Are these actually 'weapons of mass destruction'? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster
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Are these actually 'weapons of mass destruction'? 

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In this issue:
» US has lost a decade
» Youth unemployment in Europe most distressing
» China is in need of reforms
» Higher disinvestment target set for 2012-13
» ...and more!


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00:00
 
Derivatives. Credit default swaps. Credit default obligations. Mortgage backed securities. Some of these very terms are enough to leave a bad taste in the mouths of global and Indian investors alike as these instruments are reminiscent of the global financial crisis and its crippling impact on the financial markets and economies of countries across the world. Warren Buffett even termed these derivatives as 'weapons of mass destruction'. One of the main gripe was that many of these 'financial engineered' products were so complex that most did not understand how they worked. And thus, in such a scenario financial innovation is certainly not bound to find many takers. But is all financial innovation bad?

As the Economist points out, financial innovation has certainly yielded its share of benefits. Some of these have been very apparent on the retail side. Here methods of making payments have changed the way people use and carry money. Even various derivative products have their advantages if used judiciously and with knowledge of the potential risks involved. After all these products existed even before the financial crisis and did not pose much of a problem then. Hence, to assume that all financial innovations are bad right from the start may not really work. The key is to keep a check on these products to see that they have not soured over a period of time.

One of the reasons why these financial products turned dangerous and led to the subprime crisis was greed. Here, the phrase 'too much of anything is bad' holds true. Greed leading to use of innovations inappropriately, to take on exposures that one should not, to manufacture risk rather than transfer it, to add complexity in order to plump up margins rather than solve problems. These were what fuelled the crisis and will continue to do so in the future as well. Indeed, when greed grips, finance in all its forms can turn bad. More importantly, financial innovation has responsibility attached to it. Those who innovate such products need to understand what these products can do and whether they benefit the society at large.

Do you think financial innovation in all its forms is bad? Share your comments with us or post your views on our Facebook page / Google+ page.

01:26  Chart of the day
 
Japan and its lost decade is a phenomenon we are all familiar with. With recession crippling most of the advanced economies, stagnation in growth and high unemployment means that many of these countries seem to have gone the Japan way. As today's chart of the day shows, Greece has fared the worst among all its peers. In economic terms, it is just about to enter the year 2000. The US for instance, is back where it was 10 years ago. Not surprisingly, given that Germany has weathered the European crisis better than its peers, in economic terms, the country has certainly fared better.

Data Source: The Economist

02:11
 
If a capital input is not giving the result expected of it, it makes sense to dispose the same, isn't it? This could be true for most capital inputs but what about those that are made in flesh and blood? We are referring to the human labour. The fact that this capital input is capable of showing emotions and also carrying out a revolution if need be, makes disposing off the same a rather difficult job. As a consequence, some extremely skewed policymaking comes to the fore. The Economist points out how of all the Eurozone's many problems, youth unemployment is perhaps the most distressing. Nothing but a result of the lopsided policymaking that we just discussed. Spain could serve as a good illustration as it is believed to have the highest youth unemployment rate.

So, where did Spain go wrong? Well, it designed policies that incentivised keeping old unproductive workforce employed and young, productive workforce unemployed or only temporarily employed. The end result? Lower overall productivity and a high youth unemployment rate. Germany is a lot better at managing its workforce if its youth unemployment rate of mere 7.8% is any indication. But it is believed to pursue strong wage restraints and thus, is not highly prosperous either. For now, the Anglo Saxon model of little or no employment protection appears to be the best positioned. For it prevents accumulation of work force at declining industries and encourages it to seek newer, more promising industries. The reason this works is it comes pretty darn close to the laws of nature. And painful for an individual it might be, the bigger picture does turn out good.

02:56
 
The dragon nation has impressed one and all with its fiery rate of economic growth. But as per a latest World Bank report, the future for China is not as bright and shiny as its past. The country that relies heavily on exports to drive its growth may face a future of sharp economic slowdown unless it puts reforms into place. Chinese leaders till date have concentrated heavily on the stability in the high rates of growth. Rather than looking at how to sustain this growth. As a result, state owned enterprises have grown at rapid fire pace. Competition has been kept at bay by not allowing foreigners to participate in sectors like auto, energy, banking, etc. Private sector has little incentive to expand as the banks prefer to lend funds to major state owned enterprises. Plus, the absence of competition and domestic consumption act as further disincentives. All in all, the policies of China have helped them to get this far. But unless they change their ways, the road forward will get bleaker each year.

