Cedric:Whats wrong with that picture?Absolutely nothing
1) Assets = Liabilities and2) Assets = Liabilities + Owner’s Equityare both exactly the same equation.In some texts 1) is written because Owner’s Equity is also defined as a ‘Liability ‘ which is from the Corporation as a Legal Entity to the investor.Cedric I don’t know how sensitive this point might be but when you buy a stock for $200 and it falls to say $100; you sell the stock and you had a loss of $100.One man’s equity loss is another’s gain.Clueless reporters mention things like ‘the market crashed 7% eroding xyz gazillions in ‘investor wealth’.A crashing equity market only means that there’s an overall movement from equity to debt instruments (debt here includes deposits with banks).If you assume a simple world where people only have stocks, bonds and checking accounts:Stocks + Bonds + Checking Accounts = Constant KNote that this reasoning applies only in this assumed simple world. As you complicate things with more and more financial instruments, you will still getTotal Equity + Total Debt = Constant KNote that Equity has a risk + return profile which comes directly from variability of business returns.Debt has a risk + return profile which comes from credit risk; and in the ultimate analysis credit risk is simply another form in which the risk of business returns is expressed, apart from the issue of simple trust.Financial engineering provides the ability to create various risk + return profiles beginning from your simple world of stocks, bonds and checking accounts.So you can have instruments which start with credit risk in a debt instrument and create an ‘equity rated’ instrument which has a higher risk + return profile.Similarly you can start with a lower risk + return profile stock and create an equity option which has a much different risk + return profile than the stock.In terms of flows, you can create instruments which provide an initial cash inflow, while exposing you to theoretically unlimited outflows, such as for example short positions in call options.No matter how much you alter the risk + return profile of instruments, your original equationTotal Equity + Total Debt = Constant KStill holds.Coming to the point of some instruments which are ‘off balance sheet’ you’re just saying that from the perspective of one entity those assets are off their balance sheet but those instruments are still reflected in another balance sheet somewhere else.
Wednesday, October 29, 2008
The Red Indians are Collecting Wood Like Crazy!!!
This is the typical structure of circular self referential loop in markets which can cause a recession or a huge boom to be expected, which later never materializes:
It was autumn, and the Red Indians on the remote reservation asked their New Chief if the winter was going to be cold or mild. Since he was a Red Indian chief in a modern society, he couldn’t tell what the weather was going to be.
Nevertheless, to be on the safe side, he replied to his Tribe that the winter was indeed going to be cold and that the members of the village should collect wood to be prepared. But also being a practical leader, after several days he got an idea. He went to the phone booth, called the National Weather Service and asked “Is the coming winter going to be cold?” “It looks like this winter is going to be quite cold indeed,” the meteorologist at the weather service responded. So the Chief went back to his people and told them to collect even more Wood.
A week later, he called the National Weather Service again. “Is it Going to be a very cold winter?” “Yes,” the man at National Weather Service again replied, “It’s definitely going to be a very cold winter. ”
The Chief again went back to his people and ordered them tocollect every scrap of wood they could find. Two weeks later, he called the National Weather Service again. “Are you absolutely sure that the winter is going to be very cold?” “Absolutely” , the man replied. “It’s going to be one of the coldest winters ever. ” “How can you be so sure?” the Chief asked. The weatherman replied, “The Red Indians are collecting wood like Crazy.”
It was autumn, and the Red Indians on the remote reservation asked their New Chief if the winter was going to be cold or mild. Since he was a Red Indian chief in a modern society, he couldn’t tell what the weather was going to be.
Nevertheless, to be on the safe side, he replied to his Tribe that the winter was indeed going to be cold and that the members of the village should collect wood to be prepared. But also being a practical leader, after several days he got an idea. He went to the phone booth, called the National Weather Service and asked “Is the coming winter going to be cold?” “It looks like this winter is going to be quite cold indeed,” the meteorologist at the weather service responded. So the Chief went back to his people and told them to collect even more Wood.
A week later, he called the National Weather Service again. “Is it Going to be a very cold winter?” “Yes,” the man at National Weather Service again replied, “It’s definitely going to be a very cold winter. ”
The Chief again went back to his people and ordered them tocollect every scrap of wood they could find. Two weeks later, he called the National Weather Service again. “Are you absolutely sure that the winter is going to be very cold?” “Absolutely” , the man replied. “It’s going to be one of the coldest winters ever. ” “How can you be so sure?” the Chief asked. The weatherman replied, “The Red Indians are collecting wood like Crazy.”
