Subprime Crisis by RdG

8/2/2019 Subprime Crisis by RdG

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Warning number 1: This is a long post, part of a multi-post series on the crisis in the financialmarkets.

Warning number 2: I never took an Economics or Finance course in my life. I will not quoteeconomists or provide citations and statistics. Not because I want to be simple and lucid. Itsbecause my knowledge of finance is extremely limited. All that follows is based on myunderstanding of the present financial situation, an understanding formed by reading the popularpress.

Warning number 3: Which means that everything I say below may be wrong. But whats wrongin that? At least, I didnt get half a million dollars bonus and an apartment in Manhattan asreward for being wrong. Right?

The backdrop

In a land far far away (the United States of America) a long long time ago, there was a greathousing boom.

Okay wait. I am getting a bit ahead of myself.

So first a little perspective.

In the US, buying a house is considered to be one of the best investments one can make. This isparticularly true because the government, as part of long standing policy, encourages people toown their own homes by allowing tax-deductions on mortgage interest payments. This means if

you took a loan to buy a house and are making monthly payments towards the mortgage as wellas toward property taxes, the government puts some of that money back into your pocket byallowing you to deduct a per centage of those expenses from your federal taxable income. Inother words, a certain portion of your house-ownership cost is written off by the governmentfrom your tax bill.

Since the US government does not consider providing any such relief to people who rent (thoughsuch people are generally worse off than home owners), the financial incentive to own a home isthat much greater.

So yes. Where were we? Yep. The housing boom. For the last few years, prices of houses were

going up and up in the US driven by ever-increasing demand. So much so that people, manymany of them in fact, started thinking like Mr. Bullah below:

Hey this house is worth $500,000. In a year it will be $600,000. So if I can sell it then, I can geta 20% return on investment.

Of course there is a small problem. Bullahs net worth, in terms of his savings, are $10,000 (2%of the houses cost). And just to make things worse, he has a bad credit history having defaultedon his credit card bills a few times. In order to make the very basic minimum down-payment forthe house (usually 20% of the cost), he needs $100,000 i.e. $90,000 more straight away.


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He goes to the bank.

Now in normal situations, the loan officer would look at Bullahs bank statement and his credithistory and show him the door telling Bullah politely (after all his name is Bullah) that he justdoes not have the equity to make such an expensive purchase.

However these are not normal times.

What happens is that on seeing Bullahs loan application, the loan manager smiles, shakesBullahs hand and provides him the loan on his down-payment. Yes the full $90,000. Plus theloan manager also provides as loan the rest of the house cost (i.e. loans him an additional$400,000) enabling Bullah to take possession of the house right away with zero-down.

So what does Bullah provide as collateral? Nothing.

The only catch is that in exchange for the high (and unreasonable) risk the bank is taking ongiving this loan , it expects a very high rate of interest from Bullah. This transaction betweenBullah and the banker (let his name be Lucky Chikna) is what is known, in common parlance, assubprime lending. Lucky Chikna is happy because he is going to get a lot of money as interestfor his investment (albeit more than a bit risky), which, in turn, is going to translate to a highercommission for him.

And Bullahhe is only too glad to get any loan.

As he tells his worried brother Chutiya: Dont worry about the high rate of interest. In a year,

we will recovered our money and quite a bit more. So no problem.

And so this came to pass that thousands of such sub-prime loans are written by greedycreditors out to make a fast buck on the high interest rates and then accepted (often many loans atonce), with glee, by equally greedy common citizens who think, based on advice given bypundits, that the housing market would be the golden goose that would keep on giving. Yearafter year.

The Federal National Mortgage Association, nicknamed Fannie Mae, and the Federal HomeMortgage Corporation, nicknamed Freddie Mac, are special private corporations that have stronggovernment ties. Fannie Mae and Freddie Mac were started by the US government so that they

may provide credit to the banks (i.e. the primary lenders who loan money to people to buyhouses). This was to enable primary lenders to provide more mortgages to common people andthus promote home ownership.

In short a Baap ka baap.

Let me explain how I think this works (the actual process is a bit more involved). Say I buy ahouse for $500,000. The total amount I have to pay back to my bank at the end of thirty years(my mortgage period) is $600,000 distributed over monthly payments. The bank however has topay the seller of the house $500,000 right away and then wait for 30 years before they have their


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full principal and interest back. In other words, the money would be stuck for that period oftime.

This is where Fannie Mae/Freddie Mac come in. They go to the bank and if they believe that thebank has followed sound lending practices, they buy the mortgage from the bank for say$520,000. Which means that the bank gets its $500,000 back immediately along with $20,000interest without having to wait for years. It has thus not only made a profit but it has recoveredits principal leaving it free to re-invest this amount into another mortgage.

Now Fannie Mae/Freddie Mac will be the party responsible for collecting on the $600,000. Sincethe mortgage was bought for $520,000, at the end of the mortgage period it will have made a$80,000 profit.

Now where did Freddie Mac/Fannie Mae get this $520,000? Why doesnt it worry about the fact

that its money will be stuck for 30 years? That is because Freddie Mac/Fannie Mae sell what areknown as mortgage-backed securities to investors.

Just like an index fund allows an investor to invest in a bouquet of companies with the spread ofcompanies reducing his risk of betting his money all on one horse, a mortgage-backed security(MBS) allows an investor to own stakes in a large number of different kinds of mortgages.

So when Freddie Mac/Fannie Mae make the $80,000 profit on its $520,000 investment, it cankeep a per centage of the $80,000 as its commission and passes on the rest as dividend to theMBS-holders i.e. all those who made an investment in that particular mortgage.

Now as is evident, higher the rates of interest are on the mortgages that form an MBS, more arethe payouts to the investors in that MBS. With financial experts betting on the housing market togrow and with the consistently high returns on such securities, the prices of MBSs appreciatedgreatly with investment banks, institutional investors like pension funds and hedge funds allrushing in for a piece of the action. And added to the fact that securities issued by FreddieMac/Fannie Mae had an implicit backing of the federal government (i.e it was expected thatthe government would cover the investment in case of financial downturns) and one canunderstand the craze for Freddie Mac/Fannie Mae MBSs.

Now were Freddie Mac/Fannie Mae head honchos well-aware of the shaky foundations of theMBSs they were peddling? You bet they were. But then why should Bullah and Lucky Chikna

be the only greedy ones when Lambu Atta , the big boss of Freddie Mac/Fannie Mae is also inthe game? Buoyed by the high returns on MBSs, the management of Freddie Mac/Fannie Maehelped themselves to obscene bonuses and vulgar pay-increases. Of course, in the midst of all theexcesses, they conveniently forgot that their charter officially stipulated that they were to usetheir profits to buying more mortgages, increase capital flow in the housing market and thus pushdown mortgage interest rates.

