Vivek Kaul
“So let’s watch Gentlemen Prefer Blondes,” she said the other day.
Knowing her taste in movies did not go beyond Salman Khan beating up the baddies, I was left wondering why did she suddenly want to watch a nearly 60 year old Hollywood film? But then her statements could be disguised questions at times and so I thought its best not to cross question.
“Yes, sure why not,” I replied. “Let me get the DVD out.”
As I tried searching for the DVD, it suddenly occurred to me, why she wanted to watch the movie. The movie had the sexy Marilyn Monroe crooning “Diamond’s are a girl’s best friend” and Valentine’s Day was round the corner. So it was her idea of giving me a hint about the stone she badly wanted.
“Well, I really can’t find the DVD,” I said. “Guess you must have put it away when you cleaned a few weeks back.”
Not the one to give up so easily “let me look for it,” she said, and found the DVD in a few minutes. And at that moment I thought it was best to get to the point straight away.
“So you really want that stone?” I asked.
“Don’t call it a stone, dear,” she replied. “It’s a crystal clear white diamond which is forever.”
“Guess you have been reading the entertainment supplements of newspapers a way too carefully over the last few days.”
“Yes I need to get my sales pitch right,” she replied rather blatantly.
“But you know na there are problems with diamonds?”
“What problems?”
“Well, for one they are very easy to buy but very difficult to sell.”
“Now since when did something which is easy to buy become a problem,” she replied, ignoring the more important part of the statement.
“Selling gold or silver is very easy. But most jewellers do not buy back diamonds that they did not sell. Also, even if they do decide to buy they offer around 75-85% of the prevailing price.”
“Oh, is that really the case?”
“Yes. You see ascertaining whether a diamond is really a diamond is not a cakewalk and is an expert’s job, especially in a day and age when artificial diamonds look as good as the real thing, if not better. This is something that cannot be easily ascertained as is the case with gold.”
“So?”
“Hence, the easiest way for a jeweller to operate is to simply not buy anything that he hasn’t sold. At times jewellers agree to buy diamonds only if the customer agrees to buy a diamond of higher value from them.”
“So what is the problem?” she asked, not getting the point. “We can always buy a diamond of a higher value. I mean we need to move up in life.”
Now that was getting into the realm of the deeply philosophical. “Since when did moving up in life become equal to buying diamonds?” I wondered. But then I wasn’t the kind to give up so easily and decided to continue with more logic.
“Also, precious metals like gold and silver have a daily price, which is easily available. In fact these days most newspapers publish the daily price of gold/silver right under or around their mastheads. So when you buy gold/silver chances you are likely to be offered a price which is around that daily price,” I explained.
“Hmmm!” she said in a very non committal tone.
“Diamonds on the other hand have no standardised pricing, though there is something known as the Rapaport Report which is issued to jewellers. This puts out the price of diamonds based on 5Cs of a diamond i.e. carat, , clarity, colour, cost and cut. But this list is not available to an average customer. And more than that grading diamond becomes very difficult once they have been cut and set in jewellery. The best time to grade a diamond is when it’s lose.”
“But what is the point you are trying to make?” she burst out, sounding very hassled.
“Well, the point is you really don’t know what price you are going to get for a diamond when you try to sell it.”
“But who wants to sell it?”
“I’ll get back to that question. Let me explain to you how the diamond trade actually works.”
“Okay, go on,” she replied.
“The diamond trade has had a monopoly of a single South African company called De Beers. As Edward Epstein points out in his brilliant article Have You Ever Tried to Sell a Diamond? “De Beers took control of all aspects of the world diamond trade, it assumed many forms. In London, it operated under the innocuous name of the Diamond Trading Company. In Israel, it was known as “The Syndicate.” In Europe, it was called the “C.S.O.” — initials referring to the Central Selling Organisation, which was an arm of the Diamond Trading Company. And in black Africa, it disguised its South African origins under subsidiaries with names like Diamond Development Corporation and Mining Services, Inc. At its height — for most of this century — it not only either directly owned or controlled all the diamond mines in southern Africa but also owned diamond trading companies in England, Portugal, Israel, Belgium, Holland, and Switzerland.””
“So, what is your point?” she asked.
“As Barry J. Nalebuff and Adam M. Brandenburger write in their book Co-Opetiton “De Beers, a South African company, has a monopoly over the world’s diamond market. Most of the world’s diamond produce is sold through the Central Selling Organisation of De Beers.” The control that De Beers has over the diamond market has come down over the years, but it still remains reasonably strong.”
