Investors’ Appetite for Risk Related Return (RRR)
When one wants to make tons of money, he should be surrounded by thousands of fools, says an old adage on the stock market. It reiterated itself when Warren Buffet announced investment of $ 5 billions in Goldman Sachs (GS) and $ 3 billions in General Electric (GE) fetching him 10% interest per annum in addition to free warrants convertible into shares for next 5 years at currently depressed prices.
It was considered by many as signs of confidence from one of the most revered and legendary investors of all time, Mr. Warren Buffet. No one bothered to ask the investee companies, why was he given the yield of 10% that was normally associated with the junk grade bonds or companies. Have this bluest of blue chip companies degenerated into junk status? Are they next on line of “Olympic 2008 Parade of Bankrupt financiers?”
No one even noticed the rapid transformation of the legendary investor into usurious Money Lender at his advanced age of 78. No one even noticed that there was no real liquidity crisis, but the lenders like Mr. Buffet have lined up on the side line to seek the Risk Related Return (RRR) from the potential borrowers. “Greater the Risk, Higher you Pay” was the simple message displayed on the foreheads of every possible lender.
Otherwise, when the FED was willing to lend at meager 1.5%, why should the GS and GE pay up 10% to Mr. Buffet? Within hours of receiving $ 3 billions from Mr. Buffet, GE rushed to the commercial paper market to raise further money for the payment of wages and salaries, and was glad to see the FED chief Mr. Bernanke dressed up in Santa Clause, disbursing billions more at just 2% (cut to 1.5% on following day). In short, $ 3 billions of Mr. Warren Buffet appear to have “gone with the wind “within hours.
What Mr. Warren Buffer announced was misunderstood and misinterpreted by almost everyone on Wall Street, Main Street, Capitol Hill, Fed, and entire community of journalists, analysts, commentators and interviewers. He meant, but did not say it, that the real market rates were extremely high, regardless of billions of dollars being printed in the backyard of Federal Reserve for free distribution later, and that no one was willing to lend unless he was rewarded with the return associated with the risk. (RRR)
Across the Atlantic, in London, relatively free market, the LIBOR rates rose to the highest, and yet no one was emerging as lender to lend to even commercial bank.
Why lenders look for higher return when the risk increases?
If the lender lends today $100 for just 3% (when the FED rates is only 1.5%), and that loan goes bad, he has to lend it 33 times (100/3) more just to recover the old loan, and that too, provided no new loans going bad.
If he had lent at say 24%, and if the loan goes bad, he has to lend only 4 times more to recover his old loans, presuming again all new loans remain good. This is why the local governments have to raise the funds at 20% or more in some cases. That is, there are lenders apart from Mr. Buffett.
When the risk profile of large banks have increased to the extent of bankruptcy running into hundreds of billions of dollars, the money market does become very tight, and the lenders withdraw into shelters when the market rates continue to be managed low by FED. The action of the FED to pump the markets with over $900 billions a day before and cutting the rate by 0.5% does not help. The money goes to bankrupt banks that merely set off the new funds against old losses. They do not lend more.
Mere injection of liquidity is not enough. The FED has to make it conditional, that if $50 billions are given to say, Citi group, it should deploy funds only for granting new loans or buying the new Commercial papers issued by various corporate business with suitable sub limit so that the money is distributed widely. Supposing, the sub limit is set to $ 500,000 for small businesses to $2 billions for large businesses like General Motors, they can carry on business by paying their employees the wages and salaries.
Float a New Bank or use smaller Regional Banks and fund them with $ 200 billions
Bush Administration may extend new loans through new bank or existing smaller banks to small businesses, large corporate entities, and consumers, subject to real tangible security with first lien. Limit the loans up to 25% of their annual sales, so that money rolls over every 3 months at least.
Why avoid large existing banks?
All large banks are saddled with billions of dollars of old bad loans. Most of them are irrecoverable as they have no security backing. They are secondary papers with second lien. The primary security has been foreclosed, seized and sold by the primary lender, with nothing left for secondary holders. By funding these bankrupt banks is like adding fuel to fire. Good money would be thrown after bad money. When the money is scarce, the efforts should be to use the new supply as efficiently as possible.
The banks that are almost bankrupt may be asked to transfer deposit and loan accounts (including primary mortgaged loans with first lien (not the secondary derivative papers) to new banks, so that normal business continues.
Old banks with billions of dollars of bad loans without security may be merged with each other so that cross obligations are set off against each other. If after this adjustment, they are still unviable, let them die the natural death or hold the talks with debtors to accept only 20% of the outstanding debts repayable in next 5 years. Thus, the liability of the large banks will be reduced to 20% and liquidated @ 4% over next 5 years.
Higher Rates are biggest enemy to leveraged derivatives and swaps
We are in the midst of highly leveraged economy. It has to be deleveraged. These derivatives thrived in low interest rates environments where the cost of swap was very low. If the rates rise to reasonable level, even up to 9%, all leveraged transactions will be forced to reverse immediately. At the same time, the Bush Administration may fund the banks Mortgaged loans to consumers at special rate of say 3%, so that their interest cost does not rise. This kind of differential interest scheme may bring immediate stability in the market place.