Money as they say does strange things to memory.


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In the lucrative business of buying mortgages, Freddie Mac/Fannie Mae were not the onlyplayers in the town, though they were the largest. Different kind of financial institutions likeinsurance companies and even normal banks were falling over themselves in order to buy sub-

prime mortgages from the primary lenders and sell them as part of their investment products. Yesthose very loans that had been given to credit-unworthy people like Bullah who had no assets tocover the huge amounts of money they had taken out.

Something was bound to give. With a financial disaster of a war, rising national debt, fallingdollar, job losses and out of control oil prices, those people who had taken multiple mortgagesout on their $10,000 bank account no longer had the money to make the high monthly payments.

The buyers they had predicted would buy their houses at a premiumwell they were no whereto be found.

So thousands and thousands of home-owners just threw up their hands and declared bankruptcy.Houses were foreclosed and seized. People were evicted.

But then the question remained: who would buy these seized homes?

No one. Cause people had no moneya state technically called Loot gayee Laila. Banks, oncethey realized that the housing bubble had popped, had tightened their lending policies (after thehorses had all bolted) and so loans were no longer easily available. Houses stayed on the marketforever. Their prices nose-dived.

And mortgage-owners were left holding non-performing, fast deprecating assets on which they

had to pay property tax in order to keep holding onto them till a buyer could be found.

Remember that $600,000 payment Freddie Mac/Fannie Mae needed in order to pay the dividendsto the MBS holders and also take their commission, the expectation of which had forced MBSsto stratospheric levels ?

Well the news was that there was no $600,000 coming.

MBSs , once bought at high premiums, had started losing their value rapidly.

Disaster was now at the gates. For banks who had invested in mortgages themselves. For Freddie

Mac/Fannie Mae. For people who had bought MBSs. For anyone who had guaranteed amortgage or bought one. In short, ruin for most of the economy as black suit bankers sat on amountain of useless MBSs that was often not worth the piece of paper written on.

Was that all? As the line from Bombay Boys goes Abhe khatam naheen hua chutiye.

I made one gross oversimplification in my preceding narrative. (Well more than one. But bearwith me.)


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When greedy banker Lucky Chikna gave the loan to Bullah, he told him that Bullah will get theloan only if he takes out an insurance on his mortgage so that if in the (unlikely) case that Bullahcannot make good on his financial commitment, the insurance company will pay the remaining

amount on the mortgage. Bullah now has to make monthly payments for his mortgage insurance(over and above his mortgage payments) but Bullah doesnt care. Cause he has the pot of gold atthe end of the rainbow. The fact that the mortgage is insured is also good for Lucky Chikna as hehas covered his bases, should someone ask him what kind of risk mitigation steps he has taken.

Now lets consider the situation from the point of view of the insurance company. Ibu Hatela, thebig chief, suddenly gets all these house-buyers who want mortgage insurance and are ready topay a nice premium for them. Ibu thinks to himself : This is good. With the way the housingmarket is, there is not much chance of the house buyer going bankrupthe will always be able tosell his house and make a lot of money. So no chance of him defaulting. Let me keep on sellingthese insurance products.

And so he keeps selling. Because his company is well-known, the insurance-buyers never askhim Do you have assets to cover all your insurance liabilities?After all, when we buy carinsurance from Geico or Progressive, do we ever stop to ask them if they actually have themoney to pay $25,000 for damages, if I total someone elses car? No we do not.

And so insurance companies kept on making out these insurances far beyond their coveringcapacity. The premiums were like free money, insuring (as one expert opined) cars in acountry where there were no car crashes. Why just housing? Companies started insuring anykind of big loan with the guarantee of coughing up the cash should the loaner default. Just likemortgage-backed securities, these I shall pay up when you cannot instruments (technically

called credit default swaps) were being bought and sold on the market at high premiums andcompanies who were dealing in them were raking in the profits.

What that meant was Ibu Hatela would sell the rights to collect premium from Bullah to anotherguy, say Ballu Bakra and Mr. Bakra would in turn sell that credit default swap to someone else.The market for credit default swaps were red hot AIG, one of the biggest names in insurancehad $78 billion worth of swaps !

Again, all this was fine till the day the housing market went boom. Thousands of people began todefault on their loans. All the cars in that crash-free world had just run into each other. Theinsurance companies and the buyers of credit default swaps, needless to say, did not have the

cash to cover the claims. With the housing market going down, different other kind of businessdeals started going sour. Even more debt insurance claims were made. And the more they weremade, the deeper the owners of credit default swaps sank into the swamp.

Then of course there were the investment banksthe Bears and Sterns and the Lehmans of theworld. They had their proverbial finger in each of these superhigh yield pies be it the mortgage-backed securities or the credit default swap markets. As a result of years of high-paying lobbyinginitiatives, the investment banks had made sure that they operated under the minimum ofcontrols and oversight, freeing them to take unreasonable risks while investing.


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Initially it all went according to plan. Even better than the plan as a matter of fact. The more theyraised the stakes and the more outrageous the risks they took, more money they got.

Income forecasts were manipulated by taking into account the so-called value of the creditdefault swaps whereas in reality it was nothing but funny money that existed only in anoptimistic future, a tomorrow that would ultimately never come. And with such rosy forecastsand on the back of its great current performance, Wall Street paid out record performancebonuses across the board.

Till of course disaster struck. The MBSs sunk to junk and people started calling in the creditdefault swaps. The banks did not have enough assets to cover even a fraction of its liability.

When angry young man Amitabh Bachchan says on screen: Main paanch lakh ka sauda karneaaya hoon, aur mere jeb mein paanch phooti kaudi bhi nahin hai! (I have come to conduct a deal

for 500,000 but I do not have even 5 paise in my pocket) it sounds macho and cool. Now wheninvestment banks are shown to have followed that same principle, its quite horrifying. To put itmildly. No wonder then that investor confidence and their overall credit-worthiness suffered.

The only way for the Lehmans and the Bears and Sterns to be able to survive would have been toraise money from the market and use it to discharge their obligations. But the credit market hadfrozen up. No financial entity in Wall Street was trusting anyone else with their resources.Starved of its cash flows, an investment bank like Lehman Brothers that had survived the GreatDepression and two World Wars went belly-up. So did Bear Sterns before it was acquired.

AIG and Freddie Mac/Fannie Mae were in danger of coming to their knees but since they were

considered too critical to fail , they were given federal life-lines through infusion of tax money tokeep them afloat.

Two of the biggest banksWashington Mutual and Wachovia were not so lucky and was takenover by other corporations.