“So?”
“De Beers operates like a cartel, deciding on the supply of diamonds every year and thus ensures that the market is not flooded with them. In recessionary years it cuts down the supply of diamonds dramatically thus ensuring that they don’t lose value. Diamonds over the years have been found in countries like Angola, Australia, Nambia and so on. In 1960s, huge diamond reserves were found in Siberia, making Russia a big supplier. Hence, diamonds are not scarce as they are made out to be,” I explained.
“Thanks for giving me a crash course on diamond economics,” she said saracastically, hoping that I stop.
But I was in no mood to. As Nalebuff and Brandenburger point out “People value diamonds highly because they perceive them to be scarce. They’re not, but it’s the perception of scarcity that counts.”
“Hah!”
“And let me come to the bit about not selling a diamond.”
“What about that?”
“A perception has been created over the years about diamonds being a permanent part of a couple’s life. As Epstein points out “Both women and men had to be made to perceive diamonds not as marketable precious stones but as an inseparable part of courtship and married life. To stabilize the market, De Beers had to endow these stones with a sentiment that would inhibit the public from ever reselling them. The illusion had to be created that diamonds were forever — “forever” in the sense that they should never be resold.” This perception has been created by a long running diamonds are forever advertising campaign.””
“Yes it’s a perception. But then have you ever heard the phrase perception is reality?”
“Well, you can maintain that reality by buying fake diamonds i.e. man made diamonds. Essentially there are two kinds of fake diamonds: moissanite and cubic zirconia (CZ). As Geoffrey Miller, a consumer behaviour expert, writes in Spent – Sex, Evolution and Consumer Behaviour “There is a rationale behind not spending the amount on real diamonds. Casual observers can’t tell them apart, nor can most pawnshop owners using the standard thermal conductivity tests for distinguishing CZ from diamond. Only experts may notice the subtle double refractions (birefringence) caused by Moissanite’s hexagonal crystal structure.””
“Ah! Should I say I am impressed?”
“In fact the quality of so called fake diamonds has gone up dramatically gone up over the years. As Miller writes “The arms race between real and fake has also undercut the De-Beers diamond cartel for more than a century, as ever-better imitation diamonds have been developed: titanium dioxide (synthetic rutile) in the 1940s, synthetic strontium titanate (Fabulite) in the 1950s, yttrium aluminum garnet(YAG) in the 1960s, gadolinium gallium garnet (GCG) in the 1970s, cubic zirconia (CZ) in the 1980s, and silicon carbide (Moissanite) in the 1990s. CZ makes for an excellent imitation diamond…Moissanite, introduced in 1998, is even closer to diamond, with a similar hardness, density, and luster, yet more brilliance (a higher refraction index) and more “fire” (a higher dispersion index).””
“But fake at the end of the day is fake na. I won’t be able to carry it off with the same panache and confidence as the real thing,” she said.
“Hmmm!,” I replied, ignoring what she had just said. “Did you know that every time you buy a diamond you might be supporting a dictator or a rebel movement in Africa?”
“You won’t stop! Will you,” she said in an exasperated tone.
“As Alan Beattie writes in False Economies – A Surprising Economic History of the World “Diamonds, in particular, are a near-perfect mineral with which to fund freelance rebel movements or alternate governments. They act almost like a global currency, being small and light and holding their value well. Despite the attempts of an international campaign, the Kimberly Process, to register their source, they are very hard to trace. The Sierra Leone civil war dragged on for a decade from 1991 after the Revolutionary United Front, the main rebel movement, gained control of diamond mines and used the wealth to fund their operations,””came a long wielding response from my side.
“Okay. Now that you have said so many things let me just say one thing. My sister’s husband is buying her a big diamond or stone as you call it, this Valentine’s Day. And I guess that makes it very clear that you will have to do the same,” she said, having the last laugh.
My mind went back to a line that the short story writer Hector Hugh Munro better known by his pen name Saki, once wrote “A woman and an elephant never forget an injury.” And with that I started making a mental calculation of what the damages would be.
The article originally appeared on www.firstpost.com on February 12, 2013
(Vivek Kaul is a writer. He can be reached at [email protected])
Month: February 2013
Watch out: The coming currency wars can really drive up gold prices
Vivek Kaul
“Devaluing a currency is like peeing in bed. It feels good at first, but pretty soon it becomes a real mess.” – A line attributed to a senior official of the Federal Reserve of the United States
Central banks around the world have been on a money printing spree since the start of the financial crisis in late 2008. The Federal Reserve of United States has expanded its balance sheet by 220% since early 2008. The Bank of England has done even better at 350%. The European Central Bank came to the party a little late and has expanded its balance sheet by around 98%.
