How Wall Street’s crisis affects the Indian economy
By, Adhvith Dhuddu

Wall Street’s landscape and the face of the US economy changed dramatically in the past few months. It’s famously known that when the US sneezes, the world gets a cold, and it’s looking ominously similar this time around. Despite the resilience and growing strength of the Indian economy, these changes will significantly affect Indian business, trade and commerce. It’s also becoming clear that our economy is in fact intertwined with the world economy and has not decoupled with the US economy in any way.

Risky leveraging by investment banks and a slump in the real estate markets in US were the root causes of this quandary which put the financial system in peril. In the last few years, the ability to leverage gave institutions on Wall Street access to ample capital and increased their risk appetite (which increased fund flows to emerging markets). Momentum built up in leveraging was felt across the globe as capital was pumped continuously into emerging markets and unconventional assets. But this financial fallout and recent government intervention has forced many firms to deleverage and use cash conservatively. The ability to raise $600 million with $20 million collateral (1:30 leverage) is a thing of the past and this will drastically impact capital inflows to India. We will see a significant slowdown in foreign capital inflows and foreign direct investment as a direct effect of deleveraging, inaccessibility to new capital and higher cost of credit in the US and Europe.

It’s extremely important to recognize that the accelerated growth in our economy was driven significantly by foreign investments, which are sure to dry up in the short to medium term. Not because India is a less attractive investment destination, but because of insufficient capital and inability to leverage available capital. When investment banks, hedge funds and high net worth individuals could borrow $1 billion with only $50 million in collateral (1:20 leverage), the $1 billion could be distributed to India, China, Brazil and Middle East into equity, real estate, commodities and fixed income assets. But when the amount available is only $50 million (no leverage) or $250 million (1:5 leverage), any amount of distribution to emerging markets and asset classes translates to less capital inflows into India and other emerging markets. This credit crunch, or more appropriately, “capital crunch,” forces us to realize that there is less capital available for disposal around the world.

Consequences of this fallout will be far reaching and be felt in emerging markets at least temporarily. The US is a consumer driven economy (70 percent of GDP) fueled by credit and buoyed by cheap imports; Asian economies that export heavily to the US will feel the pain as spending slows down and credit gets expensive. Here in India and in Bangalore, IT bellwethers, who garnered major portions of their business from financial companies, could feel the brunt when US corporations delay IT spending plans. Financial firms are struggling to capitalize even their daily chores, so this environment will undoubtedly create less spending and reserved capital expenditure plans.

Not only will this crisis dampen the mood of investors, but will send many of them into hibernation. A lot of wealth has been eroded in this financial crisis, and investors in the US are worried more about wealth preservation than wealth creation for now. More individuals and funds will look for steady returns with less volatility leading to more conventional and safe haven assets. A rush to quality will attract many investors to established economies like the US, UK and Japan. One argument is that companies in emerging markets are undervalued now and offer good bargains which should attract investors. But this is also true in developed markets where global giants like GE, Boeing and Microsoft are trading at extremely attractive PE ratios (Click Here: DOW 30 stocks with quotes, charts and key ratios like PE, EPS, etc). The only bright spot from a foreign investor’s perspective is the weak Indian currency. This is the only factor which could attract investors to India. The fall in the Rupee is a classic sign of foreign investors exiting India, at least temporarily. This decline doesn’t necessarily imply a weak Indian economy, but underscores the temporary rise in demand for the US dollar, as assets are sold all over the world and money is sent back to US to recapitalize banks and companies.

The drastic weakening of the Rupee (Click Here: US Dollar-Indian Rupee Chart) will be short lived as federal intervention and an increase in money supply will eventually dent the US dollar. The US dollar’s rise is temporary and is not being driven by a strong fundamental economy. Usually when any country around the world has a financial crisis, it’s cost of borrowing sky rockets, except for USA. When the US was in a full blown financial and economic crisis, the cost of borrowing for the US government was at an all time low, reflecting the raw power of the US, and the fact that humongous amounts of debt are transacted in US dollars.

Companies should incorporate this outlook into corporate plans and use this opportunity to rein in spending, accelerate cost cutting and optimize assets and resources in their organization. The future isn’t all that grim as a slower growth rate of 6-7 percent per annum is much better than no growth or negative GDP growth which the US has to confront soon. Many factors like increased local consumption, favorable demographics and a driven population will keep our economy and nation buoyant.

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WHAT HAPPENED ON WALL STREET?

By, Adhvith Dhuddu

Shock and awe ravaged through the minds of millions from Wall Street to the Great Wall this week as tremors in the financial sector bought down industry giants Lehman, Merrill and AIG. An unfortunate convergence of ugly factors contributed to this saddening collapse leaving thousands jobless and millions a bit poorer. These are undoubtedly historic times with no precedent leaving many jittery about the future, which is why an elemental breakdown of the major factors that contributed to this crisis is vital.

The leverage factor: Investment Banks (IB's) over extended themselves with this luxury that many financial institutions used conservatively. The Bear Stearns collapse exposed the super leveraged nature of IB's where they could borrow $30-$35 for every $1 of collateral (1:35 leverage). This is primarily what IB's were armed with to maximize profitability and dampen the losses. Fearful of similar consequences Lehman frantically deleveraged their highly leveraged balance sheet by selling assets and raising capital impacting their profitability. It's important to remember that the new capital raised to decrease leverage could have been used as collateral for more capital which Lehman could have used to generate revenue.

Recapitalization and mark to market accounting: In addition to raising capital to deleverage balance sheets, Lehman and Merrill had to continue their daily activities which require large amounts of capital. Complex financial trades performed by IBs require them to put up and receive massive amounts of money (tens of billions) on a day to day basis, making them heavily cash dependent.

Because mark to market accounting forces investment banks to value assets at market prices rather than perceived or book value, it exacerbates the pain by damaging the balance sheet. These accounting practices are being heavily criticized and blamed for the crisis because they cloud the real values of assets, the balance sheets of these institutions and hence the value of these companies. This massive and unending need for cash to recapitalize and deleverage coupled with the high cost for credit literally strained these institutions to the last penny.

Access to Fed funds: Unlike commercial banks, IB's don't have direct access to federal funds. Their primary sources of capital are commercial banks for short and long term lending and cash infusions from customers, hedge funds and private equity firms. This again handicapped many IB's as the cost of borrowing surged, credit markets froze and their credit rating was slashed. For this specific reason, the existence of IB’s with the independent broker-dealer model is being questioned.