And most importantly, the High End Girlfriend Index, the true indicator of the value of WallStreet fatcats, collapsed spectacularly.

The face of the financial world had changed within a few weeks.

But the drama..that was just beginning.

With investment banks and financial institutes sitting on stockpiles of toxic mortgage-backedsecurities and credit default swaps, the same instruments that Warren Buffet had dubbedweapons of mass financial destruction (with the only point to note is that unlike the weaponsof mass distraction and Santa Claus, these really existed), lenders were as eager to loan thesepeople money as anyone would be to leave their kid alone with Michael Jackson.

Money market mutual funds are considered to be some of the more conservative (i.e. safest)investment instruments. Just as a normal index fund is a distributed investment in a bouquet of


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companies and a mortgage-backed security in a collection of mortgages, a money market mutualfund is an investment in a basket of short-term loans. It is this well of money that investmentbanks and businesses in general tap into as sources of short-term financing.

Let us assume that Shankar, the main protagonist of Gunda, runs a coolie agency in an airport.In a typical month, his assets are tied up in his various investments like the hotel in Ooty (a hillresort) he is building and advance payments for rocket-launchers that he uses to get rid of evilmen. However he still needs a steady supply of liquid cash to keep the business running payhis employees (back-up dancers) and creditors, buy fresh inventory and also to make freshinvestments (like in increasing the fleet of auto-rickshaws he owns). How does he get thismoney? By taking out short-term loans from money markets.

In brief, money markets (the markets for money) serve as the grease that keep the wheels of thefinancial world spinning.

Now however, with investor panic, this grease was drying up. And fast. On a single day inSeptember, nearly $90 billion dollars of cash flowed out of the money market. Not just moneymarket mutual funds but people were moving their money out of banks also. Now the FDIC(Federal Deposit Insurance Corporation) insures for every person $100,000 dollars of hisinvestments in every account type (single, joint) at each bank . So as long as investments werebelow that amount, there should be no reason to withdraw. So why then the obscene rush tomove money out of savings and checking accounts?

Thats because most people, because they have believed normal banks to be solid as rock, hadleft deposits in accounts that had gone way over the FDIC limit. They now realized how risky

that was in the present economic situation and had started moving their money out andredistributing it to the banks perceived to be stronger, leaving the weaker banks, already undercredit pressure, gasping for air. In addition, because no one trusted anyone any more, someinvestors were skeptical whether facing a series of massive bank failures, the FDIC would beable to make out the payment to which they were committed to in a timely manner (not muchgood being compensated for your money years later). Better to move the cash out.

This hemorrhaging of deposits from banks and money markets is what is known, in commonparlance, as a run on the bank, considered to be possibly one of the most catastrophic nationalconsequences of loss of investor confidence. While runs on the bank have historically beenassociated with a bunch of rioting people outside bank branches trying to withdraw whatever

they could before it folded, with electronic withdrawals, the run, while not so visible, was still asinsidious and as potentially damaging to not only the credit markets but also to the economicsecurity of the country.

This was serious stuff. The financial equivalent of a 9/11.

The government reacted by announcing a guarantee program for money market funds. (byextending a FDIC-like assurance of the government covering your investments for period oftime in money market instruments). That was however trying to put a band-aid on a shotgun exitwound.


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In order to stem the downturn, the federal government imposed a temporary ban on short-selling,a form of speculative bet that people place on the decline of a companys value. This wasbecause short selling is considered to be something that destabilizes the market artificially and

contributes to driving stock value even further down. ( For those who want to know what shortselling is, read the following paragraph. Else fast-forward over it, as you would over an itemsong in a Hindi movie, as the paragraph does not affect the rest of the narrative.)

[ Say Kundan is a short seller. He is convinced that Shankar's Airport Coolie (AC) business isgoing to go bust. He devices a plan to profit from his hunch. But what can he do--- he does notown any stock in Shankar's AC company. Kala Shetty however does. Kundan takes as a loanfrom Shetty 10 shares of the AC business, with the guarantee that within a week, he will giveShetty his shares back and also $100. Kundan now sells the stocks at $100 (its current value) ashare and makes $1000. A week later, due to the fact that Shankar has been sent to jail byInspector Kale and also because of the fact that Kundan has just dumped a large quantum of AC

stock (10 is considered to be a large number as per this example) on the market thus increasingsupply and creating a resultant value drop, the stock value of AC crashes to $10 a share. The slyKundan buys 10 shares of AC back, spends 10 times 10 = $100 on the transaction, gives theshares back to Kala Shetty and also $100 as promised and has now made a profit of $1000 in aweek. Which Kundan now presumably spends on bottles of Chandan which he gifts it to his girl-friend from London. ]

The root cause of investor loss of trust needed to be handled. Namely how to dispense of thebillions of dollars stuck in stinking mortgage-based securities.

Put on the ghungroo on my foot and watch the deramaaaaa. No that perhaps was not United

States Treasury Secretary (the equivalent of the finance minister) Paulson actually sung but thepoint is that his 3-page recipe to rescue the economy (with the innocuous title of Troubled AssetRelief Program) was a trigger for much drama.

According to the plan, the US government was to spend $700 billion to buy out troubledmortgages, thus providing financial institutes with much needed liquidity (i.e. real instrumentsof transaction they could use as opposed to worthless pieces of junk paper with numbers onthem) and thus restore normal flows of capital through the financial system. In other words, a by-pass surgery to make blood flow again to the heart of the economy, gasping for oxygen fromtoxic asserts blocking all the arteries.

The $700 billion, we were assured, was not going to go into a bottomless hole. Since the MBSswere backed by actual assets (houses) on some of which mortgage payments were still beingmade, the MBSs bought from the banks through the $700 billion investment would be earningmoney right away and later on when the housing market comes back to normal, the MBSs couldeven bring in revenue for the tax-payers, thus making the $700 billion payout sound less badthan it actually was. Paulson stopped short of saying that this government action would pay foritself (i.e. realize the $700 billion investment fully) as that spin of paying for itself had alreadybeen used for the Iraq war. And we know how that turned out.


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An additional provision of the bill was that this buy-out was going to be affected by the USTreasury Secretary and his staff under a process which was going to be above scrutiny by electedofficials and the courts effectively making Paulson the economic dictator of the US, free to take

whatever decisions he deems fit without any kind of oversight or threat of prosecution. In otherwords, Paulson wanted to turn the US into Dongri-La and himself into Dong with the proposedBill asserting, as clearly as possible, Uparwala wrong ho sakta hain, par Dong kabhee wrongnaheen hota (God may be wrong, but never Dong)

Greeted with guarded optimism by Wall Street, the proposed piece of legislation unleashed atidal wave of public anger at what Paulson was proposing. The Bill, (initially referred to as thebailout package and then changed to the more politically apposite rescue package) waswidely seen as the federal governments plan of diverting tax payers dollars to pay for WallStreets excesses, effectively telling Wall Street When you guys make a profit, its yours tokeep. When you make a loss, the whole nation shares the financial grief.

