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D.Muthukrishnan (Muthu), Certified Financial Planner- Personal Financial Advisor

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Inside Job

Posted by Muthu on June 28, 2011

John Maynard Keynes said: 

“Capitalism is the astounding belief that the wickedest of men will do the wickedest of things for the greatest good of everyone.” 

Though I don’t fully agree with the above statement, in certain context, it still continues to be true. 

I’m going to talk about an academy award winning movie ‘Inside Job’. Though it is a documentary, it is a financial thriller, much better than many other movies. It is an entirely true story; a sad story of how the economic crisis of 2008 cost tens of millions of people, their life long savings, jobs and homes.

This is not the story of the past; still it is continuing in U.S. and many parts of Europe.

This film explains very clearly how all this happened due to insatiable greed of Wall Street. 

The beauty of this film is in its ability to make a common man understand the complexities of the crisis. At the end of the film, you would have anger as to why these men are not in jail and instead continuing to enjoy millions of dollars of salaries and bonuses. How much main street (Washington) is run by people in Wall Street is evident through this movie.

We cannot also forget the fact that only in a capitalistic and democratic society; making of these kinds of films are possible.

In my opinion, all advisors must see this movie and it would definitely help investors to know what not to do with their money and whom not to trust.

There is natural tendency of market participants to ask for lesser regulation or almost deregulation. But with out regulations in place, we cannot expect people to behave better. There has to be both positive and negative incentives which rewards good behaviour and penalises bad behaviour.

U.S.is paying a heavy price for deregulating Wall Street, a process which started under President Reagan in 1980’s.

Icelandwas a leading country in all social and economic indices. Their GDP was $13 billion. As Iceland wanted to follow deregulation and leveraging, three banks were allowed to borrow $120 billion dollars, 10 times the GDP of the country. Leveraging of this magnitude always creates bubble as too much money chases too few assets.

The banks made circular trading by creating money market funds and parking their money in the same. This created the multiplier effect without any solid base.

The result, Icelandwent burst along with its banks.

Banks are back bone of economy and they need to be well regulated. Deregulating banks would result inU.S.like situation where hundreds of banks have gone burst. Living inIndia, we do not understand the extra ordinary job RBI is doing in this regard. Our banking system is one of the most robust in the world.

We have unsung heroes like Dr.Y.V.Reddy, former governor of RBI.

This film explains how greedy investment banking firms created money out of nothing.

Profits were shown when they were none by booking them in advance through a complex set of accounting procedures (remember Enron? Read ‘Conspiracy of Fools’. It’s available in Eloor Library).

Leveraging is dangerous, especially in banking. Investment banks lobbied with SEC (Securities Exchange Commission) to relax the leverage. At some time, it was as high as 33 to 1. This means that they can borrow 33 times of their equity. This also means a mere 3% drop in their asset base can wipe them out. Why they did it? Greed for more and more money. This resulted in collapse of giant institutions taking down the entire system along with them.

AIG (American Insurance Group) insured sub-prime debts through Credit Default Swaps (CDS) and went under. If you don’t understand CDS, you would be surprised to hear George Soros himself saying that he is old fashioned and do not understand such things.

For those who want to understand about CDS can read ‘The Big Short’ by Michael Lewis. Only after reading this book I understood (to some extent) what exactly these are and how they ruined the U.S.financial system.

After great depression till 1980’s, U.S.was growing well, banking and financial services were well regulated.

When the financial services got de-regulated, a tiny percentage of population got extremely wealthy and it is a down hill for rest of the country.

Derivatives were one such unique innovation. Derivatives are useful for the purpose of hedging risks. Since Wall Street like to trade every thing, derivatives was used to trade everything under the sun, without the need of even the underlying asset.

As Satyajit Das (yes, you can see Indians like Satyajit Das, Raghuram Rajan contributing for this film) points out that in insurance one can only insure his house. Through derivatives, any number of people can insure anyone’s house. Sounds mad? Why some one should do that? It’s a pure gambling; speculating on anything which can be converted as a financial instrument. So if the house gets burnt, the loss is magnified as so many people are gambling on the same piece of property through derivatives.

Warren Buffett has repeatedly pointed out that derivatives are financial weapons of mass destruction and converting financial markets into gambling markets are not good.

The CFTC (Commodity Futures Trading commission) in U.S. issued a proposal to regulate derivatives. It was turned down due to hectic lobbying by Wall Street. In December 2000, Congress passed the Commodity Futures Modernization Act, which banned the regulation of derivatives.

Eight years later the country paid a heavy price for it and continuing to do so.

Seeing this movie helped me to strengthen my conviction against trading; especially in derivatives – whether it is in stock or commodities or currency market.

Innovations and advances are not always necessarily good. Especially in the world of finance, many innovations in the last 3 decades have caused more ham than good.

90% of the volume in our stock exchange, NSE is in derivatives. The remaining 10% is only belongs to what is called cash segment, where people trade and invest in shares. Even in this 10%, many are traders and only some are investors. That explains why very few people make wealth through market.

If we approach stock market as a casino, the result would also be similar. Roughly 98% of the people loose money through this approach. Instead if we invest in companies through stock markets, our wealth grows. The same market gives different result for different approaches.

You may ask if it is that simple, why not everyone make money? I let Albert Einstein answer that: ‘Any fool can know. The point is to understand.’

From the mails and calls I get, what appears to be the simplest way is impossible for people to internalize and follow with emotional discipline.

I think the single most value addition I’m doing as an advisor, is trying to create awareness and help people internalize this approach.

My attitude, understanding the desires and fears of my clients, but not yielding to them and be objective while I plan their over all personal finance, being truthful and share what I consider appropriate without worrying about loosing a client for being so, are probably my core strengths. I do have reasonable knowledge and skills. But that is some thing I keep working on by continuous learning. I give more importance to my approach than my knowledge.

I deviated and indulged in talking about myself, which is enjoyable for me but need not be for you.

I was speaking with a journalist of a personal finance magazine some time ago. She told me that most of the queries and feedback she gets is on commodities market. Commodity trading is catching up very fast and everyone is getting excited at the opportunity to make quick money. Commodity market is basically a derivative market speculating on the future prices of commodity. These markets encourage you to take position with a small margin of 5% to 10%. So by investing Rs.10 lakhs, you can play with Rs.1 or 2 crore worth of commodity.

So with a 5% margin, if you make 5% return, it gets amplified as 100% returns due to leveraging. If you make 5% loss, then the entire capital gets wiped out. Despite repeated losses, people continue trading till they have nothing more to loose. Overcoming the lure of easy money is extremely difficult.

Our regulations and regulators are good. For example, SEBI does not allow mutual funds to trade in derivatives. They can take a position to hedge risk only if there is a corresponding position in underlying stock, that too if the fund mandate allows.

Unlike Iceland scenario, RBI does not encourage banks to do circular trading with mutual funds. A bank cannot park more than 10% of their networth in money market funds.

Financial markets should be there to serve the economy in channelising and allocating capital. If they are allowed to run the economy, more ‘inside job’ would follow.

I would strongly suggest seeing this film. Even if you are not able to understand it fully, you would have definitely learnt something. It’s your money and educating yourself is the best way of protecting yourself.

One Response to “Inside Job”

  1. Vikas Mathur said

    sir, please write articles more often…we crave for such knowledge as well as your musings! : )

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