Failure of counterparty surveillance and "Self Regulation": Regulating IB's and hedge funds are complicated. The quantitative and mathematical nature of their operations require them to trade equities, bonds, debt, forex, futures and options in massive quantities at lightning speed. The positions on their balance sheet change literally everyday making the risky and highly leveraged nature of their positions tricky for regulation. Although the Federal Reserve knew of the threats posed by this due to their closely intertwined nature to the financial system, they never saw the need to regulate because of the high level of counterparty surveillance and, "self regulation" at IB's and hedge funds. Laissez-faire economists often hailed this development of, "self regulation," as something unparalleled. The unfortunate consequences of not regulating these IB's are what we now face and there sure is nothing unparalleled about the present crisis.

Credit rating agencies: The Moody's, S&P's and Fitch's of the world which are expected to be proactive and offer leading indicators were disastrously late to the party, reacting to the crisis by issuing warnings when it was no news to the financial community. These agencies share a massive portion of the blame simply because they failed to perform their fundamental duty: to accurately assess the quality of credit. A lot of pain could have been salvaged if these agencies were forthright in their assessments and exposed toxic balance sheets of troubled IB's.

Freddie, Fannie, and the underlying factor: The fall in real estate prices triggered this chain reaction, which is about half way through. Outlook in the real estate market doesn't look very sanguine either, which means this crisis could be painful and prolonged. A weak US dollar was an incentive for many overseas investors to explore real estate investments here and provide the much needed boost. But a steady strengthening of the dollar and apprehensions about the overall economy is now keeping these investors away. Local investment in real estate is not sky rocketing anytime soon as Americans are concerned more about wealth preservation than wealth creation for now.

Freddie and Fannie were taken over the by the government which could either be a boon or a bane in this situation. These two institutions are the primary sources of home mortgages underwriting a huge portion of them. If the federal government preoccupies itself in the takeover and transformation process and allows business as usual to continue at Fannie and Freddie, the required stimulant in the housing market will be absent. But if the feds recognize the need for a boost in the real estate market, ease regulations and churn out more affordable and flexible mortgages into the market this will undoubtedly attract buyers and spur the real estate market.

Financial models, illiquid markets and over the counter trading: Many of the troublesome assets that contributed to Lehman's decline were the toxic credit derivative swaps, and similar products. Most or all of these products had very illiquid markets forcing IB's to come up with complex mathematical models to price these securities. With no credible regulatory institution in place there was absolutely no accountability which led to pricing at will and pricing based on trust. The illiquidity in the secondary market only aggravated this as insufficient buyers and sellers led to a non-market math modeled and misleading pricing.

This recent implosion indicates a lot more than the dampened mood on Wall Street. This fallout clearly showed how financial engineering and innovation outpaced the federal financial market regulators who were caught off guard, desperately trying to save face and avert a lock down of the financial system in the country (and around the world).

Back to the basics: The last few decades saw the rise of a new type of bank: the investment bank. Well common sense now prevails and has proven that there is in fact only one type of bank: the normal bank where individuals park their savings which the bank then lends out at rate. Many wondered how the investment banking business model is sustainable, where short term loans are leveraged 1:30 and used in long term investments with no direct access to federal money. There was no credible regulator and the IB's had no oversight of any kind. Any venture capitalist would debunk these flaws in the investment banking business model if no IB ever existed and an ambitious entrepreneur draws up such a plan. There is talk about the new normal, because Wall Street's landscape has changed dramatically in the last six months. There will be a new normal: we will get back to the basics and have just one type of bank, the commercial bank.

The Future: Of the five major IB's which operated using the independent broker-dealer model, only two, Morgan Stanley and Goldman Sachs remain. It's very unlikely that Morgan could survive this crisis and the future looks uncertain even for Goldman in this fragile market environment. Leverage that was built up over years is hard to undo in a weeks or months. The deleveraging process will be nasty and unfortunate because the losses will be socialized and divided amongst taxpayers but profits will be privatized.

History has proven that our economy is one of the most resilient and nimble structures around the world. It has braved diverse problems from accounting scandals to bank failures and continued to roar forward. This is largely attributable to the strong foundations of America, competent regulatory institutions and the grit of the American worker. Although this down phase is looking ominously different, one can be sure that when the bad times pass, investment opportunities will open up.

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BEGINNING OF EXTENDED VERSION (ON BLOG):

The right remedies: Understanding the intricacies of the US and world financial system would take years. But here are some measures that the Fed and Treasury could have taken to diminish the volatility and lessen the panic.

1. The cost of credit for all the companies in question surged dramatically around rumors that credit rating agencies were exploring the option of downgrading their credit ratings. If some internal financial levers were pulled to stop these credit rating agencies from downgrading, this would have bought companies time, and saved billions of dollars of taxpayer money because credit could've been generated easily.

2. Mark to market accounting wrongly portrayed the balance sheets and hence the value of companies, which resulted in credit rate agencies downgrading debt and increasing the cost of borrowing. Practicing mark to market accounting when there is no market for securities is fundamentally flawed and this rule has to be scrutinized and reviewed.

3. Prevent hedge funds and investors from opening up naked Credit Default Swap positions that gamble on company's defaulting (i.e. no one should be allowed to purchase a credit default swap if the buyer of the CDS has no underlying asset to protect)

Financial or economic crisis: What started out as a financial crisis isolated to credit derivatives and the debt markets could soon transform to an economic crisis. The unfolding of events in this crisis has terrified normal folks and experts on Wall Street. For the first time in the history of Wall Street, brokers and bankers were actually asking for regulation and begging for intervention. These events have dented the confidence and questioned the sustainability our borrow-and-spend economy, which might result in a weaker US currency and the emergence of a multi-currency reserve system. In a consumer driven economy where prices of fuel, gas and food are on the rise, a simultaneous increase in the cost of borrowing will only intensify the pains on Main Street.

Large and small businesses depend on short term credit for their everyday transactions, and the dangerous freeze in the credit markets is harming the lifeline of corporate America as they operate with a broken backbone which is an illiquid credit market. Ordinary folks often use the stock market as a barometer of the economy which could be misleading sometimes. In this case especially, while the stock market recouped major losses by the end of the week, credit markets remained frozen and inaccessible which was scary and abnormal.

The Money Trail: Lots of hedge funds made massive profits in this financial crisis. Having mastered the system, there is a possibility that some firms legitimately exploited the loopholes for huge profits. With this basic understanding of CDS’s let me illustrate one instance of how this is possible.