The Bank of Japan has been rather subdued in its money printing efforts and has expanded its balance sheet only by 30% over the last four years.
But now it seems to be getting ready to join the money printing party. Japan has had a deflationary scenario since 2009, meaning that prices have been falling. The Bank of Japan is now targeting an inflation of 2% and wants to reach the goal at an earliest possible date.
The plan is to print and flood the financial system with as many yen as required. As a higher amount of money chases the same amount of goods and services, the hope is to create some inflation.
When prices are flat or are falling or are expected to fall, consumers generally tend to postpone consumption(i.e. buying goods and services) in the hope that they will get a better deal in the future. This impacts businesses as their earnings either remain flat or fall. This slows down economic growth.
On the flip side, if people see prices going up or expect prices to go up, they generally tend to start purchasing things. This helps businesses as well as the overall economy. So by trying to create some inflation the idea is to get consumption going again in Japan and help it come out of a more than two decade old recession. With prices of things going up people are more likely to buy now than later.
Other than trying to get consumption going again there is another part to this story. When countries print money the idea is to cheapen their currency against other currencies and thus boost exports.
As the Bank of Japan starts printing yen to create inflation, there will be more yen in the market than before. And this will lead to a fall in the value of the yen against other currencies.
But the market does not wait for things to happen, it starts to react to things it expects to happen. Given this, the Japanese yen has been losing value against the dollar.
Three months back one dollar was worth 79.4 yen and now it is worth 93.5 yen. So how does this help Japanese exporters? Let us say a Japanese exporter sells a product worth $1million. Earlier when he converted dollars into yen he would have got 79.4 million yen. Now with the yen losing value against the dollar he will get 93.5 million yen. Since the exporter’s cost in yen remain the same, he is makes a higher profit.
What the exporter can do now is cut prices in dollar terms and even then earn a higher profit. Lets say the exporter cuts the price by 10% in dollar terms and now sells the good at $900,000. When he converts this to yen he earns 84.1millon yen ($900,000 x 93.5). This is higher than the 79.4 million yen he had earned earlier.
By cutting the price in dollar terms the Japanese exporter becomes more competitive in the international market and thus can hope to sell a greater number of goods. This will lead to increased exports and and that will help economic growth. At least that’s how things are supposed to work in theory.
The yen has also depreciated against the South Korean won. South Korea and Japan compete in several export oriented industries like automobiles and electronics. Around three months back one Japanese yen was worth 13.7 Korean won. Now it is worth 11.75 won. This has made the South Korean exports lesser competitive than Japan.
So for a brief while Japan might have a competitive advantage when it comes to its exports. But the thing to remember here is that money printing is not something that only Japan can indulge in. The South Koreans can also print as many won (their currency) as possible. Politicians in South Korea have lately been voicing their concerns on this and have talked about measures to stop the won from gaining value against the yen. Interestingly one yen was worth 11.6 won on February 4. Since then it has appreciated to 11.75 yen.
The point here is very simple. Money printing is an idea which every country can implement. And countries will resort to it more and more in the years to come to protect their exports. In fact countries have already been voicing their concern on a rapidly depreciating yen. As Liam Halligan chief economist at Prosperity Capital Management pointed out in a recent piece “Germany, also, is deeply concerned about the yen’s recent fall and the prospect of further weakness. With an eye on his country’s all-important export sector, Bundesbank president, Jens Weidmann, recently mauled Tokyo’s new affinity for loose money, referring to “alarming infringements” and an “end to central bank autonomy”.Three months back one euro was worth 101 yen. Now its worth around 125 yen. This appreciation of the euro is bound to impact the exports of countries like Germany which use the euro as their currency.
Germany cannot cheapen the euro by simply printing it, like Japan is doing with yen because euro is used as a currency, by 16 other countries. Given that Germany cannot decide unilaterally to go ahead and cheapen the euro by printing it. A little under half of the German GDP comes from exports.
But other countries have no such problems. The Czech Republic is looking to cheapen its currency koruna and Sweden is looking to cheapen the krona. It won’t be surprising that other countries around the world, specially the export oriented economies of South East Asia, soon join the money printing party, in order to ensure that their exports don’t get uncompetitive.