Public resentment against the Wall Street types, (i.e. the ones in long black coats and mufflerswith a Starbucks latte in hand earning a million in bonuses on average) perceived to havebrought about this economic cataclysm as a result of unbridled greed, was at a histoic high. Atthis time, the message of forgiveness and support for Wall Street was needless to say extremelyunpopular. The resentment against the Paulson plan was magnified when the popular press keptreminding everyone as to how the very same people had lobbied extensively (euphemism forpaid off politicians and decision-makers) for reduced government oversight under the umbrellaprinciple of free markets solve everything, were now asking for the most blatant form ofsocialistic financial interventions in order to save their asses.

A further contributory factor to the public outcry was that, thanks to their record over the pastmany years, not many in the US trusts the government to do anything other than benefit theirpaymasters (lobbyists, special interest groups).

Paraphrasing one of the greatest prophets of the modern era:

Aajkal Wall Street-giri aur netagiri eki baap ka do harami aulaad hain

(Today Wall Street and political leaders are the bastard twins of the same father)

If the deficit of trust had led to the freezing of financial markets, a similar lack of confidence was

responsible for the fact that Americans were unable to believe anything that the administrationtold them. The problem is indeed systemicthere is an undisguised animus that manyAmericans feel towards the political system , something that has been exploited by Obama withhis message of change and even to an extent by Palin with her cultivated image of a bumbling,but good-at-heart Washington outsider, reflecting the values of common middle-class Americansas opposed to those of the Columbia-Harvard business school gasbags who had run the countryto the ground.

And one could not blame the Americans for being anything but skeptical of the plan consideringthe people who were endorsing it. First of all, considering the esteem with which President Bush


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is held in by the general public as of now, his throwing his weight behind the Paulson plan was ahuge blow for it.

After the blatant lies of the weapons of mass destruction, torture and wire-tapping, themismanagement of Hurricane Katrina and the complicity in financial scandals, the presentRepublican governments ability to be even moderately truthful to the nation, manage acomplicated process and safeguard the interests of the common man (as opposed to the uppercrust of the financial world who were historically their biggest financial donors and backers) wasseriously in doubt. To put it mildly.

Lest it be assumed that the Democrats were the knights in shining armor (because of the fact thatwhile Republicans are known to represent big businesses, the Democrats are perceived as theparty of the common man), it should be said that they were as deep in the mud of public mistrustas the Republicans. It was Democrat hero, Bill Clinton who had, under pressure from Wall

Street, signed the repealing of the Glass-Steagall Act that had been instituted during the GreatDepression to prevent commercial lenders from making certain risky investments. With itsrepeal, banks were now free to trade in instruments like MBSs, thus increasing both their risks asalso their profits. Also it was President Clinton who had aggressively pressurized FannieMae/Freddie Mac to promote home-ownership among weaker economic sections by relaxingrestrictions on what kind of mortgages they were allowed to buy, a presidential directive that wasenthusiastically followed by Fannie Mae/Freddie Mac as they started guaranteeing mortgagestaken out on risky sub-prime loans. Now whether their enthusiasm about sub-primes was becauseof the social commitment of the Fannie Mae/Freddie Mac management or because of the higherrate of return that sub-primes brought in (the higher rates promising higher executive payouts) Ileave the astute reader to judge.

People with Freddie Mac/Fannie Mae links had always held influential positions inside theDemocratic party hierarchybe it the person who decided Obamas running mate to the deputyattorney-general under Bill Clinton. And the top four people who had benefited from FreddieMac/Fannie Mae campaign contributions were 1) Chris Dodd , 2) John Kerry, 3) Barack Obamaand 4) Hillary Clinton (do we see a pattern in 2, 3 and 4hint: all prospective presidents at sometime or the other). Chris Dodd you ask? Why him? We do not know but the fact that he is thechairman of the Senate Banking Committee that has jurisdiction over, among other things,public and private housing and banking and federal monetary policy, may have something todo with it. Or not.

And the final nail in the coffin of lack of public trust in the whole bail-out process. Paulson, whowas asking for dictatorial power and freedom from all oversight, was an ex CEO of GoldmanSachs. What were the chances that he would look after the interests of the common folks asopposed to those of his old friends on Wall Street? What were the chances of Mamata Banerjeeand Ratan Tata doing the funky chickendance (this explains the dance) together?

It was not just the trust factor that made the bill such a turkey. It was clear that the bill, cobbledtogether like a homework assignment, had little details of how exactly the buyout was going tobe performed. Perhaps because Paulson himself did not know. Perhaps Paulson did not want totell us. For instance, how would mortgage based securities be valued? Say the paper value of an


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MBS is $100. The actual market worth, as of today, is $2. What is the value at which if thegovernment bought it, it would benefit both the bank as well as provide the government theopportunity to make a profit later? Should the government buy it at $3? If it did, that wont really

increase the institutess liquid assets defeating the bills purpose. Should the MBS be bought at$90? The financial institutes would be ecstatic but the government would now be holding agrossly overvalued asset with no chance for profit.

Since the valuation of toxic securities was not a straight-cut thing, the question was who woulddo it? Experts from Wall Street would be paid a consultancy from the government to use theirexpert knowledge to determine a fair value ! Which means that Wall Street fatcats wouldcollect once again, from the pockets of taxpayers, while wiping the detritus of financial excretafrom their own soiled bums. Not to speak about the unacceptable conflict of interest that exists inthe whole transaction.

So if the proposed legislation was flawed, what were the alternatives? A section of conservativeand libertarian economists were opposed in principle to any kind of government intervention.They argued that banks who were weak should be allowed to go under and file for bankruptcy.The owners would be wiped out, and the debtors (to whom the bankrupt organization ownedmoney) would be free to sell the companys assets or take controlling equity in the company. Inthis way, the markets themselves would rectify the anomalies. The problem with this is that thiswhole process of self-stabilization often takes a lot of time and the existence of normal economicconditions to work out. In the present situation, a quick fix was needed and the conditions of thegeneral economy were anything but normal.