CREDIT DEFAULT SWAPS (CDS) SIMPLIFIED
BUYER OF A CREDIT DEFAULT SWAP (or insurance): Hedge fund, investment bank or an accredited investor.	SELLER OF A CREDIT DEFAULT SWAP (or insurance): An investment bank, hedge funds and insurance companies.
Buyer purchases a CDS (or insurance) for an underlying asset (the underlying asset could be a loan, a bond, or any type of obligation). There is no requirement that the buyer of the CDS be the owner/holder of the underlying asset.	The CDS seller is selling the insurance for the underlying asset for which the seller will receive regular payments like insurance premiums.
The CDS buyer makes regular payments to the seller of the CDS, like insurance premium. So if XYZ hedge fund buys a CDS for Lehman Brothers debt from Morgan Stanley, XYZ hedge fund will make regular payments to Morgan Stanley, who in this case acts as the insurer for Lehman’s debt.	The CDS seller pockets the regular premium paid by the buyer and promises insurance in exchange. So in this case Morgan Stanley would have priced the CDS on Lehman’s debt based on complex models and sold that insurance to XYZ hedge fund. Morgan Stanley in turn receives and keeps the premiums.
XYZ hedge fund (the buyer of the CDS) is in effect, buying insurance and transferring the risk on Lehman’s debt to the seller of the insurance.	The seller of the CDS, Morgan Stanley, is in effect taking on the risk of the buyer’s underlying asset, Lehman’s debt, and is insuring it. So CDS buyer has transferred the risk to the CDS seller.
In the case of a credit event, the buyer of the CDS (XYZ hedge fund) gets a massive payout from the seller (Morgan Stanley), because the underlying asset has defaulted (i.e. Lehman’s debt defaulted).The payout can be a cash or a physical settlement based on the contract terms.	In the case of a, “credit event,” (i.e. bankruptcy, bond or credit default, obligation default, etc.) because the CDS seller has been collecting premiums and assumed the risk of the underlying asset, they are obligated to compensate the buyer for that. So Morgan Stanley compensates XYZ hedge fund proportionally.

Taking the same example used in the CDS illustration, where XYZ hedge fund buys a CDS for Lehman debt from Morgan Stanley, where the hedge fund in this case does not own or has no exposure to Lehman in any way, and it’s just a speculative play. When any bank, hedge fund or private equity firm buy a CDS on corporate bonds, on company short term or long term debt, this in turn lowers the price and value of these bonds.

Once XYZ hedge fund buys loads of CDS on Lehman’s debt, it is a good thing for this hedge fund if Lehman defaults on its debt. XYZ hedge fund can now short the stock (which was extremely easy to do before the present rules took effect, hedge funds and institutional players could short the stock naked, i.e. short massive amounts of the stock without actually owning it). Observing a rising short interest in the stock, other market players add to the downward momentum and drive down the stock price to depressed levels.

Depressed stock prices forces credit rating agencies to step in and downgrade the company’s debt, which could result in a bankruptcy filing (if sufficient capital cannot be raised for new collateral levels) or a default on their credit. Now, XYZ hedge fund, the buyer of the Credit Default Swap makes enormous profits because Lehman defaulted and Morgan Stanley, the seller of the CDS has to deliver a huge paycheck to XYZ hedge fund. Many suspect these practices could have been rampant in the last few months. One expert described this as, buying (or owning) your neighbors insurance and running his house over with your truck.

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TACKLING INFLATION THE RIGHT WAY

Economist John Maynard Keynes said, “Inflation is a form of taxation which the public find hardest to evade and even the weakest government can enforce when it can enforce nothing else.” This invisible tax eats into the savings and incomes of the rich and poor alike, but impacts the lower rung more. In a developing economy like ours, the absence of a social security safety net and absence of income and employment insurance in the unorganized sector (which employs a significant portion of our population) severely aggravates the inflationary consequences for lower and lower-middle class families. The published inflation rate clouds the all important rate of increase in the price of basic food articles which affects the majority of our population.

Many attribute the current spike in inflation to global externalities like widespread commodity price rise, supply shortages, demand increases, etc. This is true only to a certain extent but there are various India specific factors that can be calibrated to tame inflation. Here are a few.

1. Money Supply Levels: When the supply of money increases, there tends to be a cyclical effect of more money chasing the same number of goods and services, directly inflating their prices. A post analysis of the most vicious inflationary periods of recent times (Germany and Japan in the 1970s, USA from 1973 to 1982) showed that the primary driver of inflation was high levels of money supply. By simply looking at RBI statements, it is clear that money supply in increasing at an alarming rate. This must be controlled, and RBI has been taking steps in the right direction in this department (by hiking CRR, SLR and other important rates). But the pace of tightening has to be accelerated even if it is at the cost of a slow growth rate for 1-2 years.

2. Currency Suppression: Despite the endorsement of many economists and other financial pundits, our Reserve Bank continues to control our currency, not allowing market forces to dictate the right price. This flawed approach to undervalue the currency to help only export-oriented industries is wrong and unsustainable in the long run. The government should slowly adopt a hands-off approach to currency management and let the Indian Rupee appreciate.

A stronger Rupee will automatically reduce food exports, keeping more food at home, hence increasing supply. The increased purchasing power of our currency will help us buy more food and essentials from abroad (increasing supply again) and the cost of goods and services at home will decrease (because of the increased purchasing power of our currency) coalescing to suppress inflation.

3. Other Temporary Policies: In addition to this, our Government should also announce some emergency policies like temporary food credit, or water/electricity subsidy for lower and lower middle class families to help them navigate these tough times. Raging inflation is also a disincentive to save and families that live on low wages struggle to make ends meet. This should be considered by the Center and some temporary measures to help our economically backward must be implemented.

BAD TIMING AT THE WTO

The recent collapse of trade negotiations at the WTO received widespread scrutiny from economists, public servants and industrialists. Some praised our commerce Minister, Mr. Kamal Nath’s unwavering stance to protect the interest of the Indian farmer and others warned that this breakdown in talks could reignite a protectionist era in modern trade and commerce. But the unfortunate finale of the WTO talks shed light on various macroeconomic and geopolitical issues that converged to result in a collapse in negotiations.

A pivotal factor was the severe and unpredictable surge in food and energy prices putting many countries in uncomfortable territory at the negotiating table. No country, developed or developing, wanted drastic changes in import or export policies fearing a sudden inflow or outflow of essential commodities and hence fueling regional instability. Clearly the global macroeconomic environment created temporary disincentives which were reflected in the rigid and inflexible nature of some negotiators.

The US always enjoyed the kingmaker position at global trade talks, often overpowering their way to pro-US policies. Clearly, other nations did not appear to be at the mercy of US negotiators this time around and showed resolve, not giving in to their demands. This does not symbolize the decline of American influence but instead reflects the growing clout of the BRIC countries. Emerging economies no longer have to compromise and can confidently voice their concerns not fearing any severe backlash.

Prominent voices have highlighted that this outcome could be detrimental to expanding global trade because agricultural and farming sector presented the biggest trading opportunity ever to strengthen ties between countries. These opinions cannot be discounted and our officials should ensure this does not take place.

One has to realize that food/agricultural subsidies are the most complex and sensitive areas not only for India but every country at the WTO table. Farming and agriculture is the only sector where every single government has some subsidy program in place. For example, the Americans have enormous subsidies for corn growers, China has subsidies in place for rice farmers, many European countries have widespread subsidies, and our farmers also get significant aid from the government. For this simple reason, no government wanted to risk a backlash from their farming sector, forcing them to be extremely cautious in their decision making process.