Columnist Matthew Lyn of The Wall Street Journal’s Market Watch writes “There are plenty of calls for a lower euro to ease the growing recession in Europe: Jean-Claude Juncker, the chairman of the Eurogroup of finance ministers, has started describing the euro as “dangerously high.” And don’t be surprised if the Federal Reserve starts trying to edge the dollar down as well as it tries to lift growth in the United States…So if the Bank of Japan, for example, manages to get the yen down in value, the Europeans and Americans will react rather than see the Japanese knock out their industries.”
In short, the world is getting ready for a currency war, as countries try and print more and more money to hold the value of their currency against other currencies and thus ensure that their exports remain competitive.
Mervyn King hinted at it when he said “ My concern is that in 2013, what we will see is the growth of actively managed exchange rates as an alternative to the use of domestic monetary policy.” Even George Soros, the famed hedge fund manager, feels that a currency war is the biggest danger facing the global economy. ““I think the biggest danger is … a currency war,” Soros told CNBC.
This might lead to the collapse of the confidence people have in paper money. James Rickards author of Currency Wars: The Making of the Next Global Crises feels that the “The biggest risk is the rapid collapse of confidence in paper money. They can’t just keep printing…All major central banks are easing…Eventually so much money will be printed that this will lead to inflation. The endgame is collapse of the international monetary system — sometime sooner than later.”
This really brings gold to the fore. As the threat of more and more paper money being printed increases it is likely that people will move more of their paper money into gold. And this will push up the price of gold. Rickard’s long term price estimate on gold is $7000 an ounce, nearly four times the $1670 an ounce it is currently trading at. As he puts it “ Gold could trade in a range between $3,000 and $10,000, Rickards says. “We’re not going to get there all at once.”
This is something that Lynn agrees with. As he writes “The more central banks try and manipulate the value of paper money the more investors will grow disillusioned with it. There is only one quasi-currency that nobody tries to devalue — only because they can’t — and that is gold. If central banks engage in a round of competitive devaluations, then the value of any of paper currency measured in gold will only go up.”
Gold has been more or less flat for a while now. The purported reason behind this is that the Federal Reserve of United States has been lending out gold to banks known as bullion banks which are in turn selling that gold so as to drive down its price. After they have slightly driven down the price they buyback the gold and thus make a profit. This benefits both the bullion banks as well as the Federal Reserve. The bullion bank wants to make money. And the Federal Reserve does not want the price of gold to go up.
If the price of gold goes up, its a reflection of the failure of the policies adopted by the Federal Reserve to get the American economy up and running again.
The article originally appeared on www.firstpost.com on February 11, 2013
(Vivek Kaul is a writer. He can be reached at [email protected])
Modi’s challenge: Transforming from an Advani to Vajpayee
Vivek Kaul
Tavleen Singh in her very interesting book Durbar recounts one of her earliest reporting experiences in Delhi. The year was 1977 and the state of internal emergency declared by the then Prime Minister Indira Gandhi was still in effect. The opposition leaders had come together to address a rally at the Ram Lila maidan in Delhi.
The leaders started to arrive in their white Ambassador cars by around six pm in the evening. The ground was full. And the boring speeches started one after the other. As Singh writes in Durbar “I thought people might start to leave unless somebody said something more inspirational. It was past 9 p.m. and the night had got colder although the rain had stopped.”
But nobody had left. They were all waiting for a certain man called Atal Bihari Vajpayee to speak. By the time Vajpayee rose to speak it was well past 9.30 pm. The crowds clapped chanting ‘Indira Gandhi murdabad, Atal Bihari zindabad‘. As Singh puts it “He acknowledged the slogans with hands joined in a namaste and a faint smile. Then, raising both arms to silence the crowd and closing his eyes in the manner of a practiced actor, he said, ‘Baad muddat ke mile hain deewane.’(It has been an age since we whom they call mad have had the courage to meet) He paused. The crowd went wild. When the applause died he closed his eyes again and allowed himself another long pause before saying, ‘Kehne sunne ko bahut hain afsane.’ (There are tales to tell and tales to hear). The cheering was more prolonged, the last line of a verse that he told me later he had composed on the spur of the moment. ‘Khuli hawa mein zara saans to le lein, kab tak rahegi aazadi kaun jaane.’ (But first let us breathe deeply of the free air for we know not how long our freedom will last). The crowd was now hysterical.”