Higher Rates also help Insurers
Ask AIG – why and where did it lose in billions of dollars, when there were not much claims due to natural calamities, fire, flooding, or death of individuals. They did not lose in their core business.
The insurance companies receive free premium income from the insured. They found difficult to invest in higher yield long term treasury or local government bonds or well rated corporate bonds.
Mr. Greenspan has effectively killed the market of long term treasury bonds (10 to 30 years) by artificially lowering interest rates or even cancelling 30 years bonds altogether for 4 years (2003 onwards) so that interest servicing cost for the treasury remain artificially low on its massive public debt.
When the insurance company found no alternative long term high yielding safe treasury investment they started looking for exotic derivatives that used to give them higher yields, without realizing what they were getting into. The companies like AIG finally started buying highly risk derivatives like CDO, (Collateralized Debt Obligations) CDS (Credit Default Swaps) and CLN (Credit Linked Notes) without realizing the financial risk and legal evaluation of the securities to backed.
If the insurance companies had option to invest into say, 6% 10 year bonds or 8% in 30 year bonds, they would not have invested into derivative papers with fake back up securities.
Money should have some cost
The Money has been printed so much that the toy homes can be built by the American children with real US dollars. If Paulson and Bernanke prints $1 trillions now, they will have to print 100 Billion $10 Currency Notes with the logo of ex-Presidents. If they are spread on the 8 lane high way in United States, it will cover 22,600 Miles
The economists like Greenspan and Treasury Secretaries like Rupert Rubin or Henry Paulson (from Goldman Sachs) made the money worthless the moment they were issued or created. Their money did not have any cost except 1% to 2% for most of the times. Their theory was that low interest will boost the stock market that will increase GDP (which will increase the value of their stocks held in Goldman Sachs) That low interest necessarily promote growth or GDP was a myth, in fact a blatant lie.
Low Rates do not increase GDP or lead to healthy growth
Look at Japan.. It has been following near Zero interest rate policy since 1994. 14 years have passed and its Nikkei has slumped from 38000 to 9000+ yesterday (lost 75%) with no perceptible growth in real terms. A retiring Japanese with 10 millions yen finds difficult to take care of himself in his last days because he does not earn anything on his life time savings. If he spends, he feels that his savings will be empty in a few years. If he was getting even 6% interest, he would have got interest income of 600,000 yen which he could spend without seeing his savings depleted.
Reasonable high Long term rates do encourage savings and increase GDP in real terms
In country like India, the growth is robust because long term interest rates for Provident fund etc are over 10%. This encourages savings from where the people spend without seeing their savings depleted. The PF amount is invested into long term high yielding Government bonds that assures steady decent income.
Look at what happened in USA
And look at what these Greenspan and company did for United States. Often he was applauded for his brilliant management of economy. His philosophy was that the consumers contribute to GDP. So to make them spend more and more, he lowered the interest rates at all the times. That made the consumers to contract more and more debts – credit card, car loans, educational loan, home loans, top up loans on home mortgages and host of other loan products that fatten the banks with usurious interest rates. The loser was American consumer all the time.
Look at the signs at large stores selling Car to furniture. No interest for 6 months, no payment for 12 months….etc. This is what happens when the money is free and does not have any cost. The people just become spendthrifts and go bankrupt. If they find difficult to pay – file for bankruptcy – that’s all. It is more like “Payable when able” not, payable on Demand in case of a promissory note.
Money, Treasury and Gold
If money does not have cost, they are more like Toilet paper. They can be printed overnight in Bernanke Press. Treasury bonds are also papers – can be printed at the sweet will of President Bush or Paulson or Bernanke. Papers like Dollar and Treasury bonds can be printed and re-printed like books are reprinted with popular demand. Gold can not be produced artificially – it has to be dug from the ground
Why Interest rate will go to 24% to even 30%
If you can not control inflation, control inflation numbers, were the theory, belief and practice of Greenspan. He invented new theory of inflation – Core Inflation and Non –Core inflation which was excluding violent food and energy prices.
Goddamn idiot! Food and energy constitute over 40% of household budget. Every family has at least 2 or 3 children, one of two college going young adults, 2 to 4 cars depending on the number of adult members in the family. How could you exclude the cost of Energy (gas for 2 or 3 cars, heating oil, propane or cooking gas for stoves and oven, electricity for cooling or heating home,water and pool) and Food from inflation and adjust your interest rate policy accordingly? This was the disaster. Did Greenpan really know the basics of Economics?
When I left stock broking field, the CRB index was 191 – it rose to over 430 recently, that is gain of 240 pts in less than 7 years. This index covers over 17 elements of daily use – from Orange juice to Oil to dairy products and commodities of daily use. In other words, the inflation rose by 31% per year (240 divide by 7). The United States was having “negative interest rates” by at least 25% for over 7 years in a row.