Going forward the failure of these talks should not deter economies to negotiate again, but this time exchanging ideas at a smaller scale and taking it one step at a time can help. More bi-lateral and tri-lateral trade agreements should be formed before embarking on multinational trade agreements.

THE NEXT THREAT: INFLATION

The demise of Bear Stearns, failure of IndyMac Bank, troubles at US mortgage giants Fannie and Freddie and the housing debacle coupled with the nasty deleveraging process saw our markets and economy on tenterhooks. Each time we escaped with minor setbacks, clearly reflective of the resilient and agile nature of our financial structure. But something more ominous is gaining momentum which could potentially rattle the economy if kept unchecked: Inflation.

Economist John Maynard Keynes once said, “Inflation is a form of taxation which the public find hardest to evade and even the weakest government can enforce when it can enforce nothing else.” Unfortunately, not much light is being shed on this issue and our Fed is under the illusion that inflation is under control. Something very significant is about to unfold because a variety of factors could converge to drive inflation to disturbing levels.

A post analysis of the most vicious inflationary periods in recent history has shown that inflation primarily finds its roots when money supply increases dramatically. This creates a condition where more money chases the same goods and services, hence driving up price. But now, in addition to an oversupply of money, other factors like high commodity and agricultural prices, imported inflation, rising producer price index and a weak US currency will contribute to drive up inflation.

Money Supply Exploding: The Fed and the Treasury have our printing presses on overtime and money is being printed and pumped into the economy at an alarming rate. The sharp cuts in interest rates from 5.25 to 2 percent in a few months accelerated borrowing by banks and expanded money supply in the form of credit. Amidst all the turmoil, Congress approved a $150 billion stimulus package adding more money into the system now in the form of cash.

Lost in all this noise was a disturbing and vital piece of news which received no coverage. The Treasury/Fed decided to stop publicly releasing M3 money supply information. M3 is an extremely important number because it the broadest measure of money circulating in the economy which is tracked closely by economists. This number gives a clear picture of how much money is in the system. Having been publicly available for decades no rational explanation was given for this retraction. Although less accurate measures of money (like M1 and M2) are still available, it severely hinders the capability to quantify the amount of money in the system.

Imported Inflation: Textiles, electronics, furniture, toys and now even inflation is made in China. Many developing Asian economies which export heavily to the US are experiencing high levels of inflation. Central bankers and regulators in India and China are fighting vigorously to tame inflation, sometimes even at the cost of growth. But inflationary forces are still largely at bay in those economies and a significant portion of that inflation gets imported into the US through their exports.

This unfortunate phenomenon significantly affects our inflation rendering the US government helpless because this inflation is imported. This particular source of inflation is not about to drawdown anytime soon and has to be tackled.

Rising Agricultural/Commodity Prices and PPI: Significant price rises in commodities, agricultural and food products are inciting widespread agitation here and around the world. The producer price index (PPI) is widely considered a leading indicator of where consumer price inflation or CPI is headed. Measuring inflation in primary input articles for a wide array of manufacturers, the PPI reflects the rising cost of production and manufacturing which will eventually be passed on to consumers. Even this number has been on the rise, raising several red flags, which the Fed has chosen to ignore. There seems to be no reprieve for the PPI, which are disturbing signs going forward.

Misery Index: Many economists track the famous Misery Index (unemployment rate plus inflation) which is currently at 10.72 percent (unemployment at 5.7 percent and inflation at 5.02 percent). The appropriately worded indicator basically reflects the overall mood of the economy and the signs don’t look very sanguine going forward.

All these factors will converge and drive inflation to outrageous levels, so now is an appropriate time to look at your portfolio for asset re-allocation.

Your Money: Usually high-inflation periods result in super-low real returns when invested in the stock market (if stock market is up 15 percent, inflation is at 10 percent, your real return is 5 percent). This is primarily because of US Dollar devaluation and loss of purchasing power. Majority of local and dollar denominated investments will drastically underperform and here are some ideal avenues to park your funds in this situation.

1. Buying foreign currencies via ETN’s like CNY and INR or best, buying foreign currencies directly.

2. Investing in commodity rich country’s government bonds with high yields like Australia: Here you are positioned to gain from both currency appreciation and bond yields.

3. Shorting the US dollar via ETF’s like UDN.

4. Purchasing TIPS or Treasury Inflation-Protected Securities.

5. Purchasing significant quantities of gold, silver or other precious metals as a hedge.

6. Buying ETF’s, ETN’s and their options that track inflation.

7. Generally divesting from dollar-denominated assets.

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FKCCI ARTICLE: JUNE/JULY 2008 ISSUE

GOLD WILL CONTINUE TO GLITTER

By Adhvith Muralidhar Dhuddu, Regular Columnist

There’s been much hullabaloo about investing in gold and gold related companies in the last few months. Although gold has historically been a low yielding investment in the long run, it has run up spectacularly and more than doubled in the last few years. With the stock markets in India, China and the USA in shambles right now and other asset classes drastically underperforming, investors are exploring safe havens like gold, silver (and other precious metals and commodities) to park their funds. But let’s look at some basic drivers of supply and demand for gold to see if it will continue to shine.

1. Inflation and Gold as a safe haven: Inflationary periods are detrimental to any economy and if high inflation persists for long, it consistently erodes the value of a country’s currency. Going back to the basics of money, we recognize that the primary function of money is: (a) to preserve value, (b) to be a medium of exchange and facilitate easy transactions, (c) to be a unit of account to help measure the value of an economy. The second and third function can be taken for granted as this is fulfilled irrespective of the type of currency or money used. But the most important function of money is to preserve and store value. If Rs.10 could buy you 5 tomatoes a few years ago, but can only buy you two tomatoes now, clearly the purchasing power of the currency has declined and it has failed to preserve value. Governments and central banks use politically appropriate verbiage and label this inflation.

When this phenomenon unfolds there is a rush to accrue assets that don’t decline in value and historically gold has been that safe haven. Gold is traditionally identified as a safe haven investment that preserves capital and increases in value gradually. But what is unfolding now is monumental because not only are emerging economies experiencing high inflation, slowly the US and the European economies will face inflationary problems. When this occurs, the rush to accumulate gold will drastically drive up the price with an increase in demand.

2. Gold investments via ETFs, ETN’s and increased access to retail investors: The only access individual investors had to invest in gold was jewelry and coins making it an illiquid and untradeable asset. But this is rapidly changing. Now, investors can buy, sell and trade gold with ease with the introduction of Exchange Traded Funds (ETF’s) and Exchange Traded Notes (ETN’s).