Saturday, October 18, 2008
Time to go long in US Equities, Nifty Futures, etc!
I think it's time for people to realize that most of the discussion about a long term recession etc is actually false. It's time for people to go long in equities seriously.
The reason I think this is that there seems to be a very big influence of the SWFs' strategy on market movements worldwide.
The SWFs according to the WSJ's reports this weekend, are going long in US banking stocks.
http://www.zawya.com/Story.cfm/sidZW20081018000005/WSJ(10%2F17)%20Mideast,%20China%20Return%20From%20Sidelines/
Earlier the SWFs were long in commodity futures and the rising price of oil was totally disconnected with the underlying physical demand and supply of oil.
Now that equity prices have fallen quite a lot, SWFs are going long on them. By Christmas most people would have forgotten all about the 'Return to the Great Depression' argument and the markets should be much further up by then from where they are today.
The reason I think this is that there seems to be a very big influence of the SWFs' strategy on market movements worldwide.
The SWFs according to the WSJ's reports this weekend, are going long in US banking stocks.
http://www.zawya.com/Story.cfm/sidZW20081018000005/WSJ(10%2F17)%20Mideast,%20China%20Return%20From%20Sidelines/
Earlier the SWFs were long in commodity futures and the rising price of oil was totally disconnected with the underlying physical demand and supply of oil.
Now that equity prices have fallen quite a lot, SWFs are going long on them. By Christmas most people would have forgotten all about the 'Return to the Great Depression' argument and the markets should be much further up by then from where they are today.
ICICI Bank Vs HDFC Bank
Following are some points from fundamental analysis of ICICI Bank Vs. HDFC Bank. (These are two of the largest private banks in India)
Results as of their FY 2008 Annual Reports:
As of March 31, 2008:
ICICI Bank had a market price of 1044.22 and a diulted EPS of 39.15.
HDFC Bank had a market price of 1331.25 and a diluted EPS of 46.22.
Therefore P/E ratios were at: ICICI Bank: 26.67 and HDFC Bank: 28.80.
Since then, HDFC Bank has announced results for both Q1 and Q2 FY09 whereas ICICI Bank has announced results for Q1 FY09 only. On October 27 2008 ICICI Bank will announce results for Q2 FY09.
As of October 17, 2008:
ICICI Bank had a market price of Rs. 395.00 whereas HDFC Bank had a market price of Rs. 1000.00.
P/E ratios on October 17 comparing the previous year's EPS against the current market price:
ICICI Bank: 10.09 HDFC Bank 21.93.
This analysis shows that the market value of ICICI Bank is almost only 50% of its market value as of March 31, 2008, benchmarking against HDFC Bank.
Factors:
There were rumours that ICICI has gone bankrupt and a large number were withdrawing their deposits from the bank as of the first week of October.
As of the first week of March 2008 there was controversy around the level of ICICI's losses from exposure to sub prime mortgages/ credit default swaps internationally.
Despite the above rumours, I think ICICI Bank is a very good buy at this stage for any investor who has a long term perspective.
Results as of their FY 2008 Annual Reports:
As of March 31, 2008:
ICICI Bank had a market price of 1044.22 and a diulted EPS of 39.15.
HDFC Bank had a market price of 1331.25 and a diluted EPS of 46.22.
Therefore P/E ratios were at: ICICI Bank: 26.67 and HDFC Bank: 28.80.
Since then, HDFC Bank has announced results for both Q1 and Q2 FY09 whereas ICICI Bank has announced results for Q1 FY09 only. On October 27 2008 ICICI Bank will announce results for Q2 FY09.
As of October 17, 2008:
ICICI Bank had a market price of Rs. 395.00 whereas HDFC Bank had a market price of Rs. 1000.00.
P/E ratios on October 17 comparing the previous year's EPS against the current market price:
ICICI Bank: 10.09 HDFC Bank 21.93.
This analysis shows that the market value of ICICI Bank is almost only 50% of its market value as of March 31, 2008, benchmarking against HDFC Bank.
Factors:
There were rumours that ICICI has gone bankrupt and a large number were withdrawing their deposits from the bank as of the first week of October.
