Financial crisis - the ticking timebomb...

This post is an advanced version of one of my earlier post, How the Bubble burst.

What is the credit crisis?

It's a financial fiasco including:

• Sub-prime mortgages
• Collateralized debt obligations (CDO)
• Frozen credit markets
• Credit default swaps (CDS)

The credit crisis brings two groups together, Home owners and Investors. There is common place for either of these groups to suffice their respective needs - a bunch of financial institutions commonly known as Banks.

It is these banks which actually initiate the process of creating this time bomb.

How does it actually work?

1. Let's say, a family A wants to buy a house and needs some money. 

There is another group called Z who is financially well off and has stash of money which it would like to invest.

2. Now, A goes to this bank B in need of money and the bank B lends them in return of an agreement to pay EMI (equated monthly income). A is happy because he knows the house that he bought at x amount is appreciating in terms of value and doesn't mind paying the EMI. B lends mortgage to many such home owners.

3. People from group Z would like to invest their money and want to become richer so they go to bank B for deposit, but, bank B pays a very low interest rate. So, not all investors from group Z are happy. In fact, very few park their money at low interest rate in the bank B.

This is observed by another investment bank 'IB' (probably of higher magnitude) and approaches small bank B. IB buys out these mortgages from B at a very good price and B is happy as it sold off its risk at better price! 

4. IB collects many of these mortgages and bundles them in one box. This box receives EMI monthly from all these mortgages. Now, IB does financial analysis and splits this box into three parts viz, Safe, Ok and Risky. This is called, 'Collateralize debt obligations' (CDO). A CDO works like cascade with Safe block at the top, when the money flows in, it first fills in the Safe block, then in the Ok, and finally in the Risky block. This means, in case if there is some family which defaults to pay their EMI then, first it will impact the lower most i.e Risky block.

To compensate this, the bottom block has the highest rate of return and the top most block has the lowest but still better rate of return as compared to bank B.

To make the top most block more safer IB will take a small fee usually called, 'Credit Default Swap' (CDS). Usually the CDS fee is charged by the insurance firms to protect the investor. Credit rating agencies will give the rating AAA on it. Credit rating firms have nothing to lose and they get money to rate the risky CDOs as AAA.

(Credit rating AAA is considered as the safest investment area)

Thus, Group Z investors are interested in these top block of safe CDOs which pays of better than normal bank B deposits.

IB sells of the rest of the CDO blocks to other high risk taking institutions like hedge funds, etc... thus, IB sold it risks and makes millions and is obviously happy!

Everyone is happy, in fact the Z group investors are so happy with the return on their investment that they demand for more of such safe CDOs. So, IB calls up bank B and asks for more mortgages. But bank B has no new mortgage as there are no more home buyers.

Now, as we know that prices of house are ever increasing so bank B thinks, if the home owner defaults then his house can be sold as collateral. Thus, bank B starts adding risk to the mortgage like, no down payments, no income checks etc... This is called 'Sub-Prime Mortgage'.

This is where the time bomb actually starts!

The above process, from 2 to 4 repeats. unsurprisingly, few the home owners start defaulting. Which stops EMI from the home owners. So what! Bank IB sells of their houses as house prices are high and covers up the default. But slowly and gradually as more and more home owners start defaulting, a situation arises where there is more supply then demand. Obviously, the housing prices will not increase in fact they plum.

Now the family A which is still paying the EMI thinks, "why we are paying so high value of EMI for house which is not worth that much?", and even they put up the house for sell and don't want to pay EMI. 

This increases the default rates and further diminishes the value. So now the question is, IB had taken a lot of credit from other countries to make the CDO boxes which is now worthless and IB cannot afford to pay back the money it borrowed. This situation is not only with IB but also, the family A, bank B and group Z. This is known as 'Frozen Credit Market' and eventually they go bankrupt. 

...BOOOOOOOOOM!!!!!!!

Why Day Trading in Capital Markets is waste of time!

As discussed in my earlier post, How to make money in Stock Market that, it is not so easy to make money in capital markets, am sure you must be thinking, "What a loser I am!"
So, most of the investors today are trying to become rich by either "Active" Investing or Investing in "Passive" instrument.