The boxed portion of the gold supply demand table below clearly reflects the rise in demand for gold by retail investors via ETF’s and other similar products. This is poised to increase tremendously as the demand to invest and trade gold continuously increases. The rise in popularity of these ETF’s and ETN’s is evident in the US markets and as other emerging countries’ financial markets mature to provide these instruments, the demand and popularity for them will increase. Another vital factor is that gold is considered a safe haven not just by US investors or households in India, but every individual, bank, and fund manager knows that gold is a safe haven investment and as access, liquidity and tradability increases, there will undoubtedly be more demand.

3. Role of Central Banks, Sovereign Wealth Funds and Foreign Exchange Reserves: As more wealth is created in third world and emerging economies and as foreign exchange reserves of export oriented countries continue to swell the demand for gold will continue to rise. The US Dollar’s recent decline has hurt the value of foreign exchange reserves forcing policymakers to identify another stable currency or any other form of capital preserving asset. And many central banks are slowly transitioning portions of their funds to gold, silver and other precious metals. Not only is gold turning out to be a safe haven for retail investors, even central banks and sovereign wealth funds want to park their funds in gold.

Nobel Prize economist Joseph Stiglitz clearly delineated in his book, “Making Globalization Work”, the flawed single currency reserve system. Many of the fears he outlined are slowly unfolding with the US dollar becoming a less favorable reserve currency. Allocators of forex reserves are prudently diversifying their funds by exploring other currency options like the Euro and Yen and safe haven commodities like gold and silver.

4. The Dollar Factor: The weakening of the US dollar has significantly affected the price of gold. Like crude oil, gold is a dollar denominated asset and its relative price has risen with the fall in the value of the US dollar. At least 15 to 20 percent of the price rise in gold can be attributed to the weakening of the US dollar.

Although the US Dollar/Indian Rupee relationship has been choppy, the overall strength of the US dollar (measured best using the US Dollar Index), which compiles the US Dollar exchange rates with the Yen, Euro, Pound, Swiss Franc and other major currencies has significantly declined. So the USD’s comprehensive weakness in the last few years helped inflate the price of gold, silver, steel, copper, crude oil, natural gas and many other US Dollar denominated commodities. Hence, going forward, the movements of the US Dollar will considerably impact the price of gold.

5. Universal demand and supply: Given below is a table outlining the worldwide supply and demand for gold in the last ten years. A comfortable balance can be observed in the supply less demand column which fails to explain why the price of gold has increased so much. What’s important now is not what the historical relationship was, but what will the supply demand relationship will look like going forward.

The increase in demand for gold going forward cannot be denied. Going forward, demand for gold to use in electronics, dentistry, and other industrial applications will only increase. But the supply picture for gold does not look very bright. Gold supply has increased at an average rate of 2-3 percent historically and this number is not about to change any time soon. One has to remember that the supply of gold is limited to how much gold is mined which limits the availability of this commodity.

6. Extreme Cases: Some economists have boldly predicted that the days of fiat currencies are numbered and the world will return to the gold standard. This could unfold if a major currency like the Dollar, Euro or Yen completely collapses or if inflation in developed economies like US reaches the stratosphere rendering paper money to be completely valueless. Although these are extreme cases nothing can be ruled out. In this case, the value of gold will also reach the stratosphere trading at eight to ten times of its current price.

Clearly, the current dire economic scenarios around the world, and other favorable factors outlined will send the price of gold higher. One should explore to see how they can diversify to include gold in their portfolio.

Federation of Karnataka Chamber of Commerce and Industry: April 2008 Issue
INFLATION’S LOOMING THREAT GOING FORWARD,
by Adhvith Dhuddu, Regular Columnist

The first four years of our Finance Minister’s term unfolded with buoyancy and resilient growth in most sectors. GDP grew handsomely, rising household incomes pleased the masses, corporate profits scaled new highs, the stock markets ventured into uncharted territory and prices across the board were relatively stable.

But the recent and sudden spike in prices exacerbated the looming inflationary threat and is creating jitters in the Finance Ministry, Commerce Ministry, RBI and more so at 7, Race Course Road, the PM’s Residence. Speculation about early elections is alive and well but even the regularly scheduled May 2009 elections could be marred with high inflation and outrageous price rises. This recent price rise is merely a preview of the agony faced by the electorate if appropriate measures are not taken to prevent further price rises and curtail inflation.

Recent measures taken during the damage-control mode seemed to have assuaged some pressures but pivotal factors which determine inflation (discussed below) are still at bay. Our FM, PM and RBI governor have vocally pledged that price stability

In a great nation like India, it is quite a pity when a starving family and has to make a choice between food and medicine when somewhere in the country food reserves in godowns are rotting.

is a high priority objective and are even willing to sacrifice growth to suppress inflation; a positive sign. But let’s examine what the FM has said before about inflation, price stability and monetary policy to measure him against his own benchmarks and analyze some root causes of inflation to tackle unfavorable price rises in the future.

Economist John Maynard Keynes said, “Inflation is a form of taxation which the public find hardest to evade and even the weakest government can enforce when it can enforce nothing else.” This invisible tax eats into the savings and incomes of the rich and poor alike, but impacts the lower rung more. In a developing economy like ours, the absence of a social security safety net and absence of income and employment insurance in the unorganized sector (which employs a significant portion of our population) severely aggravates the inflationary consequences for lower and lower-middle class families. The published inflation rate clouds the all important rate of increase in the price of basic food which affects the majority of our population. For example primary articles (which comprises 22 percent of the WPI and contains food articles) registered a growth of close to 9 percent at March end.

Many attribute the current spike in inflation to global externalities like widespread commodity price rise, supply shortages, demand increases, etc. This is true only to a certain extent as these trends have been in place for sometime (1-2 years). There are some reasons unique to India which is driving up inflation and needs to be tackled. Here are some of the fundamental macro issues causing inflation (and will continue to do so if they are not confronted).

1. Outrageous Money Supply: Going back the basics of inflation you learn that it is primarily caused by money supply issues. A continuous increase in money supply creates a situation where more and more money is chasing the same number of goods and services and this automatically drives up prices (irrespective of the supply-demand equation of the product). The importance of this characteristic cannot be stressed more because it has been the primary cause of high-inflation periods in recent economic history. USA (1973-1982), Germany

A continuous increase in money supply creates a situation where more and more money is chasing the same number of goods and services and this automatically drives up prices.

(during the 1970s) and Japan (1971-1980) experienced high inflation during the periods mentioned. All these were caused due to an increase in money supply and the central banks of all these economies had to drastically reduce money supply and increase interest rates to squeeze inflation out of the system.

