Tuesday, February 3, 2009

Explanation/Prediction of the Financial Crisis

Amitabh (Vijay Gupta) in his first meeting with Sanjeev Kumar says "Main Paanch Lakh Ka Sauda Karne Aaya Hoon Aur Meri Jeb Mein Paanch Phooti Kaudi Nahin Hain".

Now fast forward to the early 2000's to a hypothetical US homebuyer (say VJ Gutkowski) in say Las Vegas --- "I have come to buy this Five Hundred Thousand $ House, and I have No Down Payment."

Sanjeev Kumar (a builder of homes and owner of Raj Constructions) agrees to sell the plot to Amitabh. Upon hearing that Amitabh is going build a colony of houses on that plot, a financiar Prem Chopra agrees to lend five lakh rupees.

In the USA, Sanjeev Kumar and his company would be any homebuilding company; and Prem Chopra could be a well known investment bank. VJ Gutkowski was categorized as SUBPRIME, and probably held an adjustable rate mortgage (ARM). His reasoning was "House prices are rising and I will probably sell this house before the ARM resets to a higher rate.". The investment bank took his mortgage and other similar mortgages and securitized them, i.e. created mortgage-backed securities (MBS) and collateralized debt obligations (CDO).

Amitabh creates his own construction company (Shanti Constructions), and begins competing against Sanjeev Kumar. Both attempt to purchase more land to build more houses, and end up bidding against each other at a land auction. The net result is an inflation in land prices, with Amitabh outbidding Sanjeev and wildly overpaying. Revenge is Amitabh's reason for doing so, he was born out-of-wedlock and Sanjeev is his father.

Spurred by the low interest rate policy favored by the US Federal Reserve (US Central Bank) many people (PRIME as well as SUBPRIME) rush to buy homes. Since MBS & CDO's diversify risk and increase profitability, Investment banks make home lending a priority. This causes land and home prices to inflate, leading VJ Gutkowski and other Americans buy more houses. Note that the initial impetus to the housing bubble may have been different (Trishul-Revenge Vs. USA-Low-Interest-Rates-MBS-CDO's); but the effects are similar.

The Indian Govt. creates a scheme to promote affordable housing, and both Amitabh and Sanjeev tender bids. Using underhanded means (gets the senior Govt. official to believe that Amitabh is trying to bribe him), Sanjeev Kumar wins the bid. An incensed Amitabh purchases all the available adjacent land and advertises his intent to build sell and better houses at half the price. This naturally leads to a collapse in housing prices, and brings a lot of trouble for Raj Constructions. Suppliers start demanding immediate payment and investors/bankers are loath to lend any further money. Sanjeev Kumar has to mortgage his home and office in order to borrow money to keep his business afloat.

What the Federal Reserve gives, the Federal Reserve taketh away. From 2004 to 2006, the Fed hiked the Fed Funds rate from 2.0 to 5.25; thereby effectively pricking the US housing bubble. Homebuyers saw their house prices collapse and simultaneously their ARM's adjusted to a higher rate of interest. Many subprime homeowners defaulted on their mortgages, and this lead to an increase in losses on the underlying MBS & CDO's. To prevent further losses, Banks began to tighten lending standards.

Sanjeev Kumar enlists the help of Prem Chopra to try and prevent Amitabh's colony from being built. Prem also controls cement distribution, and refuses to supply Amitabh. An enraged Amitabh informs the police who promptly sieze Prem's assets. Prem and Sanjeev gang up and plot to kill Amitabh. Meanwhile, Amitabh has purchased all of Sanjeev's mortgages and IOU's; and in a grand gesture returns them back to Sanjeev. After the obligatory fight scenes, the movie ends with Sanjeev sacrificing his life, and Shanti & Raj Constructions merging to creating Shanti-Raj Constructions.

Remember that Prem Chopra in the US is an investment bank, and one that is deeply affected by the housing/MBS/CDO collapse. This investment bank declares bankruptcy, leading to a severe credit crunch. Again different reasons for the discontinuation of Prem Chopra/Investment Bank; but again the effects are similar --- credit crunch.

A reader may well insist that no such credit crunch happened in the movie, if anything in the movie "All's well that ends well". But did all really end well ? Note that the two merged companies still owned a surplus of houses that were rapidly depreciating. Also, Amitabh must have had to go into debt to be able to buy all of Sanjeev's debt (note that in a distressed environment even his assets must have collapsed.). Add to this fact that one major financier had disappeared and others will unwilling to lend --- has to result in a credit crunch.

OK, OK, OK; this economic stuff may finally be too much for some people --- peace.
Trishul happens to be one of my favorite Amitabh Bachchan movies. I apologize for taking some liberties in this review, my intentions were to try and explain the circumstances leading to the current financial crisis. Both Amitabh and Sanjeev deliver powerful performances, and are ably supported by Shashi Kapoor, Hema Malini & Rakhee.

On a more serious note, to better understand some of the issues and some possible solutions; I recommend the following books/sites.

1) Structured Finance & Collateralized Debt Obligations - Janet M. Tavakoli.
2) Monetary History of the United States - Milton Friedman & Anna Schwartz
3) Essay in the Great Depression - Ben Bernanke
4) Writings and Commentary of NYU Prof. Nouriel Roubini (www.rgemonitor.com).

Some definitions
SUBPRIME - Persons with an irregular or incomplete salary history, probably had a bankruptcy in the past. (FICO score < 620)

ARM - A mortgage whose interest rate changes at pre-defined points in time. The new rate is a fixed spread added to well-known rate such as LIBOR.

MBS - A bond that pays interest and principal from the monthly mortgage payments of the underlying pool of mortgages.

CDO - A derivative instrument that uses MBS and other securities.