03:37
 
Notwithstanding the temporary blip this week, stock markets in India have been booming this year. The big-ticket IPO of MCX also seems to have revived primary market sentiment. Industry chamber Assocham now wants the government to take advantage of the same. It has asked the Center to set a higher disinvestment target of Rs 700 bn for the 2012-13 fiscal. This will help the govt. to raise resources for development and bridge India's fiscal deficit. Last year, an ambitious target to raise Rs 400 bn was set. But the government could barely raise 3% of the total through the stake sale of Power Finance Corp. Due to bad stock market conditions, several sales had to be postponed. Well, we hope this year's budget target at least comes close to being achieved.

04:11
 
The finance minister certainly has his plate full when he presents the annual budget on March 16. This is because the Prime Minister's Economic Advisory Council (PMEAC) has issued some dreadful warnings and some cheerful forecasts. PMEAC has warned that fiscal consolidation should be given utmost priority and current account deficit should be curtailed. This can be done by lowering subsidies and increasing the tax-GDP ratio by withdrawing excise and service tax cuts. PMEAC has also forecasted inflation will cool off to 5-6% and GDP will increase to 7.1%. But here is the where the numbers don't add up. If subsidies are cut (which is difficult due to rising oil prices) by increasing prices of diesel, kerosene etc than inflation will start to rise again. Thus, with rising inflation and zooming taxes, it will be very difficult to accelerate growth. The only way this can happen is if international oil prices fall or if the rupee gains strength. But if rupee increases, exports will take a hit and current account situation will only worsen. Thus, it will be a challenging task to increase growth with higher taxes and high oil prices.

04:47
 
In the meanwhile, the Indian stock markets were in the red for a larger part of the trading session today as selling pressure mounted. At the time of writing, BSE Sensex was down by 223 points (1.2%). Barring IT and metals stocks, most other sectoral indices were at the receiving end. Among the Asian stock markets, China and Japan were the top gainers.

04:56  Today's Investing Mantra
"It's not whether you're right or wrong that's important, but how much money you make when you're right and how much you lose when you're wrong." - George Soros
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10 Responses to "Are these actually 'weapons of mass destruction'?"

N.M.R.Shreedhar

Feb 26, 2012

Hi, I fully endorse the views of Mark kranthi -- the point with financial innovation or any innovation for that matter , is it can be used either way--for instance nuclear power can be used for power generation as well as terrorist goals, so also finacial innovation. While it is well known that financial innovation has brought about net based trading and e-transfer of funds, it has also brought ruin to scores of people who have blindly invested based on hot tips--perhaps the ease with which one can invest has prevented them from studying before jumping headlong. Similarly a phenomenon called "Program trading" or even quant-based trading has brought financial misery to many.
Ultimately one needs to remember that trading in the stock market is a zero sum game, and there are no instant get-rich ways. regds

Like 

AJ

Feb 25, 2012

One thing that is rock solid truth is we humans never learn from our past. Just go to the history and we tend to repeat the same mistakes. We regret our bad decisions when they hit us back hard or soft. But our memories fail us at wrong places and wrong times. The fact is, that's way we want it.

Like 

Sivaramakrishnan

Feb 25, 2012

I do not agree that Derivatives should be categorized as WMD. But this is only good for HNI's and not for retail traders. When i mean HNI's, i expect the person to have a minimum of Rs 5Crores, and only 20% allocated for trading capital and just 10% out of the trading capital as exposure to Derivatives which itself should give a return of 25% on the trading capital if the person has good skills and discipline.

I agree other instruments like CDS and others have been severely criticized by the stock market gurus of US Financial markets that they need to be discontinued are banned. In fact, I read in a newsletter that CDS in simple terms is buying an insurance on your neighbours house and waiting for it to go up in flames to collect the sum assured. I presume that it is an instrument where the insurance is taken on derivative products which itself is only a neighbour to the cash equity product.

