Financial crisis of 2008 in a nutshell

I recently had the pleasure of reading two good novels by Michael Lewis - 'Liar's Poker' and 'The Big Short'. Both are engaging and a far cry from the usual insipid narrating style of usual financial works. Taken together, they offer tremendous insight into capitalism as practiced on Wall Street.

The blame can be put on three key players: 
1. Alan Greenspan, then Chairman of the US Federal Reserve
2. Rating agencies like Standard and Poor's and Moody's
3. Greed of Wall Street

Alan Greenspan kept interest rates very low after 2001. Two things happened due to this: a) this allowed borrowers to borrow more. b) people with money looking to make good returns give it to Wall Street banks which converted housing mortgages into bonds. Everyone thought that the price of a house never goes down. The bonds would fetch an interest more than what the investors would get if they deposited money in US banks. Rating agencies blessed these bonds with highest ratings (AAA) and the Wall Street banks were thus able to sell them to interested buyers.

Wall Street symbolizes 2 things: greed and smartness.  Traders, bond salesmen, etc. quickly figured out that this can be turned into a money minting machine. So, they devised a system where housing mortgages will be given to even most undeserving (with no real job, no capacity to repay the mortgage, no down payment, lowered interest payment for first 2 years) people. Effectively, people were told to lie in the documents and they got the loan. This way, migrants from other countries working daily wage jobs also got housing loans.

The ratings agencies looked at average FICO (credit) scores and not the individual FICO scores of each person taking the mortgage. So, all that needed to be done was to stuff a bond with mortgages of people with substandard FICO score and put mortgages of some individuals with high FICO score. The only challenge was finding some people with high FICO scores. This was solved by taking advantage of the fact that people with a short credit history or no credit history tend to have high such scores. That's how a migrant also got mortgage. Such a mortgage is basically subprime (below prime). The crisis which it brought is famously known as Subprime Mortgage Crisis or the Financial Crisis of 2008.

Once the ratings agencies stamped AAA rating on such pool of mortgages (a bond), the Wall Street banks sold it to institutional investors, pension funds, university endowment funds, insurance companies (AIG FI) etc. The ratings agencies were in competition with each other and were paid fees by Wall Street banks for the process of ratings. They didn't want to say no to Wall Street as banks would have taken their business to competitive rival firms. It was basically a job done shabbily with utter disregard to the responsibility bestowed upon them.

Wall Street didn't stop there. They collected the most useless tranches (it's like picking the lowest floor from a building where the bond quality deteriorates as you go from top to bottom) from various such rated bonds and created a CDO (Collateralized Debt Obligation). Wall Street is notorious in giving incomprehensible names to products. It has nothing to do with complexity. They just want that common public should believe that they do some magical work by giving their products such esoteric names. To draw an analogy, a CDO is basically all bad apples from dozen different crates put together to create a new crate of apples. Then they got good ratings for this CDO too (like 80 percent AAA rated). AIG FI was a sucker for these bonds and CDOs. Some wall street banks also bought them. They even created a synthetic CDO!

Mike Burry (played by Christian Bale in the movie - The Big Short), a loner with Asperger's and a hedge fund manager, first predicted the crisis by betting against the subprime mortgage bonds. He secured CDS (Credit Default Swaps) from Wall Street Banks. A CDS is simply a bet that bond price of mortgage bonds will crash and in the event of this happening, the bank would pay the insurance securer (Mike Burry) the equivalent amount of the value of such bonds. If the reverse happened (that is, the bond prices didn't crash), Burry would pay fee in installments to the same bank.

He correctly predicted that after 2 years the teaser rate (lower rate of interest initially given to borrowers) would expire and the higher floating rate would kick in. This would happen around 2007 and then the number of defaulters would dramatically increase. This would erode the quality of the bonds, CDOs, and Synthetic CDOs as the underlying asset (the houses) drop in value. This is exactly what happened.

Prominent Wall Street banks like Lehman Brothers and Bear and Stearns collapsed in 2008. Other banks like Goldman Sachs, etc. survived when the US government decided to bail them out with taxpayer money to prevent global meltdown of financial institutions. It also bailed out AIG FI with $85 billion dollars.