The other alternative proposed by more liberal economists was that since the basic problem was

the stoppage in the flow of liquid assets, the government should deal directly with that problemrather than try to buy deprecated assets like mortgage-backed securities. They argued that thefederal government should pump in money to the tottering institutes in exchange for shares (i.e. aportion of ownership) and options (the rights to buy stocks in the future at low prices) so that thegovernment not only has share-holder control over the organizations that took aid but also standsto benefit when they finally make profit and their value rises. As a matter of fact, this wasprecisely how the federal government had done the AIG insurance bailout because even theywere not fool-hardy to pay for toxic credit-default swaps. However this measure was opposed byWall Street (which still had more than a bit of influence) who wanted their toxic investments off-loaded but did not care to give government a role in running their business. And also opposed byconservative experts who were dead-set against the concept of government owning equity in

major financial institutions as this was nothing but nationalization-something that is, to trueblue free-marketeers, a nightmare of the proportion of having Hugo Chavez as son-in-law.

Amidst the confusion of multiple voices-some of which were saying that the US economy wasa few days away from apocalypse and some of which were saying that the magnitude of theproblem was being magnified by spin-meisters in order to bail out powerful agents in Wall Street(the same way in which the bogey of WMDs led the country into another quagmire a few yearsago)presidential politics added to the drama. And uncertainty. With the presidential elections alittle more than a month to go and both parties eager to at least postpone the economic collapse,should it happen, to at least after the elections, it was assumed that the House (the lower house of


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parliament) and the Senate (the higher house) would pass Paulsons plan after somemodifications of course.

In order to take credit for the passing of this plan, McCain suspended his campaign and jetted toWashington DC. There in a meeting with Bush and Paulson and Obama, McCain ,whose arrivalin Washington had been cheerled by Fox as the game-changing moment in the crisis, did what Ihad done many years ago in a digital logic viva. He froze, staying silent through most of themeeting. Obama took the initiative and the contest which had been effectively tied, opened upwith Obama sprinting ahead.

The final version of the bill that went to the floor of the House had gone from 3 pages to 110pages. Paulsons Dong-like powers were removed for one. Secondly, the government wouldacquire equity stakes in the firms that were being helped so as to let tax-payers get their moneyback through future profits. Thirdly, banks would work with authorities to avoid foreclosures and

give relief to people struggling to make payments (after all if the Lamboo Attas were beingbailed out, why not the Bullahs [reference last post]) Fourthly, to calm public anger, limits wereput on executive compensation in the institutes that would benefit from the bailout.

The bill was put to vote on the House. While most people expected the bill to pass, albeit by theskin of its teeth, in a surprising turn around, the Bill was defeated as House Republicans, whetherit be because they were scared of public disapproval or whether they felt they were personallynot getting anything out of the deal, engineered a sudden revolt in the ranks and the Bill fell. TheDow Jones fell over 700 points, the single largest drop in twenty years. Investors rushed tomove their money into gold and government-issued Treasury bonds. Over more than a trilliondollars in assets were wiped out in the ensuing carnage.

All however was not doom and gloom. Warren Buffet, the financial prophet of our times,announced his investment of $3 billion in troubled General Electric to follow his $5 billioninvestment in Goldman Sachs. In exchange for his investment, he would be getting stocks andoptions (i.e. equity stakes) of the two companies. The move was clearfollowing the immortalprinciple of value investment championed by his guru Benjamin Graham, Buffet was buyingequity in companies whose current market value he considered was less than their net value. Inother words, he was betting that these companies were better off than the market thought theywere and so their stock values were bound to rise.

Now would Buffets decision convince skeptics that if played right, the government too, on the

back of its equity stakes, could come up with a profit under Paulsons plan? The vote went to theHouse again. This time, the 110 page bill swelled to 400 pages. Included in it was a direction tothe president to propose a law that would ensure that financial institutes would re-imburse thetaxpayers for any losses on their investment after five years. (note the way the re-imbursment totax-payers is not mandated directly by the Act but is merely postponed for another bit oflegislationa bit of legistlation that is likely to be quietely defeated once the spotlight shiftsaway from the economy !) An important addition was the measure to raise FDIC insurance from$100,000 to $250,000 (i.e. the government will give back $250,000 of your money per accounttype per bank if your bank fails), a move that was expected to soothe the frayed nerves ofordinary investors.


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However bizarrely, along with some of the most critical legislation of modern times were taggedon items that guaranteed government spending for critical infrastructure items as childrenswooden arrows and wool research (politicians pulling the wool over peoples eyes?) and a tax

break for that thing that can restore liquidity, albeit in a very different wayPuerto Rican rum.

No I am not kidding. These were the sops that were added to the bill as incentives to Housemembers so that they can turn their votes from No to Yes. And nothing makes politicianshappier than when special interest groups that support him/her are happy. The Bill was thenpassed by the Senate and the President signed it into law.

And how does Wall Street react to the bail-out? By firms expressing their disinclination toparticipate in the bail-out because executive salaries are capped if you take help. Yep thats WallStreet !

If there is one thing that the whole fiasco teaches us (not that this lesson is anything new) is thatwhile the concept of free markets are good and that of government controls very bad, theoperation of free markets almost without any kind of oversight or control (which is whathappened on Wall Street where government restrictions were over the years subverted by lobby-driven legislation) is doomed to lead to catastrophe. This is not the first time this has happenedin the 90s unbridled capital flows caused by uncontrolled market operations (what JagdishBhagwati called gung-ho capitalism in his book In Defense of Globalization) brought downthe economy of many of the South Asian tigers. I dare say it will not be the last.

So what happens now? Experts believe that $700 billion is a ball-park figure and the actual costto fix the market would run into trillions.Will inflation run wild in the meanwhile? Will the US

sink into a severe recession? Will the economic crisis be looked upon as the historic event whichdecided the US presidential elections? Will the housing market go south for two-three moreyears?

With the massive cost-cutting measures that will be put into place at financial institutions sure toaffect IT spending straight-off (the first people who get fired at investment banks are the ITguys), will US banks abandon their unconditional love for closed-source proprietary vendors likeMicrosoft and Oracle (this love is because of the supposedly high levels of security thesecompanies provide) for so-called riskier but orders of magnitude cheaper open sourcecomputing infrastructures and will that decision bring about a re-alignment in the IT industry?

And why, oh why, does Ganga ask Shankar in Gunda: Kyon tu baraf peeta hain whiskymain daal ke?? [Why do you drink ice after pouring it in whisky?]

I wish I knew.

The Dow Jones Industrial Average (DJIA) gains 936 points on a spectacular Monday. And then,like the proverbial monkey on the oily pole, drops 733 points on Wednesday, making it thesecond worst single day drop in Wall Street history.