Looking at the numbers from the recently released Annual Policy Statement 2008-09 from the RBI (abbreviated as RBI-APS-0809 for future references) proves the above point. According to the report, money supply (M3) increased by 20.7 percent in 2007-08, and 21.5 percent in 2006-07. Supply of money in the form of bank credit to the commercial sector increased 20.3 percent and 25.8 percent in the preceding two years respectively. All these increases are above the long term average rate of money supply growth in India. In fact later in the report RBI even acknowledges that, “money supply has risen above indicative projections,” and hence has decided to slow the printing presses. They plan to moderate monetary expansion (i.e. money supply) this time around only at 16.5-17 percent. The RBI deserves restrained applause because this is a step in the right direction and the problem is being tackled at its root. This is just the start and there should be a continued effort to control the supply of money, or we could see multi-year inflationary periods like the ones experienced by USA and Germany in the 1970s.

A common argument that is cited to support the increasing money supply numbers is the increase in net capital inflows. I will discuss this in detail later.

2. Inefficient Food Distribution Channels and Farming Techniques: Anyone blaming the supply-demand mismatch for recent price spurt in food articles needs to think twice before making that claim. The Ministry of Agriculture recently released numbers stating that, “total food grain production is expected to increase to an all-time high of 227.3 million tonnes in 2007-08 from 217.3 million tonnes in 2006-07.”

So, if the increasing disposable income of families is being reflected in the increased demand and supply of food is at record levels, why is it that food prices are going through the roof? It’s a simply because of horrendous and outright awful supply chain management and distribution techniques (or lack of them) that is driving up prices. The various middlemen coupled with rotting grains in the warehouse automatically decrease supply and increase the prices. No rain God, clearing of debts, increasing of fertilizers, giving free electricity or water, increasing/decreasing all sorts of taxes and duties, banning and placing limits, etc will solve this. It’s been tried repeatedly and has failed miserably. It’s pretty abysmal when our farmers are toiling hard in the fields only to see significant portions of their crop rot in godowns because of inefficient food and crop management.

In a great nation like India, it is quite a pity when a starving family and has to make a choice between food and medicine when somewhere in the country food reserves in godowns are rotting. We boast of churning out quality engineers, being home to IT behemoths and rich industrialists, but these are insignificant if we cannot feed our own people well. India’s food economy has to be strengthened and some basic steps like improving distribution channels, optimizing supply chains improving storage facilities must be undertaken. Knowing the unreliable nature of our government especially in the agricultural sector, the best way of doing this is to introduce competition. This should be a long term commitment and will eventually be undertaken when there is a crisis, like how the

Artificially keep the Indian Rupee (INR) undervalued vis-à-vis the USD by pumping in billions of dollars is analogous to pouring money into a bottomless pit for short term happiness. This flawed approach to undervalue the currency to improve growth is wrong and unsustainable in the long run.

foundations of our economy were reformed during a crisis. When a patient’s veins or arteries are clogged hampering the blood circulation, the doctor does not pump in oxygen, replace a leg or a hand, or improve the condition of the blood, he tries to open up the arteries first to improve blood flow and then tackle other issues. This is what needs to be done in the agricultural sector in India.

3. Misguided Currency Management: The misconception that a weak currency vis-à-vis the US dollar (USD) is good for Indian businesses because it serves as a backbone for export oriented businesses is widespread in India. The cheer leading from export oriented industries and export lobbies to artificially keep the Indian Rupee (INR) undervalued vis-à-vis the USD by pumping in billions of dollars is analogous to pouring money into a bottomless pit for short term happiness. This flawed approach to undervalue the currency to improve growth is wrong and unsustainable in the long run.

I agree that advocating an absolutely hands-off approach could be detrimental and make our currency extremely volatile creating ripples in the economy. Instead there should be a slow process of decontrolling currency valuation to allow the market forces to operate with relative freedom and enable price discovery. Another option is to allow the value of the INR vis-à-vis the USD to rise faster.

Besides helping the fight against inflation a strong local currency is beneficial in other ways. A stronger INR will automatically reduce food exports, keeping more food at home, hence increasing supply. Our strong currency will also increase imports

There should be a slow process of decontrolling currency valuation to allow the market forces to operate with relative freedom and enable price discovery.

of food because the same currency can now buy more hence increasing supply again. The government can then refrain from the ancient and unsuccessful policies of raising and lowering duties, banning and limiting stocks, etc. The increased purchasing power of the INR will be able to buy more products for the same amount of money. All this will automatically reduce inflation because of an immediate increase in supply and stronger currency being able to purchase more. There are some caveats associated with this technique but if executed with precision, it can work well.

Coming back to the argument that money supply should grow to support net capital inflows, we can see how a stronger currency can solve this too. According to RBI-APS-0809, “net capital inflows surged by 172 per cent to $81.9 billion during April-December 2007,” requiring the RBI to increase the supply of Indian Rupees. In lay man’s terms, over the last few years the demand for our currency has gone up but that strength is not reflected completely at the current price of our currency. Its common sense that demand for a certain product increases in the financial markets when the market perceives it to be undervalued and slowly reduces when the market thinks the price is fair.

But, in the case of the Indian Rupee, because the value of the currency has been artificially suppressed, the demand for it doesn’t seem to go away. The government ends up fighting a battle on two fronts: it has to continue to keep the Indian Rupee undervalued (to help exporters) by pumping money, but also try to decrease the demand for

Increasing the currency’s strength will mean less money needs to be printed to support net capital inflows, less money needs to be printed to support artificial currency valuation and less money needs to be printed as the purchasing power of our currency increases, eventually also helping tame inflation.

the currency so that market forces don’t overwhelm governmental force suppressing the price of the Indian Rupee. Finally the government has to continue printing more money to support the required payments to keep the INR undervalued. As capital inflows increase, as demand for local investment increases, and in general as the demand for INR increases it should be reflected in the currency, but it is not. So allowing the currency to strengthen will automatically relive the pressure to continue increasing money supply at high rates. Increasing the currency’s strength will mean less money needs to be printed to support net capital inflows, less money needs to be printed to support artificial currency valuation and less money needs to be printed as the purchasing power of our currency increases, eventually also helping tame inflation.

Consider this practical case: A year ago the central bank was making a valiant effort to keep the Rupee at 44-45 levels (vis-à-vis the USD), but eventually gave in when they were overwhelmed by market forces (and also the rising cost of suppressing the INR) and stepped back to allow a 10-15 percent appreciation of the Rupee to 39-40 levels. What about the approximately $120 billion pumped in to keep the Rupee at 44-45 level? It’s gone, wasted and will never come back (i.e. being held in USD denominated assets); in fact its value has now decreased because the US dollar has depreciated vis-à-vis the Rupee (imagine if this money could be used in more productive ways). History has shown repeatedly that as an economy strengthens, over the long run the value of its currency will rise. It is basically pointless to continue pumping money continuously to keep the currency at an artificial level. Think of the same situation two years from now when our government will again struggle to keep the Rupee at the 39-40 level by pumping in money and again give up to let it rise to the 35-36 level. With the democratization of finance and integration of financial markets over the globe it will become increasingly difficult and expensive to control currency values.