Those rates are now catching up and there is nothing the government can do. The creative management of inflationary numbers (called manipulations in layman’s terms) can not last for ever. You have to pay for it. The pay time has finally come in October 2008.
The interest rates in United States have to rise to 24% minimum to weed out all excesses in the system that was built under the lousy regime of Alan Greenspan. May be high interest rates may remain for only 6 months, but that will force everyone to start respecting their own dollar.. The lesson that United States will learn is that “Money is not Free” and do not take it for a free ride.
How to defrost the present liquidity freeze?
Stop cutting Interest rates – in fact raise interest rates up to 6% in 6 months in increments of 1% per move. Higher rates will bring out money lenders into the market that will force down the interest rates later with more participation. Currently, their participation in almost NIL
- Adopt “differential interest rate policy”.
- Fund the banks of their mortgage finance portfolio with cheaper funds @ 2.5% for the time being. (MFR = Mortgage Finance Rates)
- Fund the banks of their Credit card portfolio with cheaper funds @ 2.5 % over the 30 year MFR
- Other bank borrowings to businesses be permitted @ 3.0 % over 30 Year Mortgage Finance Rate (that is, if MFR is 2.5%, then other commercial borrowings to be 5.5%).
- Please note that charging of even 9.5 % interest rate (based on maximum MFR of 6.5%) from FED to banks on commercial borrowing is not excessive. This is the ruling Prime Rate in most of the Asian financial centers and emerging economies.
- Bank to customer interest rates may be restricted to 2% over the Fed funds rate for respective category.
- Example, if MFR funding is at 2.5%, then the customer lending rate may be 4.5% (2% over 2.5
- The idea of allowing only 2% above Fed funds rate is to ensure that the bank does pass on the benefit of the rate cuts in future to every section of the society. Currently, they may pay more but much less than the market rates.
- Merge 3 or 4 large banks that have inter-swap positions outstanding.
This will cancel out cross obligations of each other.
- Then Consolidate the fund based external debt (not deposits).
- Call the creditors of bad loans to work out discounted solution, agreeing to pay not over 20% of debt outstanding (or more if there is real security,
- Extend Federal guarantee to such amount and charge the respective banks guarantee commission @ 2% per annum.
- Take some equity for such help or warrants convertible into shares at any time for next 10 years.
- The creditors will have no choice but to accept the compromise, otherwise they will lose everything.
EXAMPLE: If the total bad debt outstanding is $ 50 billions, reach a compromise for $ 10 billions. Extend the Federal Guarantee to $10 Billions and charge the bank guarantee commission @ 2% of guaranteed amount ($200 Millions per year).
- After all these adjustments,. Ask the bank to come out with secondary public issue
- of which the State may take up 10% of public offer. This will infuse the confidence to investing public
- of which the State may take up 10% of public offer. This will infuse the confidence to investing public
- Extend the Tax Cuts as under:
- Corporate tax be cut by 5% now, followed by another 3% in second year, 2% in third. Total 10%
- The present corporate taxes of 35% is too high for anyone to invest in USA It will come down to 25% in 3 years. (In my proposal it is brought down to 18% in progressive manner)
- This will increase the real earnings of the company and boost its stock price, enable raising of new capital and also boost the stock market. There will be real strength in the economy, not paper trading or manipulations that both Paulson and Bernanke are indulging in.
- Personal Tax Cut may be extended by reducing the initial tax slabs substantially.
The initial tax slab be drastically reduced so as to benefit the low wage and middle income wage earners.
- While Interest rate may have some negative effect on the market (in fact it will have none, because slightly more interest rate is more desirable than wholesale collapse of financial system),
- the lowering of Corporate Tax and Personal Tax will have significant positive effect on the entire range of capital markets throughout the United States.
My Letter to the President Bush was ignored and they blew up over $ 3.5 trillions in 15 days
In my book, I have designed full range of tables of Income Tax for the corporate sector and also Individuals. The plan is so comprehensive that it will be liked by Individuals and corporate alike. Not only that, I have given most valuable suggestions to increase the revenue from other sources, so what is lost in taxation, is more than compensated from the other revenue stream.
I only regret that the no one in the White House paid any attention to my 4 page letter which contained the summary of 18 chapters of blue print for the recovery of United States of America. I had also warned that if the immediate actions were not taken, worse consequences would follow. That was my letter recceived by White House on 25 Aug 2008 and the situation started worsening 15 days later. And you know what happened from second week of September. I had also sent a copy of that letter to the Consul General of Hong Kong for his information and also for proper identifcation purpose.
By not paying any attention to such important letter, at a time when the solution was eluding the nation, the Bush Administration blew up over $ 2.5 trillions in loss of market capitalization and also over $1 trillions in so called “bail out” plans.
I would release the letter shortly on this blog site within a few days.
Kalidas, Hong Kong
Article Ref: 08-006