Such was the connect Vajpayee had with the masses. Having heard him give speeches to a large audience of over a lakh, I can safely say his pauses which became a butt of jokes later when people saw him make speeches on television, would mesmerise the entire audience when he spoke to them live.
In the Lok Sabha election that followed the leading opposition parties came together to form the Janata party. Vajpayee’s party Jan Sangh was also a part of it. The Janata experience was soon over and by the 1984 Lok Sabha elections Jan Sangh in its new avatar as the Bhartiya Janata Party (BJP) was down to two seats.
From there on Lal Krishna Advani built the party on the ideology of hardcore Hindutva, taking the number of seats that the party had in the Lok Sabha to 88 in 1989 and 120 in the 1991. This fast rise of the party was built on slogans and ideas like “saugandh Ram ki khaate hain mandir wohin (i.e. Ayodhya) banayenge” and “ye to kewal jhanki hai Kashi Mathura baaki hai”. Vajpayee took a backseat for a while. It is one thing to instantly connect with the masses when you address them and entirely another thing trying to build a political party from scratch. And this is where Advani flourished.
In the 1980s and the early 1990s the BJP espoused causes like making temples in Ayodhya, Kashi and Mathura. It talked about banning cow slaughter, having a uniform civil code, and doing away with the Article 370, that gives special status to the state of Jammu and Kashmir. All this was music to the ears of voters across Northern and Western India and the party catapulted from being a political front of the Rashtriya Swayamsevak Sangh (RSS) to having some identity of its own.
In the 1996 Lok Sabha elections the BJP won 187 seats in the Lok Sabha and was invited to form the government. At that point of time it was Vajpayee and not Advani who had played larger role in reinvigorating the party, who became the Prime Minister of the country.
While Vajpayee may have been a taller leader there was practical considerations at play as well. The BJP on its own did not have the strength to form the government. It needed other parties to support it either by joining the government or supporting it from the outside. And the chances of that happening were better with a moderate Vajpayee at the helm of things than a hardcore Advani who by then was looked upon as a man who had played an important part in bringing down the Babri Masjid. At least, that was the perception among a host of political parties.
So Advani had to make way for Vajpayee as the Prime Minister. BJP’s first tryst with power lasted less than three weeks and even with Vajpayee leading, it could not attract the support required to prove its majority in the Lok Sabha. But things changed in the years to come and Vajpayee was the Prime Minister from March 1998 to May 2004.
His moderate image and larger than life persona helped him rule the country with a rag-tag coalition of more than 20 political parties.
Narendra Modi is now trying to convert his image from that of a hardcore Advani of the 1990s to that of a more moderate Vajpayee who ruled the country. At least, that is the conclusion that one can draw from the speech he made at the Shriram College of Commerce in Delhi, yesterday.
In the speech he said several things that tried to project an image of a moderate ‘Modi’. Lets sample a few lines.
– The youth of the nation has its finger on the mouse of computers and is changing the world. India’s journey has gone from snake charmers to mouse charmers
– The ambassador of a nation asked me what major challenges India faces and I said the biggest one is that how we use opportunity. When asked what the opportunity was, I said the youth. Europe buddha ho chuka hai, China budha ho chuka hai.
– This nation is being ruined by vote bank politics. This nation requires development politics. If we switch to politics of development, we will soon be in a position to bring about lasting change and progress
– We need P2G2. Pro-People Good governance
– Why shouldn’t we make the ‘Made in India’ tag a statement of quality for our manufactured products?
If the above statements are viewed in isolation Modi does not come across as a hardliner that he is typically made out to be. He comes across as a man who has some vision for India.
Politically this makes sense for both BJP as well Modi. If Modi is able to soften his hardcore image in the days to come he might start to appeal to people beyond his home state of Gujarat and votaries of hardcore Hindutva. He might also start to appeal to political parties who currently won’t touch him with a bargepole given his hardcore pro Hindutva image.
This is very important in this era of coalition politics where no single political party can form a government on its own and sticking to any ideology becomes a burden beyond a point. If this strategy of projecting a softer Modi does work, it would mean that the BJP would be going back to its soft Hindutva strategy that it followed during the reign of Vajpayee. As we all know this strategy worked wonders for the BJP till it was abandoned in favour of the India Shining strategy.
A softer Modi will continue to appeal to the traditional supporters of the BJP and at the same time appeal to those who currently have doubts about him. That seems to be the idea behind the new Modi that India saw for the first time in Delhi, yesterday.