There's a brilliant 11 minute video on youtube which is pretty explanatory:
https://www.youtube.com/watch?v=N9YLta5Tr2A

जो बीत गई सो बात गई

जो बीत गई सो बात गई।

जीवन में एक सितारा था,
माना वह बेहद प्यारा था,
वह टूट गया तो टूट गया,
अम्बर के आनन को देखो,
कितने इसके तारे टूटे,
कितने इसके प्यारे छूटे,
जो छूट गए फिर कहाँ मिले,
पर बोलो टूटे तारों पर,
कब अम्बर शोक मनाता है।
जो बीत गई सो बात गई।

जीवन में वह था एक कुसुम,
थे उसपर नित्य निछावर तुम,
वह सूख गया तो सूख गया,
मधुवन की छाती को देखो,
सूखी इसकी कितनी कलियाँ,
मुरझाई कितनी वल्लरियाँ,
जो सूख गयीं फिर कहाँ खिलीं,
पर बोलो सूखे फूलों पर,
कब मधुवन शोर मचाता है।
जो बीत गई सो बात गई।

जीवन में मधु का प्याला था,
तुमने तन मन दे डाला था,
वह फूट गया तो फूट गया,
मदिरालय का आँगन देखो,
कितने प्याले हिल जाते हैं,
गिर मिटटी में मिल जाते हैं,
जो गिरते हैं कब उठते हैं,
पर बोलो फूटे प्यालों पर,
कब मदिरालय पछताता है।
जो बीत गई सो बात गई।

मृदु मिटटी के बने हुए हैं,
मधु घट फूटा ही करते हैं,
लघु जीवन लेकर आये हैं,
प्याले टूटा ही करते हैं,
फिर भी मदिरालय के अन्दर,
मधु के घट हैं, मधु-प्याले हैं,
जो मदिरा के मतवाले हैं,
वो मधु लूटा ही करते हैं,
वो कच्चा पीने वाला है,
जिसकी ममता घट-प्यालों पर,
जो सच्चे मधु का जला हुआ,
कब रोता है चिल्लाता है।
जो बीत गई सो बात गई।

(डॉ हरिवंश रॉय बच्चन)

Secret of Success

It was a beautiful morning. The students were waiting for the Physics lecture to begin. After five minutes, the professor entered without his usual paraphernalia. Instead he brought with him a glass jar, some sand, some pebbles (big ones and small ones as well), a cup and some tea in a thermos flask. The students were bewildered at this strange assortment of goods. They animatedly chatted and wondered what the professor was going to deliver to them.

Finally, the professor spoke.

"Friends, I didn't feel like teaching the subject today. Instead I would wish you to explain me the reason for bringing these things."

He filled the jar by putting some sand and then small pebbles and then the big ones. No space was left for some of the big ones.

Then, again he emptied the jar. And this time he filled the large pebbles first, then the small ones and finally some sand. This time the contents fitted in easily.

"Does this make any sense?", he asked. He listened to students and encouraged them to give their viewpoint. He got many interesting explanations. Towards the end of the lecture, he explained to them the reason for this strange assortment:

"The whole task of filling in the contents represents the way of living life. The large pebbles represent the top priority jobs like your dreams, goals and long term success plans. The smaller ones represent jobs second in order of importance. And the sand represents the peripheral jobs. Peripheral jobs may mean the routine mundane tasks and other trivial things."

He further added, "So, we should perform the large pebble jobs (top priority ones) followed by small pebble ones and then the trivial jobs will automatically follow without much stress. However, if we follow the reverse procedure and invest too much time, money and energy on trivial jobs then at some point in our lives we are sure to realize that we wasted ourselves and didn't leave time for important jobs."

"Then what does the cup represent?", asked a student.

At this, the professor poured some tea from the thermos flask into the cup and then poured the contents of the cup into the already filled jar. The tea quickly seeped in without overflowing.

"However busy we might be with our lives, we must always have a few minutes to share a cup of tea with our friends", replied the professor.

If (Rudyard Kipling)

The poem which I like the most:

If you can keep your head when all about you
Are losing theirs and blaming it on you,
If you can trust yourself when all men doubt you
But make allowance for their doubting too,
If you can wait and not be tired by waiting,
Or being lied about, don't deal in lies,
Or being hated, don't give way to hating,
And yet don't look too good, nor talk too wise:

If you can dream--and not make dreams your master,
If you can think--and not make thoughts your aim;
If you can meet with Triumph and Disaster
And treat those two impostors just the same;
If you can bear to hear the truth you've spoken
Twisted by knaves to make a trap for fools,
Or watch the things you gave your life to, broken,
And stoop and build 'em up with worn-out tools:

If you can make one heap of all your winnings
And risk it all on one turn of pitch-and-toss,
And lose, and start again at your beginnings
And never breath a word about your loss;
If you can force your heart and nerve and sinew
To serve your turn long after they are gone,
And so hold on when there is nothing in you
Except the Will which says to them: "Hold on!"

If you can talk with crowds and keep your virtue,
Or walk with kings--nor lose the common touch,
If neither foes nor loving friends can hurt you;
If all men count with you, but none too much,
If you can fill the unforgiving minute
With sixty seconds' worth of distance run,
Yours is the Earth and everything that's in it,
And--which is more--you'll be a Man, my son!


(Rudyard Kipling)