4. Flawed analysis that banning exports, tweaking import/export duties, fixing stocks levels, etc will solve the inflation problem: For some reason, our politicians and bureaucrats don’t seem to understand that these temporary tweaks will not solve inflationary issues in the long run. Generally, a complete scrap of import or export duties is good, but banning any kind of exports or imports, mandating stock levels, etc is unacceptable in a capitalistic and forward looking economy like India and is synonymous to going one step forward and two steps back.

On monetary policy, the FM said a few years ago that, “Unless we bring the fiscal deficit down to 3 per cent or below, we cannot gain mastery over inflation.” The finance ministry along with the RBI has worked diligently to achieve this number and have to be given credit for their efforts. On last count, the Gross Fiscal Deficit (GFD) for 2007-08 constituted 3.1 percent of GDP (from RBI’s Annual Policy Statement 2008-09). A significant assist from increased tax revenue cannot be denied and definitely contributed to this achievement.

There is another crucial reason that inflation needs to be brought under control. High inflation rates usually results in an ultra-low or negative net savings

But our Finance Minister certainly deserves credit for his ability to be able to balance the demands from the left and the right, the aam admi and the corporations, the public and the private sectors.

rate. According to our own Finance Minister, “High inflation and a negative return for depositors/savers make for an explosive combination, when key elections are round the corner.” (November 2^nd, 2003). Let’s see how our captain navigates this ship going forward.

It’s a relatively stress free job to analyze numbers, rely on theories and suggest remedies for the problems facing the economy right now. But our Finance Minister certainly deserves credit for his ability to be able to balance the demands from the left and the right, the aam admi and the corporations, the public and the private sectors and still manage to keep India’s growth intact and its flag fluttering proudly in the sky.

Money WhizDom: Demystifying the Bear Stearns fallout: The week that prevented global financial calamity.

By Adhvith Dhuddu, Regular Columnist

The US hasn’t been confronted by an economic tsunami of this proportion since the Great Depression. Although the downturn in the Indian stock markets was evident, the global repercussions could have intensified if the Fed’s antidote was considered insufficient. Many around the world failed to realize the gravity of the crisis because the Feds actions prevented a sudden and sharp downturn.

Never before has the US economy been confronted by so many issues that are affecting their fiscal and economic report cards, businesses, individuals and government. Its facing declining stock and real estate prices, increasing food, commodity and energy prices, weakening dollar, trade and fiscal deficits, increasing unemployment and inflation, decreasing investment, stagnant productivity levels, low confidence levels, decreasing consumption, low saving level, increasing cost of debt in a credit dependent economy, and to top it all off the failure the world’s fifth largest investment bank, Bear Stearns.

Many on Wall Street were aware of the pessimism surrounding Bear Stearns, but the severity of the fallout was what shocked investors and caught them by surprise. The implosion of Bear Stearns indicated a lot more than the dampened psychology on Wall Street. This fallout clearly showed how financial engineering and innovation outpaced the federal financial market regulators who were caught off guard, desperately trying to save face and avert a lock down of the financial system in the country (and around the world).

To understand what exactly happened at Bear Stearns, one has to put together a few pieces of the puzzle. The crisis that unfolded here was primarily driven by a liquidity crunch or in simple terms a lack of cash to meet day to day activities. Complex financial trades performed by investment banks require them to put up and receive large amounts of money (tens of billions) on a day to day basis, making them heavily cash dependent. The fluctuating values of its investments are why large sums of money flow in and out daily.

Investment banks are unique in their practice of using extremely high leverage to maximize their returns. A Lehman Brothers or a Goldman Sachs can approach a bank, put up $1 billion in assets as collateral to receive say $30 billion dollars to invest with, and this would be 1:30

This fallout clearly showed how financial engineering and innovation outpaced the federal financial market regulators who were caught off guard, desperately trying to save face and avert a lock down of the financial system in the country (and around the world)

leverage. Although it sounds outrageously risky, investment banks thrive on this luxury, something that banks and investment firms in India don’t completely indulge in. Bear Stearns in particular was highly leveraged, as high as 1:40 in some sections of its business.

The commercial banks like JP Morgan, Bank of America or Wachovia, who provide highly leveraged cash, can anytime call upon the investment bank to put up more collateral if they feel the investment bank has immersed itself in bad investments that are rapidly losing value.

Bear Stearns was whacked with a double whammy, when distressed investors started to pull out cash and some of their investments started to decline rapidly, the commercial banks demanded more collateral. Bear Stearns slowly drained their cash reserves to meet collateral demands, handicapping them on a daily basis. Their cash reserves declined from $17 billion to less than $2 billion in just four days, sparking a bank run. Having run out of cash they couldn’t clear trades on a daily basis, were unable to provide more collateral and couldn’t repay many investors.

This is when the Federal Reserve stepped in via JP Morgan to bail them out by providing emergency funds to continue daily activities, without which the complete financial system could have gone into a seizure.

It's important to distinguish an investment bank from a commercial bank to understand JP Morgan's involvement. Individuals park their savings in commercial banks which are insured in USA by the Federal Depository Insurance Corp (FDIC) for up to $100,000 per account. It’s common knowledge that the central bank of a country (in this case the Federal Reserve) is the

After starving off a bankruptcy at Bear Stearns and realizing the severity of the liquidity crisis surrounding investment banks, for the first time in 95 years (since its inception in 1913), the Federal Reserve opened the discount window to investment banks.

primary source of money and the lender of last resort, but only commercial banks have direct access to these funds via the discount window (i.e. rate at which they can borrow from the central bank). Commercial banks can borrow directly from the Federal Reserve, something an investment bank cannot do. Investment banks are not closely regulated by the government, which is why they cannot borrow directly from the central bank.

This is precisely why the Fed had to allow JP Morgan to borrow massively, who then turned around and lent to Bear Stearns just to keep the company alive. The Feds couldn’t have lent to Bear Stearns directly and had to lend via a commercial bank. One could ask why not Citigroup or Wachovia or Bank of America, as they are also commercial banks. Unfortunately, these banks were preoccupied with cleaning up their own sub-prime mess, and JP Morgan was the only unscathed banking still standing tall on Wall Street.

When JP Morgan acquires Bear, it will primarily be for Bear Stearns' highly successful prime brokerage and clearing businesses. The two other divisions: investment banking and investment advisory are of little value to JP Morgan as its own investment banking division is a world-class setup. There was a lot of clamoring when the takeover price of $2/share was announced (now increased to $10/share), saying the company has been tremendously undervalued. Many critics might be proved wrong because the amount of garbage on the balance sheets of Bear Stearns might actually mean the company is negatively valued at say negative $10-$15 billion affecting JP in the future. But because JP Morgan has a $30 billion backing from the Fed, it might siphon off all the bad investments onto the Fed and retain the good ones eventually having little to no affect on JP.