Whether that happens remains to be seen. As marketing guru Seth Godin writes in All Marketers are Liars “Great stories happen fast. They engage the consumer the moment the story clicks into place. First impressions are more powerful than we give them credit for.”
Given this getting rid of first impressions in the minds of the voter is very difficult unless you are the Congress party, and do not stand for anything. So it remains to be seen whether people of India will buy the new story that Modi is trying to project at the national level. But then we all have to start somewhere.
The article originally appeared on www.firstpost.com on February 7, 2013
(Vivek Kaul is a writer and can be reached at [email protected])
Why Uncle Sam should also be suing itself, not just S&P
Vivek Kaul
The American government has filed a suit against the rating agency Standard And Poor’s (S&P) seeking $5 billion in damages. The suit filed by the Department of Justice alleges that the rating agency gave good ratings to bad mortgage securities to earn a handsome income.
In the United States a home loan is referred to as a mortgage.
Lets try and understand this in a little more detail. Starting in around 2002 American banks and other financial firms started giving out what came to be known as subprime home loans. The term ‘prime’ was used in reference to the best customers of the bank. And loans to such customers were prime loans.
In its strictest sense a subprime loan was defined as a loan given to an individual with a credit score below 620, who had no assets and was thus unlikely to qualify for a traditional home loan. A credit score was a number calculated on the basis of the borrower’s past record at paying bills and loans of all kinds, the length of his credit history, the kind of loans taken etc.
On the basis of the number the lender could get some sort of an idea of what sort of a risk he would enter into by lending to the borrower. That was the purported idea behind the credit score. In the normal scheme of things, a borrower categorised as “sub-prime” would not have got a loan.
But those were days when anybody and everyone got a loan. Banks did not keep subprime loans on their books. What they did was that they pooled these loans together and sold bonds against them. The interest paid on these bonds was lower than the interest the bank was charging on the home loan. The difference in interest was the money made by the bank. This process was referred to as securitisation.
The bonds were bought by investors of various kinds. When the borrowers of home loans paid interest on their loans that interest was pooled together and was used to pay interest to those investors who had bought these bonds. The same thing happened with the principal on the home loan that was repaid by the borrowers. It was pooled together and used to pay off the investors who had bought these bonds.
By doing this the bank did not maintain the risk of the home loan defaulting on its books. Also by securitising the subprime home loans the banks got back the money they had lent out as home loans immediately. This allowed them to give out fresh subprime home loans which they again securitised by issuing bonds and so the system worked. The difference in interest was the money made by the bank. The bank also charged a fee from investors for securitising bonds.
If the bank had kept the loan on their books for the entire duration of the home loan, as used to be the case earlier, they wouldn’t have been able to make fresh loans immediately. Also, they would have to carry the risk of default by the borrowers on the home loan on their books.
As far as investors were concerned they got to invest in a financial security which gave a better rate of return than government and most corporate bonds. But what made them really invest in the subprime bonds was the fact that they got very good ratings from rating agencies like S&P, Moody and Fitch. So here was a financial security which had a rating which was as good as the government bond or a corporate bond, but gave a higher rate of return.
What was ironical was that the subprime home loans bonds were given the best rating of AAA. Subprime loans were basically being given to people who would have not got loans in the normal scheme of things. The lending terms had become so easy that home loans could be made to someone with No Income, No Jobs, or assets for that matter (or NINJA loans for short).
The lenders also introduced a loan where the borrower could simply get a loan by stating his or her income. The lenders wouldn’t make any effort to verify it. These loans came to be referred to as liar loans. In 2006, 40% of all subprime loans were liar loans.
Given this, the risk of default on subprime home loans was very very high. And loans with a very high chance of default couldn’t be rated AAA, which is what was happening.
But why were the rating agencies rating subprime bonds which were backed by subprime loans most likely to be defaulted on handing out AAA ratings? For this we have to go back in history.
In fact, a major reason why subprime bonds were able to get AAA rating was because of something that happened way back in 1970. This was the year when Penn Central, the biggest railway company (or what Americans call a railroad) in the United States, went bankrupt due to sustained losses in its passenger as well as freight operations. This was an event that credit rating agencies were not able to foresee.
Till this point of time the rating agencies ran a subscription based service. Hence what the rating agency thought about a particular new bond was not known to the world at large but only to those who had the subscription service of the rating agency.
