed to this, it would not have hurt any investment bank as in the above process, the sell side activities earns the bank a huge commission and the bank themselves do not hold any toxic mortgage backed securities (these activities only makes people other than investment banks hold such securities!!!).
The issue was the buy side. Since, it was believed that housing prices never fall, independent research of the buy side suggested putting client’s money into mortgage backed securities. Even if it stayed at this, the investment banks would have escaped as they would have still earned a commission from the clients (for their advisory role that made the clients invest in mortgage backed securities!!!) while themselves not holding any exposure to the mortgage backed securities. The death knell was proprietary trading. Proprietary trading refers to a firm using its own money to invest and make profits. Investment banks started believing that investing in mortgage backed securities is such a good idea that they themselves started investing in such securities with their own money, i.e. profits of the firm. In fact, they were so gung ho about it that they borrowed also to invest in such securities. This is where they dug their own graves after digging graves for other people.
So Lehman got wiped out as a result. How did Goldman escape?
It seems that two smart traders at Goldman, Michael Swenson and Josh Birnbaum betted against the mortgage backed securities. When all the trading members in the proprietary desk were going long (i.e. buying) on mortgage backed securities, these two smart dudes convinced the top brass that the sub prime market would collapse and they should go short (take a bearish position) on mortgage backed securities. And the top brass listened. And they shorted mortgage backed securities, to such an extent that it was more than enough to compensate for the long positions that the firm held on mortgage backed securities.
Hmmmm… Really fascinating no? What on earth prompted the two smart dudes to take such a step I wonder? And they approached the top brass, since apparently, they were unable to convince their fellow traders. Hence, the short position was taken in knowledge of the two traders and the top brass, while the rest of the traders remained oblivious to it.
For a fascinating account of the above process, read here. Some excerpts for the lazy..
“The only difference between Goldman and everyone else was that Goldman had, in effect, an entirely separate enterprise, sitting on top of the firm, with the power to reverse the judgment of its own supposed experts in various markets. They were able to do this, apparently, without ever saying a word about it to their own traders. Instead of telling the fools trading subprime mortgages that they are wrong, and that they should unwind their positions, they simply offset their trades.”
The above enabled Goldman to make surprise profits of nearly $4 billion during the fiscal year ended Nov 2007, more than sufficient to overcome mortgage related losses arising out of long positions. Two issues emerge here. One, Goldman was shorting the same securities it’s supply side wing had dumped in the market. Second, while the buy side wing generously poured the money of the client on toxic mortgage backed securities, the proprietary desk was taking short positions on them on a massive scale.
So, the firm’s own money was used to short sell mortgage backed securities on the belief that their values will scoop down, while at the same time branding the securities it was short on as excellent investment opportunities to clients. The result, on it’s own investments, Goldman makes a cool 4 billion dollars while its flagship hedge fund for the clients, Global Alpha, tumbles over 35 % in the market meltdown.
But it remains unscathed and seems comfortably poised to navigate out of the sub prime mess. Genius? Luck? Fraud? You decide.
Published by Ravi Saraogi.