As of the first week of March 2008 there was controversy around the level of ICICI's losses from exposure to sub prime mortgages/ credit default swaps internationally.
Despite the above rumours, I think ICICI Bank is a very good buy at this stage for any investor who has a long term perspective.
Friday, October 17, 2008
Further Questions
1) What if the borrower is unable to afford the payment on this mortgage after some time?
Ans: The payment on a Sixty year mortgage would probably be less than the rent for a similar home. So it's unlikely this situation will arise.
2) What if the price of homes goes down much further below the current level?
Ans:
a) This is possible though not highly probable, especially if this product is in place. If this were to happen, the monthly mortgage is still much less than the rent for a similar home and the borrower would continue to be able to afford the payment.
b) Mortgage terms can be extended further from the Sixty years proposed here.
Ans: The payment on a Sixty year mortgage would probably be less than the rent for a similar home. So it's unlikely this situation will arise.
2) What if the price of homes goes down much further below the current level?
Ans:
a) This is possible though not highly probable, especially if this product is in place. If this were to happen, the monthly mortgage is still much less than the rent for a similar home and the borrower would continue to be able to afford the payment.
b) Mortgage terms can be extended further from the Sixty years proposed here.
The Sixty Year Mortgage Solution!
Please go through this interesting proposed solution to the current global economic crisis!
This solution requires very little regulatory intervention and involves absolutely no cost to the tax payer. Yet it will ensure a rapid recovery of mortgage markets, solve the liquidity crisis and avoid a global recession.
Hopefully the product described here will actually enter the market and solve the current crisis.
Also, please post this on your very interesting blog if possible.
There are four policy objectives with respect to the U.S. mortgage crisis:
1) Ordinary people living in their own home need to be empowered to stay in their home without having to default their mortgage payment and have the bank foreclose on them.
2) The housing market needs to receive a stimulus to arrest the downward trend in home prices and avert further decline in economic growth.
3) Mortgage bankers who have either already booked losses or are likely to book more losses need to be recapitalized so that liquidity in the financial system can be ensured.
4) All of the above objectives need to be met without much of an impact on the U.S. taxpayer.
All of the above objectives can be easily met with the introduction of a new commerical financial product, largely within the bounds of the existing regulatory system; but with a couple of small innovations to the current structure of a typical mortgage product.
The new mortgage product required to solve the problem is a simple mortgage loan from any private mortgage banker or other relevant private financial institution.
Though the mortgage loan will be like any other existing mortgage loan product, there will be two modifications to the product:
1) Both the mortgage banker and the borrower will have the right to foreclose the mortgage with due notice. (While I believe this is currently the case from a legal perspective it is very rare for the mortgage banker to actually exercise their right to foreclose unless there is a default by the borrower. The new product will specifically stipulate that the mortgage banker can foreclose the loan at their option with due notice, irrespective of the borrower's payment history)
2) In case the borrower should choose to foreclose their loan, or transfer it to another party, 20% of the proceeds of the sale will accrue to the mortgage banker and only 80% of the proceeds of the sale will be received by the borrower. The same would apply in case the mortgage banker should choose to foreclose from their side.
3) The term of the mortgage loan will be 60 years instead of 30 years.
a) In the event the borrower is deceased prior to the expiry of 60 years, the home will revert to the ownership of the mortgage banker.
b) The only exception to b) above would be that the borrower will have the right to bequeath the home, provided the person receiving the home continues to make the mortgage payments as usual.
c) The borrower will not be compelled by the mortgage banker to take out life & disability insurance to the extent of the mortgage principal and assign it to the bank only as a result of this increased term. The current practice on this will be followed.
4) One important change in the product will be that the mortgage banker will have norms enabling them to lend out the higher of the following two amounts:
a) The current market value of the home (as determined by a valuation, as happends right now)
b) The pay off amount on an existing mortgage loan on the home.
I request you to carefully evaluate the impact that the introduction of this new product or a similar product will have on the U.S. mortgage market and it's beneficiary impact on the current global financial situation.
Expected Impact:
Consider a typical problem right now:
The borrower has an outstanding pay off amount of say $300,000/= on their mortgage. They are unable to afford the monthly mortgage payment and they have less equity in their home than the outstanding pay off amount. The market value of the home is only $220,000/=.