In response to the crisis the Securities and Exchange Commission (SEC) mandated that brokers holding onto bonds which were less than investment grade would be penalised. But this immediately raised the question that who would decide what ‘investment-grade’ was? So SEC created a new category of officially designated rating agencies. The rating firms Standard & Poor’s, Moody’s and Fitch, were designated to be the three officially designated rating agencies.
What the SEC was effectively saying was that what the rating agencies thought about a bond was too important to be restricted only to those who were willing to pay for their subscription service. Hence, every rating from then on was publicly available.
But the ratings agency was a business at the end of the day, they had to also make money. The question was who would pay them if their ratings were publicly available? So the SEC deemed that the company which was in the process of issuing a bond, should get itself rated from the rating agencies and pay them for it as well.
This created a clear conflict of interest. The rating agencies could be easily played off against one another. And this is what happened during the entire subprime boom.
Banks and other financial institutions looking to rate their subprime bonds played off one rating agency against the other. If they did not get the AAA rating they were looking for their bonds they threatened to take their business elsewhere.
What did not help was the fact that the money the rating agencies made on rating subprime bonds was three times the money they made on rating other standard corporate bonds. This resulted in a lot of subprime bonds being rated AAA.
While the bonds may have been rated AAA, the basic point was forgotten. No bonds could be better than the home loans that were outstanding against them. And the fact of the matter was that the subprime home loans were the worst of the lot.
Given this, it doesn’t make any sense on part of the American government to blame only Standard & Poor’s for what happened. The other two officially designated rating agencies Moody’s and Fitch are equally to be blamed. And so is the American government (through SEC) for persisting with a regulation which allowed issuers of bonds i.e. banks and other financial firms to shop for a rating.
The article originally appeared on www.firstpost.com on February 7, 2013.
(Vivek Kaul is a writer. He can be reached at [email protected])
Why Mrs Watanabe can now drive the Sensex higher
Vivek Kaul
Shinzo Abe, the new prime minister of Japan, has promised to end Japan’s more than two decade old recession, through some old fashioned economics which is being now referred to as Abenomics by the experts.
For the lesser mortals Abenomics is nothing but money printing. Abe plans to go in for an ‘unlimited’ money of money printing and use the newly created ‘yen’ to increase government spending on public works.
So far so good. But what’s the idea here? In the process of printing and stuffing the financial system with an unlimited amount of yen, Abe hopes to increase money supply. As an increased amount of money chases the same amount of goods and services, he hopes to create some inflation.
The target is to create an inflation of 2%. And how does that help? In December 2012, Japan had an inflation rate of -0.1%. For 2012 as a whole inflation was at 0%, which meant that prices did not rise at all. In fact for each of the years in the period 2009-2011, prices have fallen in Japan on the whole.
In a scenario where prices are flat or are falling or are expected to fall, consumers generally tend to postpone consumption(i.e. buying goods and services) in the hope that they will get a better deal in the future. This impacts businesses as their earnings either remain flat or fall. This in turn slows down economic growth.
On the flip side, if people see prices going up or expect prices to go up, they generally tend to start purchasing things. Hence, Abe’s idea is to flood yen into the financial system and in the hope create some inflation or at least get consumers to start thinking that inflation is coming and ensure that they go out and make some purchases.
In case of a scenario where prices are falling people tend to wait to buy stuff at lower prices. In case of a scenario where prices are rising or expected to rise people tend to start buying stuff because otherwise they will have to pay a higher price for it. Either ways, human beings like a good deal.
When people buy stuff businesses see an increase in incomes and profits, which in turn spurs up economic growth. So that is the theory behind Abenomics.
Now whether this economic theory translates into practice as well with prices rising and the Japanese buying and thus helping create economic growth remains to be seen.
But there is another angle to this. As explained earlier in the article, Abe’s plan is to flood the financial system with an unlimited amount of yen. As and when this starts to happen, there will be more yen in the market than before. And this will lead to a fall in the value of the yen against other currencies.
But the market does not wait for things to happen, it starts to react to things it expects to happen. Given this, the Japanese yen has been losing value against the dollar. Three months back one dollar was worth around 80 yen. Now its worth around 94 yen. What is interesting is that between January 29, 2012 and today, the exchange rate has fallen from 90 yen to a dollar to 94 yen to a dollar.
The depreciating Japanese yen makes the situation just right for the comeback of the yen carry trade. So what is the yen carry trade?