There are two basic ways to invest your money in stocks:
1. Active
You invest your money in select stocks or in funds which try to beat the market and continually monitor and adjust your portfolio in order to get good returns.
2. Passive
You invest your money in a passive index fund or ETFs which track the index, thus incurring the minimum investing fees and just trying to achieve market returns.

Why Active Investing is a Waste of Time
To be able to consistently beat the market in terms of risk adjusted returns, you have to be either
1. A fucking genius
2. Very fucking lucky
The probability of you being a big fucking genius or at least smart enough to beat the market is very low, tending to zero. There are many very intelligent people who have tried to do it, and have failed miserably, including ME!
There is one who has done very well – Warren Buffett, and he definitely isn’t a proponent of active investing, at least not in the form that most of you practice it. Buffett swears by the power of passive investing, even though he doesn’t do it himself.
Buffett can be considered to be the most successful investor on Earth, and he has always believed in value investing and passive (indexed) investing. If he says something, I’m surely inclined to believe him. Even history shows that passive investing is the best way to invest in the long term.
Coming to the second point, the probability that you will make a good amount of money by just being lucky is also quite low. There are seven billion people in the world. Assuming that there are 10000 people who will be able to beat the market by sheer luck, the probability that you will be one of them is 1 in 700,000. The odds are just too low to even try.
Buffett is probably both – a genius and very lucky, and as you can see, there is only one of him. If you believe that you are smarter than him, or the many smart people who have tried to beat the market, and failed, you need to read this.

The only easy way to make a risk-free killing in the market is to have some informational advantage (inside information), which I assure you, that you as a normal investor, never will.
Here are some other ways to make money in the stock market.
Stop trying to beat the market by acting on ‘sure’ tips by your broker or your grandmother’s neighbor’s watchman, just because someone you know got lucky and made some money in the market, and now you feel that if that idiot could, you can too. Instead, invest in some equities or commodities index, and divert your energy to something productive, and actually create something of value. You will have a much better chance of getting rich that way.
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Note: I know that you probably think that you are the next Warren Buffett, and that you are smarter than all the idiots who couldn’t make shitloads of money in the stock market, including me, and that you are going to take a shot at it anyway. Here’s a tip: You aren’t. And don’t.

How to make money in the Stock Market

It has been quite some time now, I've been working in Capital Markets and not that I know much but, whatever I have acquired working for one of the Europe's biggest bank (refrain the name).
Here are some foolproof ways to make money in the stock market, since, obviously, investing your own money isn’t a very good option.

1. Start a Broking Firm
Get some idiot investors to buy and sell stocks daily and earn brokerage on their transactions. Convincing them that they are the next Warren Buffett or Rakesh Jhunjhunwala might help.

2. Start a Research Firm
Convince other idiot investors that you have the ‘key’ to becoming rich instantly – your valuable ‘research’ which will point them to the next multibaggers, and sell it to them. It works better if you are also their broker.

3. Start a Hedge Fund
Start a hedge fund, preferably a closed-end one. Convince people that you are the next Warren Buffett, and get them to invest in your fund. Once you have their money, invest in the riskiest securities you can find. Your bonuses are tied to the performance of your fund, and you are playing with other people’s money. Is there any better way to get rich? You have tremendous upside, limited only by the amount of risk you can take, and zero downside. Even if you fail miserably, you will still get a 2% fixed fee. If you do well, you will get the 2% fee + a 10-20% share of the profits.
Note: This will work only if you can convince other people to let you handle their money.

4. Start an Investment Bank
First of all, try to become as big as possible, by actually doing all the boring stuff that investment banks are supposed to do – IPOs, underwriting etc. When you become “too big to fail”, put all your clients’ money in the riskiest shit you can find. Start a proprietary trading division to invest your clients’ funds, and create synthetic instruments no one can understand easily. By the time they do, the world will have collapsed and the system will have to bail you out.
Even if they don’t, and your firm goes under, you still have your multi-million dollar bonuses, right?
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Disclaimer
The post above is purely based on my personal experience and understanding. It is in no way meant to offend any person or institution what so ever!