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The stock market has now entered a most dangerous period-a time of high price volatility. Asan investor, you say to yourselfThe market has gone the lowest it can go, equities are ascheap than they have ever been for a long time and I can start buying stocks now. And the

moment you think its safe to go into the water, the market goes into a free fall once again.Naturally, you panic even more and keep holding onto whatever investments you have. Unsureas to which direction the market will go and fearing for the worst, you start having a fire-sale ofyour holdings. Other people do the same thing. The market drops further. Then perhaps somelittle gains are made, market sentiment perks up and you again wade in. The shark howeversneaks up once again and before you know it, you are holding a bloody stump where once yourinvestment portfolio was.

Welcome to 2008. What the pundits are now saying is as close to the Great Depression as wehave ever been. The very worst of times. The last time they used the word depression was inthe context of the 1929 economic cataclysm. Markets then took decades to recover-General

Electric, one of the leading corporations of the day, took almost twenty five years to recoup itslosses in value.

Which means that if we accept the assessment that we are inside a depression (or somethingclose to it), then what we are seeing is much more severe than just a market correction, abear market or a recession.

And the most disquieting thing of all.

Evidently, as the big brains tell us, matters are even now nowhere near the worst.

The only silver lining. The big financial gurus have been proven very wrong in the past. Maybe,after a spell of irrational over-exuberance in the last few years, they are now compensating for itby being over-pessimistic. Or perhaps, by the law of a broken clock is right twice a day, theyare finally on the money.

The kind of disquiet and apprehension for the future that exists in the US today is almostunprecedented in recent memory. National debt is so high that the debt clock inNew York cityhad to be taken down as it had run out of digits ! Unemployment figures are at historic highs,consumer confidence (very critical to the economy for the Christmas shopping season) low andreal estate prices keep falling every month (Recently, a house sold on Ebay for $1.76)

People are angry. And angry people obsess about identifying the guilty party. Not that the actof identification serves any purpose other than to provide the mental satisfaction that theapportion of blame, even if it be as effective as shouting in a dark room, brings about .Theverdict is unanimous Wall Street is the culprit but since there is no single person who canbe lynched, all Americas anger has focused on the Republican administration, that is widelyperceived to have let investment banks run loose. And the man who has suffered most as a resultof this has been John McCain, who has seen his election lead being wiped out to be replacedwith a significant lag behind Obama (Gallup) on the back of the economic collapse. Soconcentrated has the tide of public opinion been against him that he was found to be pleadingwith the nation in the third presidential debate I am not George Bush.


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This post is not about who is to blame for the credit crisisI think that has been discussed in theprevious posts on the subject. However I cannot go to the main course without telling you aboutsomething that has fascinated me-in the same sense that Shibu Soren fascinates me, in the

same sense that two cockroaches making love hold me enthralled.

And that is greed. Vulgarly arrogant displays of it. The kind that brings the worlds strongesteconomy at the doorstep of collapse.

Story 1: After the Paulson plan became law, many financial institutions (who had lobbiedextensively for a government bail-out) were reported to be no longer as keen to avail of theprovisions of the plan because the politicians, in an acknowledgment of popular anger, had put aceiling on executive compensation for any institute that wished to avail of the plans benefits.Instead, these financial fatcats were preparing to go it alone, at least for now, to see if they couldsolve the problem without taking a pay-cut. And if they cant, they can always extend the

begging bowl later on. For now, lets empty out whatever we can.

Story 2: 70 of AIG executives, after (and I repeat after) they had been bailed out by thegovernment, went on a pleasure trip to an exclusive resort and spent many thousands of dollarson spa treatments and the other corporeal pleasures of the Wall Street life. If that was notoutrageous enough, what send me into fits of maniacal laughter was when I saw one of the AIGbosses on TV justifying it by saying that perhaps the executives were stressed out by recentdevelopments-of course later on the story was changed to be: this trip had been planned inadvance and surely once you tell kids about a planned excursion, it would be most unfair tocancel it.

Story 3: By the high standards of Wall Street compensation, 50 per cent of the total revenue of afinancial institution is spent on executive salary, when times are good. In the first nine monthsof 2008, when times were undisputedly bad, Merrill Lynch (now bankrupt)paid their execs 13times their total revenue as salary yes that means 1,300 per cent. So next time, one of yourWall Street friends tell you that that they earn more because of their astounding performance(and so jealous outsiders should get over it), kindly throw this figure in his/her face. And youdo have the right to be a bit arrogant here. After all, its your tax dollars thats providing thedownpayment for his Porsche.

But greed is not what this post is about. Its about trying to answer whether the crash of 2008 isreally as big as it is being made out to be or is all the hullabaloo just an extreme knee-jerk

reaction to the inevitable bad times that follow periods of high Wall Street numbers?

After all, the Depression was more than 70 years ago. The science of managing economic criseshas changed since then. Surely the same follies in 1929 that drove the US deeper into Depressionwill not be repeated. Steep declines in stock values and wiping out of investments have happenedmany times since, from single day bloodbaths like Black Monday to a period of free-fall likefrom 2000 to 2002 when the Dow Jones lost more than 50% of its value with $7.4 trillion dollarsvanishing. Some would say that after prolonged periods of increase in stock prices(`overheating) [about a year ago, on October 9 2007 the Dow Jones Index had reached itshighest ever number] such a crash is inevitable.


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In passing, isnt the state of the investor today, after the highs of 2007, somewhat like thehedonist party-goer who after a deliriously debauched night on town wakes up in a bathtub witha You have one kidney left message scribbled on the mirror in red lipstick?

As to big and perceived-to-be-solid corporations, they have failed before. Penn CentralTransportation Company, the biggest railroad in the United States, declared bankruptcy in 1970,shaking up the system and sending people into panic. This is also not the first time that majorbanks have gone bustthe 80s had quite a few major catastrophes in the banking sector.Inflation? Todays inflation in the US is still nothing compared to the early 80s.

So what is it that has changed over the years? What is it that is so special about this economicdownturn that has necessitated the biggest government intervention in modern history? Needlesspanic? Or is there something unprecedentedly wrong with the US economy?

First let us look at what has not changed. That is what has remained constant over the last 100years.

The follies of the common investor.

People still make the same mistakes while investing their money in the stock market that theirgrandfathers did years ago. After all what is the stock market except a composite measure of anations economic sentiments, reflecting both the fundamental irrationality as well as thecapriciousness of the homo sapien ? It is these emotion-driven swings between hopelessoptimism to debilitating pessimism in the blink of an eye, that has historically driven markets toheights unheard of and then brought it to the ground with earth-shaking violence.

So what are these follies, so eternal that they bind together the monocoled banker of the 30s tothe rimless framed soccer mom of the 2000s?

Error umber 1: This is the big one. And by far the most common. Whereas in every businesstransaction, people believe in buying low and selling high, when it comes to the stock market,they end up doing exactly the opposite.