Lets go back more than twenty years to understand where it all started. In the late 1980s Japan was in the midst of both a real estate and a stock market bubble. The Bank of Japan managed to burst the stock market bubble very rapidly and the real estate bubble very slowly, by raising interest rates.
After bursting the bubble by raising interest rates the Bank of Japan started cutting interest rates and soon the rates were close to 0%. This meant that anyone looking to save money by investing in fixed income investments(i.e. bonds or bank deposits) in Japan would have made next to nothing. This led to the Japanese money looking for returns outside Japan.
Some housewife traders started staying up at night to trade in the European and the North American markets. They borrowed money in yen at very low interest rates, converted it into foreign currencies and invested in bonds and other fixed income instruments giving higher rates of returns than what was available in Japan. Over a period of time these housewives came to be known as Mrs Watanabes and at their peak accounted for around 30% of the foreign exchange market in Tokyo.
The trading strategy of Mrs Watanabes came to be known as the yen-carry trade and was soon being adopted by some of the biggest financial institutions in the world. A lot of the money that came into America during the dotcom bubble came through the yen-carry trade. It was called the carry trade because investors made the carry i.e. the difference between the returns they made on their investment (in bonds or even in stocks for that matter) and the interest they paid on their borrowings in yen.
The strategy worked as long as the yen did not rise in value against other currencies, primarily the US dollar. Let us try and understand this in some detail. In January 1995, one dollar was worth around 100 yen. At this point of time one Mrs Watanabe decided to invest one million yen in a dollar denominated asset paying a fixed interest rate of 5% per year.
She borrowed this money in yen at the rate of 1% per year. The first thing she needed to do was to convert her yen into dollars. At $1=100 yen, she got $10,000 for her million yen, assuming there were no costs of conversion.
This was invested at the rate of 5% interest. At the end of one year in January 1996, $10,000 had grown to $10,500. Mrs Watanabe decided to convert this money back into yen. At that point, one dollar was worth 106 yen. She got around 1.11 million yen ($10,500 x 106) or a return of 11%. She also needed to pay the interest of 1% on the borrowed money. Hence her overall return was 10%.
Her 5% return in dollar terms had been converted into a 10% return in yen terms because the yen had lost value against the dollar. So this was a double gain for her. The depreciating yen added to the overall return.
But let us say instead of depreciating against the dollar, as the yen actually did, it had appreciated. And let us further assume that in January 1996, one dollar was worth 95.5 yen. At this rate $10,500 that Mrs Watanabe got at the end of the year would be worth 1 million yen ($10,500 x 95.5) when converted back to yen. Hence Mrs Watanabe would end up with a loss, given that she had to pay an interest of 1% on the money she had borrowed in yen.
The point is that for the yen carry trade to be profitable the yen would have to be either stagnant against the dollar or lose value. The moment it started to appreciate against the dollar, the returns in yen terms started to come down.
The yen carry trade worked in most years up since it started in the mid 1990s, to mid 2007. In June 2007, one dollar was worth 122.6 yen on an average. After this the value of the yen against the dollar started to go up, and fell to around 80 yen to a dollar. This had meant the death of the yen carry trade.
But with the yen losing value against the dollar again it makes the idea of the yen carry trade viable again. Between 2004 and 2008, stock markets across the emerging market rose as money through the yen carry trade route came in. This included India as well.
Things as they are now look ideal for the yen carry trade to start again. What helps is the fact that interest rates in Japan are very low almost close to 0%. Hence, money can be borrowed very cheaply.
As the yen carry trade picks up, investors borrow in yen, and sell those yen to buy dollars. This ensures that there is a surfeit of yen in the market leading to a further fall in its value against the dollar. This in turn makes the yen carry trade even more attractive.
Reports in the international media seem to suggest that it has already started happening. India now remains an ideal candidate for money to come through the yen carry trade route given that the Indian rupee has been gaining value against the dollar, which would make the yen carry trade even more profitable.
While the Indian economy falters, BSE Sensex, India’s premier stock market index might be getting ready for another rally. This time due to the blessings of Mrs Watanabe(s) from Japan. In fact when I had asked Professor Aswath Damodaran, how strong is the link between economic growth and stock markets, in a recent interview, he replied “It’s getting weaker and weaker every year.”
Reference: Extreme Money: Masters of Universe and the Cult of Risk by Satyajit Das
The article originally appeared on www.firstpost.com on February 6, 2013
(Vivek Kaul is a writer. He can be reached at [email protected])