Collateralized Debt Obligation (CDO)

Today I was watching the questioning of Credit rating agency chiefs by the Congress members. They had to justify on why the rating calls could not pick up bad instruments much before the system collapsed. All I heard was diplomatic answers to the questions from the members of the congress. None of the answers would conclusively result in solutions to avoid such events in future.

While hearing all of this, there is one more instrument, which is Collateralized debt obligation (CDO) which could result in the ripple effect from the failure of a Credit Default Swap (CDS). A CDO is an instrument where debt of firms is clubbed together. What makes this instrument sweeter is the was in which they are packaged; the debt of 100 or more companies is clubbed together such that the companies with a higher default risk are compensated by companies with lower ones. This results in higher credit rating eventually. Wachovia tells Bloomberg that $254 billion worth of CDOs have defaulted so far. Today in the questioning the President of the credit rating agency division in Standard & Poor’s, who joined the firm in September last year told the Congress people that on an average the model of rating of instruments was revised as many as 2.5 times in a year. One could very well infer here that the experts could have caught the bad debt and the resulting systemic collapse well before, as the model would have evolved with respect to changing (deteriorating) economic conditions. Even though these instruments can be very complex in nature, hence difficult to rate; definitely it should not be used as an excuse by people who make a living off rating these instruments. Now a buyer of these instruments has no direct exposure to the underlying debt / loan instruments but relies solely on the ratings assigned to the CDO as a whole and would fail to correctly access his risk exposure.

The banks in Iceland too have been reported to have heavy exposure to the CDOs and it’s sad to see reports such as an entire country going bankrupt. As reported in Bloomberg, Barclays Capital estimates that 70 percent of synthetic CDOs sold swaps on Lehman. So it is not hard to understand what kind of mess Lehman was in. As selling the CDO is relatively simpler due to nature in which they are packaged, the seller normally an investment bank would make a commission. On the other hand it allows firms to pool their debt and hide away their losses. What makes this instrument more prone to failure is the mark-to-market accounting basis. The domino effect would come now as the CDOs have part exposure to fixed income products in the form of a Credit Default Swap (CDS). The the CDS mess has already become like a folklore and will be used as case studies in times to come.

The Nerd is Cool

I feel like I am sitting in the cockpit of a F-16, the jet engines roaring, the adrenaline gushing and the crazy G-Forces, only thing it seems like a tailspin. What a time to be in the US; you get a box seat view of the events, the feeling is of your team losing. Let’s be practical, everyone is in a fix so how do we rectify it?

For starters there has already been a lot of financial slicing and dicing the financial mess on the Wall St and the Main St and I am no expert on taking full stock of the situation. As I write this there is a $675 billion bailout happening in Germany. Repeatedly, Warren Buffet has reinstated his stock buying ideology – When there greed it’s time to panic and when there is panic it’s time to be greedy and buy stocks. But I am sure not many people are willing to tread the waters in times like this. But let’s not focus on that now.

Had you been conservative and thoughtful of the long term, would you have been in panic. It pays to follow investment strategies of successful investors in the long term and read great books. Like one of the most amusing story I read about – When Warren Buffet’s father took him to meet the CEO of Goldman Sachs when he was 10 years old and then the Sage of Omaha himself coming out for the rescue of Goldman Sachs with $5 billion. Fascinating. What should we all learn from this? Patience, that’s what matters. Your thoughts and actions on your investing habits will pay off rich dividends when you will make value buys with a really long term horizon. Buffet says – when we buy a stock, think of that as if you were buying a business. Such that your whole life depends upon it. Not only you will tend to make a better informed decision but thoroughly research it before buying it.

Here are My 2 dimes in these rough times.

1. Spend conservatively. Don’t spend on things that won’t put you in a more comfortable position than you are already in.
2. Analyze more. See how many assets you have. By assets I mean what is earning you money.
3. Prioritize what matters. Think of the final goal and not just the journey.
4. Learn about your risk appetite and strike a balance between that and being risk averse.

Be more productive …

The next time you have trouble reading The Wall Street Journal on the crowded New York subway, here is a quick tip. The folks at Real Simple have put together a simple tip with screenshots to make your ride on the Lexington Ave Express to Wall Street more productive. Do check out other handy tips on the site.

This kind of reading has already turned into an art form on the crowded Mumbai locals.

How ya doin’

To start with, apologies for my prolonged absence here. I have had the opportunity in the last couple of months to see the financial and energy crisis unfold from the Big Apple. Here in the US, people are very polite and friendly to each other – asking How ya doin? To anyone who catches your eye. Usually the answer happens to be - I am fine.

There have been 2 long weekends in the US past me now, Memorial Day and the other American Independence Day. The gas prices here have risen by more than 30% since I landed. So there were fewer cars planning long trips on these weekends. Oil prices have already started their round of Beijing Olympics, smashing one record after the other. The prices at the supermarket too have been rising, with a woman balking at how much a bunch of asparagus costs. Since start of this year, around 500,000 people have lost their jobs in the US. Some of the companies are rethinking their strategies of manufacturing in China, as the cost of shipping goods to US offsets the cost advantage. It’s pretty much the downward slide which has been ongoing.

So what’s the real deal? People here are taking a more pragmatic approach towards things instead of believing in blind pessimism. They are just avoiding what hurts the most. Like the gas prices. Instead they just choose to stay back and go for dinners with their families at closer locations. It helps to look around for pockets of opportunity, like today Warren Buffet is financing a deal for Dow Chemicals, even though he has long concluded that US is in recession. Job data today, shows there has been a biggest drop in claims in over 3 years. The economic stimulus package seems to have worked for the retailers. So there are indeed reasons for hope. The Presidential elections are around the corner and people are hoping that things will turn around for the good.

So where are we headed. As for the oil scenario, which is the cause for bad sentiment all around, will only get worse with speculation due to winter approaching in the US. The financial crisis seems to worsen day by day – the latest being government bailouts feared for Fannie Mae and Freddie Mac. It’s a period of incertitude and hoping for the best.

So the real answer to the question above is – Not so good.

PS: Recession or otherwise some people can still afford to pay $2.1 million for a lunch with Warren Buffet at Smith & Wollensky.

US Home Loans vs. Indian Home Loans

Swaminathan S Anklesaria Aiyar in The Sunday Times has written a great article by reasoning why a Subprime mess is not likely to take place in India. Is this definitely an eye opener.

Read the article here.

Also, I feel he’s a great writer and some of his earlier articles are also gems. So please find the list of other articles here.

Here’s a small excerpt.

A housing boom-and-bust has engulfed the US financial sector in crisis. India, too, has experienced a runaway real estate boom, which in a few areas is going bust. The share prices of real estate companies have crashed. Yet, India has no mortgage crisis or financial sector crisis.

Why not? Mainly because of the huge amount of black money in Indian real estate. This has saved the Indian financial sector in unexpected ways. Traditionally, US mortgage lenders checked the creditworthiness of borrowers, and then made the borrower pay at least 20% of the house value, loaning the remaining 80%. So, even if the price of the house dipped, it would still be higher than the bank's loan, and the borrower had an incentive to repay it.

Also if I may add, buying a house in India involves a lot of sentimental factors associated with it. The strong family ties, concept of a joint family or living with your parents also serve as a deterrent to just switching houses or walking away from one. While the amount of black (illegal) money in circulation in India is certainly not advocated it’s an interesting outlook into how the home loan market in India works.