A new lender might be willing to re-finance but the existing banker has to agree to book a loss for this to happen.
In either case, the borrower is not in a good situation to afford the payment.
A new lender can now come in and offer a Sixty Years' mortgage product to this borrower. The lender is very motivated to do this because the lender will be able to
1) Charge a high interest for this product(say around 20% ... 20% is becoming a favorite number here for me :-) )
2) Benefit from a future sale of the home at a higher price. It's important to remember that according to the terms proposed here the lender has a 20% equity stake in the home.
For the borrower the benefit is that they will be able to stay in their home while making a much reduced monthly mortgage payment. In the longer term appreciation in the price of land will ensure that they will more than make up any losses from having to pay 20% of their home equity to the bank.
For the existing lender, there is absolutely no problem because they will realize the pay off amount from the new mortgage in case the market value is lower than the outstanding loan.
Questions and Answers:
1) If the mortgage term is extended to 60 years, will everybody want to move to this structure?
The answer is no, because taking this loan means that the borrower loses 20% of the value of the home to the mortgage banker.
Only somebody who is very serious about staying in their own home for a long term, and who is also currently distressed, will avail of this loan.
2) How long will the 60 year mortgage actually carry on?
Probably within a period of less than 2 years from now, all the 60 year mortgages will disappear from the market. This is because both the banker and the borrower are motivated to foreclose this mortgage as soon as the home values appreciate around 20%. The banker will want to book a high profit. The borrower will want to keep all of the home price appreciation as their own profit.
Please note that some changes to the 20% equity proposed for the mortgage banker might be needed. In any case the market will ensure an appropriate percentage is arrived at.
3) Will a renter want to take this mortgage?
A renter who plans to stay for a short while will not want to go for this. This is because they will be liable to go bankrupt or pay 20% of the home sale proceeds to the bank.
A long term renter will want to go for this, and afterwards they will have the motivations as any other borrower above.
4) Will owners of 2nd and 3rd homes, or speculative real estate investors go for this?
Some of them will, depending on their intention to wait for a sufficient time till the home values appreciate much beyond 20%. But somebody with a short term outlook will not go for this, again because the bank holds a 20% equity stake in the home, which reduces the speculative profits.
5) Will this product solve the global crisis?
Yes, because many lenders will be motivated to come into the market again, borrowers are a plenty and the value of the homes will increase in the short terms since the payments on a 60 year term will be around twice as affordable.
6) Should there be any regulatory or systemic changes related to the introduction of this product?
The only change might be that in future whenever the home underneath a Sixty Year mortgage is sold, it would have to be through an open auction where both the banker and the borrower are present; or to have some other mechanism to ensure mutual agreement that the home is being sold at it's correct value.
Please add to this reasoning any further insights you may have. Also, please propose any modifications you might like to.
Best regards,
Chidambaram
This solution requires very little regulatory intervention and involves absolutely no cost to the tax payer. Yet it will ensure a rapid recovery of mortgage markets, solve the liquidity crisis and avoid a global recession.
Hopefully the product described here will actually enter the market and solve the current crisis.
Also, please post this on your very interesting blog if possible.
There are four policy objectives with respect to the U.S. mortgage crisis:
1) Ordinary people living in their own home need to be empowered to stay in their home without having to default their mortgage payment and have the bank foreclose on them.
2) The housing market needs to receive a stimulus to arrest the downward trend in home prices and avert further decline in economic growth.
3) Mortgage bankers who have either already booked losses or are likely to book more losses need to be recapitalized so that liquidity in the financial system can be ensured.
4) All of the above objectives need to be met without much of an impact on the U.S. taxpayer.
All of the above objectives can be easily met with the introduction of a new commerical financial product, largely within the bounds of the existing regulatory system; but with a couple of small innovations to the current structure of a typical mortgage product.
The new mortgage product required to solve the problem is a simple mortgage loan from any private mortgage banker or other relevant private financial institution.
Though the mortgage loan will be like any other existing mortgage loan product, there will be two modifications to the product:
1) Both the mortgage banker and the borrower will have the right to foreclose the mortgage with due notice. (While I believe this is currently the case from a legal perspective it is very rare for the mortgage banker to actually exercise their right to foreclose unless there is a default by the borrower. The new product will specifically stipulate that the mortgage banker can foreclose the loan at their option with due notice, irrespective of the borrower's payment history)
2) In case the borrower should choose to foreclose their loan, or transfer it to another party, 20% of the proceeds of the sale will accrue to the mortgage banker and only 80% of the proceeds of the sale will be received by the borrower. The same would apply in case the mortgage banker should choose to foreclose from their side.