How many times have you heard something on these lines: Did you hear how much moneyRajesh has made on the stock market. He used to ride a bicycle. Now he has a Bajaj scooter.Everyone is making money on the market. Lets take money out from your provident fund and

buy some shares.

I have. And this is, on the face of it, a rather persuasive argument for buying stocks. After all ifRajesh and Rukmini are making money playing stocks and riding a bicycle or buying a newfridge, why the hell should not I?

The problem is that if indeed Rajesh and Rukmini are making money off stocks and so is Riazand Rahim, then the chances are that just like you, everyone else is making a beeline to buystocks, pushing their values up way above their true worth as investments. Hence if you jumpin as soon as you hear Rajeshs scooter vroom, the chances are that you are buying high. It


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stands to cold-hearted logic that the more the market does good, the greater is the risk thattomorrow it will do bad. And once that happens, you shall be forced to sell your stock low(the same stock you bought high in the hope of buying a scooter) in order to minimize your

loss.

Smarter than that? Perhaps you are. But this error sneaks upon you, often in a very insidious,indirect way.

Consider Tandiya Bhai, who after capturing Gol Basti decides to do some investment. Havinglearnt a lesson from his old boss, Lukka who put all his money in risky investment and then lostit all (as Lukka said about his investments: the share certificates he holds are like cinema ticketsfor a show that has already taken place) Tandiya creates a portfolio where he puts 50% of hissavings of $200 i.e. $100 in a company bond (paying 5% simple interest) and the remaining $100in a high growth stock. Namely in Lucky Chiknas Latakta Circus Limited (ticker symbol:

LCLC).

A year later, based on bumper earnings of LCLC and a huge Bull(ah) market, Tandiyas $100stocks are now worth $150 netting him a 50% return on his stock investment. His $100 in thecompany bond gave him $5. Tandiyas total worth is, at the end of 1st year, $255 ($105 of hisoriginal bond investment and $150 in stock).

Note that the 1:1 balance from the previous year is now tilted in favor of stocks. In other words,Tandiyas exposure to the stock market (i.e. the chance that something bad in the stock marketwill affect him adversely) has increased because he has almost 60% of his assets in stock. As aresult, the insurance against risk (the $105 holding in the bond account) is not as strong as it was

before. This lack of insurance is even greater a problem than it appears because since themarket is now higher than the level at which it was a year ago, the chance that the stock marketswill subsequently fall and reduce the values of his investments has increased. In short, Tandiyahas a bad risk management policy in place.

And as luck would have it, the stock markets do go south. Lucky Chikna and business partnerHaseena Tantan (duplicate of Raveena Tandon) fall out publicly and this adversely affectsinvestor confidence in LCLC. Result: LCLC stock falls by 50% i.e. Tandiyas $150 in stocksnow becomes $75. So now in comparison to two years ago, his total portfolio is now down to($100 [bond principal from 1st year] + $5[ bond interest from 1st year] + $ 5[bond interest from2nd year] + $75 [new value of stock portion of his portfolio])=$185 i.e. he has lost 7.5% of his

principal in 2 years.

So how could Tandiya have done better risk management? By taking $25 (half of $50 profitfrom 1st year) out of his stock account at the end of the first year and putting it into the low-yieldbut safe savings account. If he had done that (that is maintained the 1:1 ratio between his stocksand bond account) his total portfolio would have now been: ($100 [principal from 1st year] + $5[interest from 1st year] + $25 [added principal to the bond in the 2nd year] + $6.25[interest from2nd year] + $62.50 [new value of stock portion of his portfolio]= $198.75 i.e. he would havealmost recovered his principal.


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Looking at it another way, if at the end of the 1st year, he had sold some of his stock (i.e. cashedin) when the market was high, he could have reduced his loss to a large extent. HoweverTandiya did not. He told himself The stock markets are doing so awesome. It would be a sin to

take money out of it when the going is good and did not balance his portfolio. However aspointed out, just because the market was doing well, the risk of it going down had become higherand Tandiya would have been better advised to take out a larger insurance to cover theincreased risk (technically speaking, he should have made a better hedge).

Taking away money from a stock fund when things are doing well in a smart manner, as meansof managing risk, is one of the toughest things to do. Which is why this is a folly that is made notonly by small investors and tyros but also by the big boys and the market gurus.If one looksclosely, one would see that the major losses on Wall Street sustained by the big players havecome because of similarly improper risk management strategies where the potential of higherreturns have made fund managers take more and more risk till the camel has buckled down and

rolled over under the weight of one straw too many.

Error umber 2: The Nostradamus syndrome. When you hear people saying Biotech is goingto be the future. I am putting $10,000 on Toxic Pharma, you know that they are making ErrorNumber 2.

While you may definitely get lucky and choose a winner among companies perceived to havepotential, putting an inordinate amount of your investments in so-called growth stocks (i.e.those companies that have shown healthy per share earnings in the past one or two years or aretipped to grow) has historically been extremely risky. As well as extremely popular.

It is indeed because of this popularity, that growth stocks are almost always over-valued andthat is because everyone wants to buy them. It is worth remembering that an investment, even ina company that is great or may become great, may be bad if you paid too much for it.

Also the potential for growth of a sector does not necessarily mean that their share pricesappreciate as much as expected. The classical example of this are air-transport-stocks whichwere considered to be the growth industry of choice in the early 50s. Mutual funds that investedin the airline industry (like Aeronautical Securities) have proven to be disastrous and despite thepopularity of air-travel today, the airline industry has never performed as impressively as wasbelieved.

In addition, just because a sector looks good to grow, does not mean that you will be luckyenough to separate the wheat from the chaff. For every IBM, there are hundreds of techcompanies that have been brought to their knees. Amerindo Technnology Fund, a mutual fundthat concentrated on dot coms, rose 249% in 1999however if you had invested $10,000 in it,you would have about $1,200 left at the end of 2002.[source "Intelligent Investor"]

Error umber 3: The stock tip. Whether it be your paanwala, the guy who sits in your cubicle,or the market expert on TV giving you a stock tip, people should treat such advise with morethan a healthy dose of skepticism. Not surprisingly, they do not.


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Unless the information is of the type that is not by nature publicly available (i.e. reliableinsider information from a direct trusted source), stock tips are almost always misleading. Ifthe stock tip is good (which is rarely the case), everyone knows it, and then acts upon it. This

pushes the price of the tipped security up making it not as attractive an investment as it originallywas.

In most cases however such insights into the future are misguided.

Remember that the most intelligent men of our times with great heads for figures have sufferedhumiliation in the stock market. Case in point: a certain Isaac Newton who lost a lot of moneythus.