After starving off a bankruptcy at Bear Stearns and realizing the severity of the liquidity crisis surrounding investment banks, for the first time in 95 years (since its inception in 1913), the Federal Reserve opened the discount window to investment banks. This revolutionary move has so far warded off failures at other investment banks and also reflects enormity of the crisis. Clearly the Fed realized that desperate times call for desperate measures.

Regulating investment banks and hedge funds is extremely tricky. The quantitative and mathematical nature of their operation requires them to trade equities, bonds, debt, forex, futures and options in large quantities at lightning speed. The positions on their balance sheet change literally every day making the risky and highly leveraged nature of their positions complicated for regulation. Although the Federal Reserve knew of the threats posed by this due to their closely intertwined nature to the financial system, they never saw the need to regulate because of the high level of counterparty surveillance at investment banks and hedge funds. The

The most apparent global impact is the severe dent on the psyche of the investors from Wall Street to the Great Wall. Besides the increased cost of debt, the cost of insuring and securitizing debt has also gone up.

last time counterparty surveillance failed was the 1998 collapse of Long Term Capital Management hedge fund. Although the Bear Stearns collapse was primarily driven by a liquidity crisis, it can partly be blamed on failure of counterparty surveillance.

The impacts of this event have been widespread. The increased cost of capital has had a major blow on the investment banks forcing them to decrease their leverage significantly in the recent weeks. The most apparent global impact is the severe dent on the psyche of the investors from Wall Street to the Great Wall. Besides the increased cost of debt, the cost of insuring and securitizing debt has also gone up. Decreased liquidity in these markets is also a valid concern.

One disturbing parallel this crisis draws with the Great Depression is that in both cases banks caved in. The Great Depression saw widespread failures of commercial banks (this is when the FDIC was introduced) and this time an investment bank which specialized in advanced investment strategies like sub-prime mortgages and quantitative trading fell through. Despite their functionary difference, in both cases they perilously threatened to crumble the complete financial system and freeze liquidity. Note that the Great Depression witnessed widespread failures of banks; in this case, we have only seen one investment bank fail. Any more nasty surprises could cripple the already strained financial system, fueling speculation of a depression or a longer-than-anticipated recession.

History has proven that the US economy is one of the most resilient and nimble structures around the world. It has braved diverse problems from accounting scandals to bank failures and continued to roar forward. This is largely attributable to the strong foundations and competent regulatory institutions. Although this down phase is looking different one can be sure that when the bad times pass, investment opportunities will open up.

Money WhizDom: Demystifying, debunking recent Bear Stearns fall out

Adhvith Dhuddu, CT regular columnist

Wednesday, March 26; 12:00 AM

The U.S. hasn't been confronted by an economic tsunami of this proportion since the Great Depression. Our financial report card looks bleaker than ever with declining stock and real estate prices, increasing food and commodity prices, increasing unemployment and inflation, weakening dollar, decreasing investment, stagnant productivity levels and, to top it all off, the failure the world's fifth largest investment bank, Bear Stearns.

Many on Wall Street were aware of the pessimism surrounding Bear Stearns, but the severity of the fallout shocked investors and caught them by surprise. The implosion of Bear Stearns indicated a lot more than the dampened psychology on Wall Street. This fallout clearly showed how financial engineering and innovation outpaced the federal financial market regulators who were caught off guard, desperately trying to save face and avert a lockdown of the financial system in the country (and around the world).

To understand what exactly happened at Bear Stearns, one has to put together a few pieces of the puzzle. The crisis that unfolded here was primarily driven by a liquidity crunch or, in simple terms, a lack of cash to meet day-to-day activities. Complex financial trades performed by investment banks require them to put up and receive large amounts of money (tens of billions) on a day-to-day basis, making them heavily cash dependent. The fluctuating values of its investments are why large sums of money flow in and out daily.

Investment banks are unique in their practice of using extremely high leverage to maximize their returns. A Lehman Brothers or a Goldman Sachs can approach a bank, put up $1 billion in assets (cash, building, money in the bank, etc.) as collateral to receive say $30 billion dollars to invest with and this would be 1:30 leverage. Although it sounds outrageously risky, investment banks thrive on this luxury. Bear Stearns in particular was highly leveraged, as high as 1:40 in some sections of its business.

The commercial banks such as JP Morgan, Bank of America or Wachovia, which provide highly leveraged cash, can anytime call upon the investment bank to put up more collateral if they feel the investment bank has immersed itself in bad investments that are rapidly losing value.

Bear Stearns was whacked with a double whammy when distressed investors started to pull out cash and some of their investments started to decline rapidly, prompting the commercial banks to demand more collateral.

Bear Stearns slowly drained its cash reserves to meet collateral demands, handicapping them on a daily basis. Its cash reserves declined from $17 billion to less than $2 billion in just four days, sparking a bank run. Having run out of cash, it couldn't clear trades on a daily basis, was unable to provide more collateral and couldn't repay many investors. This is when the Feds stepped in via JP Morgan to bail them out by providing emergency funds to continue daily activities, without which the complete financial system could have gone into a seizure.

It's important to distinguish an investment bank from a commercial bank to understand JP Morgan's involvement. Individuals park their money in savings and checking accounts in commercial banks, which are insured by the Federal Depository Insurance Corporation for up to $100,000 per account. It's common knowledge that the Federal Reserve is the primary source of money, but only commercial banks have direct access to this money via the discount window. Commercial banks can borrow directly from the Feds, something an investment bank cannot do.

This is precisely why the Feds had to allow JP Morgan to borrow massively, which then turned around and lent to Bear Stearns just to keep the company afloat. The Feds couldn't have lent to Bear Stearns directly and had to lend via a commercial bank. One could ask, why not Citigroup or Wachovia or Bank of America, as they are also commercial banks? Unfortunately, these banks were preoccupied in cleaning up their own sub-prime mess, and JP Morgan was the only unscathed banking giant still standing tall on Wall Street.

If and when JP Morgan acquires Bear, it will primarily be for Bear Stearns' highly successful prime brokerage and clearing businesses. The other two divisions, investment banking and investment advisory, are of little value to JP, as its own investment banking division is a world-class setup.

One disturbing parallel this crisis draws with the Great Depression is that in both cases, banks caved in. The Great Depression saw widespread failures of commercial banks (this is when the FDIC was introduced), and this time, an investment bank that specialized in advanced investment strategies such as sub-prime mortgages and quantitative trading fell through. Despite their functionary difference, in both cases they perilously threatened to crumble the complete financial system and freeze liquidity.

Note that the Great Depression witnessed widespread failures of banks; in this case, we have only seen one investment bank fail. Any more nasty surprises could cripple our already strained financial system, fueling speculation of a depression or a longer-than-anticipated recession.

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