The Dumbest Idea In The World: Maximizing Shareholder Value

The real market vs the expectations market
In today’s paradoxical world of maximizing shareholder value, which Jack Welch himself has called “the dumbest idea in the world”, the situation is the reverse. CEOs and their top managers have massive incentives to focus most of their attentions on the expectations market, rather than the real job of running the company producing real products and services.

The “real market,” Martin explains, is the world in which factories are built, products are designed and produced, real products and services are bought and sold, revenues are earned, expenses are paid, and real dollars of profit show up on the bottom line. That is the world that executives control—at least to some extent.

The expectations market is the world in which shares in companies are traded between investors—in other words, the stock market. In this market, investors assess the real market activities of a company today and, on the basis of that assessment, form expectations as to how the company is likely to perform in the future. The consensus view of all investors and potential investors as to expectations of future performance shapes the stock price of the company.

“What would lead [a CEO],” asks Martin, “to do the hard, long-term work of substantially improving real-market performance when she can choose to work on simply raising expectations instead? Even if she has a performance bonus tied to real-market metrics, the size of that bonus now typically pales in comparison with the size of her stock-based incentives. Expectations are where the money is. And of course, improving real-market performance is the hardest and slowest way to increase expectations from the existing level.”

Continue reading : The Dumbest Idea In The World.

How the Bubble burst?

Just found this little anecdote which explains How a Bubble is formed and how/when it bursts. A simple explanation of the sub-prime crisis.
—
Once there was a little island country. The land of this country was the tiny island itself. The total money in circulation was 2 dollars as there were only two pieces of 1 dollar coins circulating around.
1) There were 3 citizens living on this island country. A owned the land. B and C each owned 1 dollar.

2) B decided to purchase the land from A for 1 dollar. So, now A and C own 1 dollar each while B owned a piece of land that is worth 1 dollar.
Thus,
- the net asset of the country now = 3 dollars.

3) Now C thought that since there is only one piece of land in the country, and land is non producible asset, its value must definitely go up. So, he borrowed 1 dollar from A, and together with his own 1 dollar, he bought the land from B for 2 dollars.
- A has a loan to C of 1 dollar, so his net asset is 1 dollar.
- B sold his land and got 2 dollars, so his net asset is 2 dollars.
- C owned the piece of land worth 2 dollars but with his 1 dollar debt to A, his net residual asset is 1 dollar.
- Thus, the net asset of the country now = 4 dollars.

4) A saw that the land he once owned has risen in value. He regretted having sold it. Luckily, he has a 1 dollar loan to C. He then borrowed 2 dollars from B and acquired the land back from C for 3 dollars. The payment is by 2 dollars cash (which he borrowed) and cancellation of the 1 dollar loan to C. As a result, A now owned a piece of land that is worth 3 dollars. But since he owed B 2 dollars, his net asset is 1 dollar.
- B loaned 2 dollars to A. So his net asset is 2 dollars.
- C now has the 2 coins. His net asset is also 2 dollars.
- Thus the net asset of the country now = 5 dollars. A bubble is building up!

5) B saw that the value of land kept rising. He also wanted to own the land. So he bought the land from A for 4 dollars. The payment is by borrowing 2 dollars from C, and cancellation of his 2 dollars loan to A.
- As a result, A has got his debt cleared and he got the 2 coins. His net asset is 2 dollars.
- B owned a piece of land that is worth 4 dollars, but since he has a debt of 2 dollars with C, his net Asset is 2 dollars.
- C loaned 2 dollars to B, so his net asset is 2 dollars.
- Thus the net asset of the country now = 6 dollars; even though, the country has only one piece of land and 2 Dollars in circulation!

6) Everybody has made money and everybody felt happy and prosperous.

7) One day an evil wind blew, and an evil thought came to C’s mind. “Hey, what if the land price stop going up, how could B repay my loan. There is only 2 dollars in circulation, and, I think after all the land that B owns is worth at most only 1 dollar, and no more.”

8) A also thought the same way.