And as to the so-called experts on TV and on the Internet, the lesser said about them the better.James Cramer, a stock evangelist and expert, who comes on CNBC and is known for his

animated sports-casterish way of analyzing markets, gave ten hot tips for the future in 2000(read them here). Most of these companies have now gone bust and according to the IntelligentInvestor, a $10,000 investment spread equally across Cramers picks would have lost 94% oftheir value by 2002, leaving the hapless investor with a total of $597.44.

Coming back to the original question. So given that people still make the same mistakes and willcontinue to do so, what is it that makes the situation so bad in 2008?

First of all, and this is perhaps because stock investments have done fairly well over the years,they are considered much less risky than they were considered to be in the 50s and into the 70s.Which is why many people in the US think nothing of putting almost their entire life savings in

the stock market.

Even more important has been the democratization of the investment landscape brought on bylow-cost online brokerages. Traditionally, investment in the stock market was an opportunityreserved for a privileged few, that is those who had a significant corpus of assets that wouldmake it economically feasible for them to hire a money manager and to shell out large brokercommissions (the money a broker takes from you as his payment for doing a stock transaction)and engage in sufficient volume of transactions that would make it worthwhile for the broker toservice the customer.

However the last decade or so has seen the proliferation of online brokerages whose low fees and

low limits on volume of transactions has removed the entry barriers to the stock market in a waythat is nothing less than revolutionary. Housewives, truck drivers, college students, grandpasare now all in the game , connected by their cellphones and laptops at all times to the market,having real-time access to market data and an always available corpus of financial knowledge,things that even a few years ago were the prerogative of the professionals.

This increased involvement of all sections of the society in the market has increased, in general,societys exposure to the vicissitudes of the stock market. Which means any slight perturbationin the markets affects peoples wealth to a far greater extent than they would two decades ago.


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This also works the other way-peoples emotions (of panic as well as of optimism and ofcourse collective follies) affect the market more significantly than they used to.

Add to it the fact that instantaneous online trades, automated trading and the availability of real-time quotes make shock waves propagate through the market faster than before, and one beginsto understand why share markets are much more volatile and exert a greater, almost instantimpact on the common man than ever before in their history.

The second reason why the crash of 2008 is different from previous collapses is that for the pastfew years, both individual investors as well as financial institutions have exposed themselves toalmost obscene levels of risk through high leverage. This means that they have not beeninvesting with just their own money but also with money borrowed from others, with thisborrowing many many times greater than their own assets.

This borrowing of money to increase your returns is called investing on margin.

And why is it so attractive?

Consider aggressive investor Inderjit Chadda, the lawyer from Damini. He has $20,000 inassets and borrows another $180,00 from a lender, promising to pay him back the principal alongwith $10,000 as interest at the end of one year. Seeing that the housing market is booming, hethen buys a $200,000 house. In a year the price of the house becomes $230,000. Chadda sells thehouse, returns the money to the bank ($180,000) and pays them the interest ($10,00) and has$40,000 left for himself. Since his initial share was $20,000 he has now obtained $20,000 asreturn on his investmentin effect doubling his money in a year.

Consider passive investor Alok Nath. He waits for many years till he himself has saved $200,000and in the process misses many opportunities for profiting from rising housing markets.Ultimately, he times his house buying at a time the housing market is going up and like Chaddamanages to sell the house for $230,000. His profit is $30,000 but on an initial investment of$200,000 making it only a 15% gain per year. Good but nothing like Chaddas returns however.Expect Chadda to do an exaggerated toss of his head,as a sign of victory, every time he seesAlok Nath

But what if Chadda made a miscalculation, like the time he dared to cross paths with SunnyDeol. What if instead, the market went down while he held the house. That is, at the end of the

year, the houses value had become $170,000. Now Chadda would still have to pay the banktheir $180,000 + $10,000= $190,000. Which means he would need to get $20,000 ($190,000 $170,000) from somewhere in order to prevent being in default of the bank. And his owninvestment of $20,000? That would have been wiped out. Chadda would now effectively havelost $40,000 in a year, $20,000 of which he himself never had.

In a similar situation, Alok Naths loss would be only down 15% i.e. he would still have 85% ofhis original investment. And he would not have to sell his kidney. At least for now.


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If you think that Chadda was being excessively cavalier in his investments, you are mistaken. At$190,000 debt for $20,000 of assets, he was well within the leverage (i.e. debt to assets) ratio of12:1, traditionally what has been considered, by US law, to be the upper limit to the amount of

leverage a bank can carry. In 2004, under pressure from the sharks at Wall Street and from theirgreasy lobbyists, the federal government entity SEC (Securities and Exchange Commission)allowed 5 investment banks to carry leverages of, hold your breath, 30 and even 40 to 1.Whichnot only opened the doors to the potential of mind-boggling returns (mind you potential) butalso unleashed the dogs of absolute financial ruin on five of the strongest pillars of the USeconomy.

And who indeed were the chosen 5?

Lehman Brothers, Bears and Sterns, Merril Lynch, Goldman Sachs and Morgan Stanley.

And we wonder why a firm like Lehman Brothers that survived a Great Depression and twoWorld Wars could not survive 2008 !

Operating under dangerously high leverage ratios is not a prerogative of the Big Boys, evenordinary investors, seduced like Inderjit Chadda, have fallen prey to it like never before. Notonly are they carrying higher risks by operating on margin (i.e. investing borrowed money),many Joe the plumbers and Jane the programmers are using the borrowed money to ventureaway from stocks into riskier, but higher pay-off financial instruments like options andfutures(which are bets placed on the price of a financial commodity in the future).

In short, ordinary investors are not only more plugged into the markets than ever before, they are

also carrying higher levels of risk. Which means that while billions will be made when the goingis good, in times like 2008, the impact of a weak market on the country is like a rifle shotthrough the brain whereas in past decades it was perhaps like a slash with a long knife on thethigh.

And finally what makes 2008 so hellish, in comparison to the past, is that the main fuel for avibrant economycorporate growth has come to a standstill in the US. The cumulative effect ofyears of steady flight of manufacturing jobs and investment capital away from the US, high oilprices that not only have led to the biggest transfer of wealth in human history but brought to itsknees many of Americas most venerable automotive corporations and the three trillion cost of aneedless war have all detrimentally affected the foundations of the market. So while money can

still be made on Wall Street through well-placed bets and the markets will go up (and down)based on trading, the fundamental supply of oxygen that keeps earnings growing, the dividendscoming and leads to overall economic prosperity have been severely constricted.

Which is perhaps the most worrying aspect of this whole affair.

Documents

Subprime Crisis by RdG