3) The term of the mortgage loan will be 60 years instead of 30 years.
a) In the event the borrower is deceased prior to the expiry of 60 years, the home will revert to the ownership of the mortgage banker.
b) The only exception to b) above would be that the borrower will have the right to bequeath the home, provided the person receiving the home continues to make the mortgage payments as usual.
c) The borrower will not be compelled by the mortgage banker to take out life & disability insurance to the extent of the mortgage principal and assign it to the bank only as a result of this increased term. The current practice on this will be followed.
4) One important change in the product will be that the mortgage banker will have norms enabling them to lend out the higher of the following two amounts:
a) The current market value of the home (as determined by a valuation, as happends right now)
b) The pay off amount on an existing mortgage loan on the home.
I request you to carefully evaluate the impact that the introduction of this new product or a similar product will have on the U.S. mortgage market and it's beneficiary impact on the current global financial situation.
Expected Impact:
Consider a typical problem right now:
The borrower has an outstanding pay off amount of say $300,000/= on their mortgage. They are unable to afford the monthly mortgage payment and they have less equity in their home than the outstanding pay off amount. The market value of the home is only $220,000/=.
A new lender might be willing to re-finance but the existing banker has to agree to book a loss for this to happen.
In either case, the borrower is not in a good situation to afford the payment.
A new lender can now come in and offer a Sixty Years' mortgage product to this borrower. The lender is very motivated to do this because the lender will be able to
1) Charge a high interest for this product(say around 20% ... 20% is becoming a favorite number here for me :-) )
2) Benefit from a future sale of the home at a higher price. It's important to remember that according to the terms proposed here the lender has a 20% equity stake in the home.
For the borrower the benefit is that they will be able to stay in their home while making a much reduced monthly mortgage payment. In the longer term appreciation in the price of land will ensure that they will more than make up any losses from having to pay 20% of their home equity to the bank.
For the existing lender, there is absolutely no problem because they will realize the pay off amount from the new mortgage in case the market value is lower than the outstanding loan.
Questions and Answers:
1) If the mortgage term is extended to 60 years, will everybody want to move to this structure?
The answer is no, because taking this loan means that the borrower loses 20% of the value of the home to the mortgage banker.
Only somebody who is very serious about staying in their own home for a long term, and who is also currently distressed, will avail of this loan.
2) How long will the 60 year mortgage actually carry on?
Probably within a period of less than 2 years from now, all the 60 year mortgages will disappear from the market. This is because both the banker and the borrower are motivated to foreclose this mortgage as soon as the home values appreciate around 20%. The banker will want to book a high profit. The borrower will want to keep all of the home price appreciation as their own profit.
Please note that some changes to the 20% equity proposed for the mortgage banker might be needed. In any case the market will ensure an appropriate percentage is arrived at.
3) Will a renter want to take this mortgage?
A renter who plans to stay for a short while will not want to go for this. This is because they will be liable to go bankrupt or pay 20% of the home sale proceeds to the bank.
A long term renter will want to go for this, and afterwards they will have the motivations as any other borrower above.
4) Will owners of 2nd and 3rd homes, or speculative real estate investors go for this?
Some of them will, depending on their intention to wait for a sufficient time till the home values appreciate much beyond 20%. But somebody with a short term outlook will not go for this, again because the bank holds a 20% equity stake in the home, which reduces the speculative profits.
5) Will this product solve the global crisis?
Yes, because many lenders will be motivated to come into the market again, borrowers are a plenty and the value of the homes will increase in the short terms since the payments on a 60 year term will be around twice as affordable.
6) Should there be any regulatory or systemic changes related to the introduction of this product?
The only change might be that in future whenever the home underneath a Sixty Year mortgage is sold, it would have to be through an open auction where both the banker and the borrower are present; or to have some other mechanism to ensure mutual agreement that the home is being sold at it's correct value.
Please add to this reasoning any further insights you may have. Also, please propose any modifications you might like to.
Best regards,
Chidambaram
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