9) Nobody wanted to buy land anymore.
- So, in the end, A owns the 2 dollar coins, his net asset is 2 dollars.
- B owed C 2 dollars and the land he owned which he thought worth 4 dollars is now 1 dollar. So his net asset is only 1 dollar.
- C has a loan of 2 dollars to B. But it is a bad debt. Although his net asset is still 2 dollars, his heart is palpitating.
- Thus the net asset of the country = 3 dollars again.

10) So, who has stolen the 3 dollars from the country? Of course, before the bubble burst B thought his land was worth 4 dollars. Actually, right before the collapse, the net asset of the country was 6 dollars on paper. B’s net asset is still 2 dollars, his heart is palpitating.

11) B had no choice but to declare bankruptcy. C as to relinquish his 2 dollars bad debt to B, but in return he acquired the land which is worth 1 dollar now.
- A owns the 2 coins; his net asset is 2 dollars.
- B is bankrupt; his net asset is 0 dollar. (He lost everything)
- C got no choice but end up with a land worth only 1 dollar
- The net asset of the country is again = 3 dollars.

The story ends now, but —
There has been a redistribution of wealth.
A is the winner, B is the loser, C is lucky that he is spared.
A few points worth noting -
(1) When a bubble is building up, the debt of individuals to one another in a country is also building up.
(2) This story of the island is a closed system whereby there is no other country and hence no foreign debt. The worth of the asset can only be calculated using the island’s own currency. Hence, there is no net loss.
(3) An over-damped system is assumed when the bubble burst, meaning the land’s value did not go down to below 1 dollar.
(4) When the bubble burst, the fellow with cash is the winner. The fellows having the land or extending loan to others are the losers. The asset could shrink or in worst case, they go bankrupt.
(5) If there is another citizen D either holding a dollar or another piece of land but refrains from taking part in the game, he will neither win nor lose. But he will see the value of his money or land goes up and down like a see saw.
(6) When the bubble was in the growing phase, everybody made money.
(7) If you are smart and know that you are living in a growing bubble, it is worthwhile to borrow money (like A) and take part in the game. But you must know when you should change everything back to cash.
(8) As in the case of land, the above phenomenon applies to stocks as well.
(9) The actual worth of land or stocks depends largely on psychology (or speculation).

If you are still reading this then probably your would be further interested in reading what and how the real burst happened. Here is the advanced version of it.

How to apply for IPOs using ASBA (in India)

Few days ago I had applied for L&T Finance Holding and I came across a new concept ASBA.

What is ASBA?
ASBA (Applications Supported by Blocked Amount) is a new payment method using which you can apply for IPOs (Initial Public Offerings). It is available only for retail investors and is supported only by certain banks. Using ASBA, you can apply or subscribe to any IPO easily without paying any money upfront.

Which Banks offer ASBA?
Only Banks certified by SEBI, Self Certified Syndicate Banks (SCSBs), can offer the ASBA facility to their customers. There are now 53 such banks which offer this facility in India.
List of Banks offering ASBA in India

How does ASBA work?
ASBA (Applications Supported by Blocked Amount) allows you to apply for IPOs without paying any money upfront. Your money is just blocked by the bank until the IPO book building process is over and the share allotment is done (you cannot withdraw it until then). After that, the money is deducted from your account based on how many shares have been allotted to you. The remaining amount is unblocked immediately.
This is much better than the traditional way of applying for IPOs. You don’t need to send a cheque for applying to the IPO or wait for a refund when the allotment is over. You also keep receiving interest on the blocked amount under ASBA.


How to use ASBA for Applying to IPOs
1. If your bank is in the list of banks supporting ASBA (SCSBs), you just need to go to your bank’s website and register your CDSL or NSDL demat account under the ASBA facility by entering your account details.
2. You can then view a list of open IPOs and FPOs and submit your bids for it using ASBA. If your bids are valid, the bank will give you an acknowledgement number and your application is complete.
3. When the book building process is over, the shares allotted to you will be deposited to your demat account and the balance amount will be unblocked in your bank account.
More details about ASBA on BSE and NSE