Financial Wisdom By Kalidas

Ref: 10-003 of 19-Jan-2010 by Kalidas PDF Download from ScribD

READ or watch any media report in Uncle Sam’s America – newspaper, magazine, Business channels on TV or any interview of senior executives of large corporate. They talk about only Top Line and Bottom Line. Top-bottom, top-bottom, top-bottom……… they go on lecturing for hours using above words in different contexts. In the process, the body, the substance, is lost.

What happens when a person with blood group A+ is on operating table and is in need of blood. Will any other group of blood be acceptable? Of course not. He will die if he is injected with different blood group.

Same thing applies in the field of finance and economy. Those of you who has read my book “Sub Prime Resolved” and the primer series “How to Invest into anything…” would have known that “Long term assets should be financed by long term liability which could be in the form of capital such as Equity or Preference shares and long term borrowings from banks, financial institutions, public issues in the form of Term Loans, Bonds, Debentures or perpetual instrument.

Thus, if you grant a loan on 10 year basis, it should be financed by either equity or 10 year long term borrowings. The borrowings have to necessarily match the maturity profiles of the financed assets. If a bank or Mortgage financing institution is granting a fixed rate mortgage on 30 years basis, he should have capital or borrowing on matching terms and maturity, those who finance the long term assets with short term liabilities are bound to fail sooner or later.

This is what is going to happen in America. The banks and mortgage institutions, with a view to boosting stock prices of their company, lent mortgages at incredibly low rates, often not exceeding 3 or 4%, and financed them from short term borrowings from Fed under Federal funds rate program or in discount windows at near zero rates. In reality, they were arbitraging between short term borrowings and long term lending rates.

THIS WAS SUICIDAL

Let us take a concrete example:
Suppose Banker A grants $ 250,000 Fixed Rate Mortgage loan @4% repayable in 30 years. The rates are fixed, without recourse (unique in America) and without escalation clause. See the stupidity of the American banker. How could they take the view of Interest rate for 30 years? How could they lend on such incredibly low rates for 30 years?

LENDER IN HEAVEN
He does not have enough capital. He borrows short term (monthly rollover or Libor based) either from Fed or inter-bank market. He pays at the most 0.25% and lends at 4% netting interest differential of 3.75% or $ 3,750 per $100,000 per borrower per year. It is his net profit with least maintenance cost. The stock price goes up, his stock options become more valuable asset and he also earns fat bonus at year-end running into millions of dollars. That is his performance. His colleagues and neighbors consider him as “Smart Ass”

LENDER IN HELL
Now, what happens when the interest rates rise? Well, until the rates rise by 2% to 3%, his profit margin merely narrows down. Instead of earning arbitrage interest differential of 3.75%, he would earn 1.5 to 2% or $ 1500 to $ 2000 per $100,000 per borrower per year.

However, when the short term interest rate rises to 3.5%, and above, he will have to visit Wash Room often. He is losing in every case. Being a fixed rate mortgage, he cannot pass on extra cost to his borrower. If he tries to under other Alt-mortgages, the borrower will come to him, hand over the key and say, sir, enjoy your property. He becomes “lender in possession” with no recourse to the borrower. In short, the banker is now in duress.

If interest goes to say 8%, he will have shell out 4% from his own pocket or $ 4000 per $ 100K mortgage per borrower per year. If he has granted $ 300 billions of such loans, he would lose 4% or about $ 12 billions from his bottom line. NOW, his bottom line becomes bottom less pit.

There are about $5.5 trillions of mortgage loans in United States. In the event of massive rise in interest rates, the banks would be losing $ 220 billions for rise in interest cost by 4%. In other words, the lenders would lose @ 55 billions for every rise in interest rate by 1%. If the rates rise to say 24% as it happened in early 80s, the bankers and mortgage lenders will lose over $ 2 trillions ($ 2000 billions) per year.

We are not counting derivatives that run nearly 6 to 20 times the above amount.

There will be catastrophe. The borrowers will not be affected because they have fixed rate mortgage. But when his lender gets bankrupt and gets sold to some third party, what happens if the said third party annuls the agreement on the ground of equity (it is possible legally) and fair play?

At the moment, thanks to four musketeers – Hank Paulson, former Treasury Secretary from Goldman Sachs, Timothy Geithner, incumbent Treasury Secretary, Ben Bernanke, incumbent Fed Chief and Alan Greenspan, former Fed chief for over 18 years. They are the “Destroyers of America”

The rates are about to rise. China has already expressed intention not to buy any more T-Bills that has infuriated the United States. A vicious propaganda is launched to the effect that China bubble is about to burst. They are trying to squeeze Chinese nose so that their mouth and purse open up.

But then, they do not know the Chinese.

When the rates begin to rise, all the banks and mortgage lenders will come under severe squeeze. The double “dhol” (an Indian musical drum) with Bernanke on one side and Geithner on the other, will make such noise that the markets would be rattled to the extreme.

Several banks will fail, in thousands. Several trillions will be lost again. The Fed will find difficult to print more and more $ notes. FDIC will be busy taking over banks day in day out with no funds in the kitty.

President Obama with no cash in the kitty, printing press closed, no majority in Senate to pass mischievous Health Care bills, will be pushed to the wall. His popularity will go down below 30 from 46 at the moment.
Hell will break lose again in the financial market. Will it happen and so early. It all depends at what speed the rates rises. It is not the question of “whether” but “when”

Ride the rally in the stocks and bonds for the time being. A financial earthquake, more severe than Haiti, is in the waiting. I could hear the simmering sound, I could smell the faint smokes, what I do not know is the precise time when this volcano and earthquake will burst and with what intensity.

Kalidas (Anil Selarka)
Hong Kong, 19th January, 2010 Ref: 10-003

Personal Blog: http://anilselarka.com
Book Web : http://www.subprimeresolved.com

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