And so also all other products which will lead only to greed when the competition gets tougher.

Like 

Sekhar

Feb 24, 2012

The regulators like SEBI are responsible for allowing such products to be marketed, as the greed on the part of financial product innovators and common investors can go unabated at times despite good education on it. These products had done more damage than ever expected. Simple businesses and products are loved by the expert Warren Buffet. Why do not common investors learn about?

Like 

Rajaram

Feb 24, 2012

Dear Mr.Sanjay, let's not get too emotional about this human/caring thing. Please note that labour and employees are reflected as "costs" in the P&L statements of corporates. And the goal of every corporate is the bring costs down to "zero", if possible. So if a corporate could operate without humans, it will! In the end, the social mandate given to a corporation is to minimize costs, maximize efficiency, and maximize return on capital to its shareholders.

But let's remember that this is a "social" mandate given to corporates. Meaning, these corporates still operate within the umbrella of the government which is elected by the people, and need to follow the rules of the land. To prevent the corporate mandate from overtaking the social mandate, its necessary to have a strong vibrant political system. This is what is lacking. When the populace sleeps, or is intoxicated (like the middle class in America was due to 20 years of extreme consumption), then no one is watching the government, and as a result, the government is not watching to see if the different operating entities within its umbrella are operating within the social mandate.

I think this movement of awakened people is starting now. Ordinary people in America are waking up, people in the middle east are waking up, and even the polity in India is waking as witnessed by the Anna Hazare movement. The Anna movement may have lost some ground due to the specific issues it picked, but it is something that will grow tremendously since these movements are the only way the government can be reminded that they represent the social mandate.

BTW, we should still allow the corporates to seek maximun returns within the ambit of the law. After all, India needs efficiency and wealth creation to create dignity and strength in the society. Subsidies, and free dole outs will only create a weak dependant population. A weak population will always be exploited, as all the "powers to be" have to do to make the population fall in line is to threaten to withdraw the "free meals".

Sorry about the long post, but wanted to passionately express that instead of critizing the corporates, we need to learn how to hold our elected government accountable to a social mandate.

Like 

Digambar Kulkarni

Feb 24, 2012

Financial Innovations are not bad.
Greed is a very basic human trait and will continue to be so; one need not complain about. Too much greed and too less greed is meaningless.
Choice of horizon is also a factor to consider. The aim of all investments to earn a profit only to spend and enjoy. Who and when is also important.
In fanancial world who outsmarts whome is an important factor. The seller and the buyer both feel they have made a profit but often one makes a profit while the other incurs a loss.

Like 

Suresh Kumar

Feb 24, 2012

Financial Innovation is not bad per se. Derivatives can help in risk management against price variation in raw materials or currencies. However, its a double edged sword, and could also result in huge losses, if you are greedy if you end up making huge forex losses on exports or imports or on raw materials. Also, a chain reaction can lead to unforeseen situations if price variation is further compouned by mass hysteria or hoarding. Stricter laws need to be in place. Greed and risk management have to go hand in hand, else the natural advantage of financial products is totally lost.

Like 

kranthi Mark

Feb 24, 2012

These guys are highly qualified , Wears expensive suits , Lives in posh and affluent localities ,drives expensive cars , Good speakers & presenters , Extremely self motivated people, Look very cool and gives impression as they are relentlessly working for social & investors cause .Derives lot of social respect from society. Their job known as Financial Advisory. They don't carry ammunition or weapons but products more dangerous and powerful than nuclear bombs which create financial destruction to your life. They are least bothered about customer's financial fortunes ,they work for their personnel appraisal and bonuses, prescribes only financial products that only gives highest amount of revenues irrespective of associated risks with respective of products . Unlike communal terrorists they won’t cover their faces with masks but wears neck ties . Their motive is increase their Assets under management and revenue and always assures and talk about doubling of our invested money at a very short span of time.
They won't talk much time once your balance is Zero .They call Customer is KING but not treats at least as a Citizen once your balance is NIL . Financial services firms designates their sales staff as Financial Advisors that they look into their priorities but not the investor priorities while conducting financial planning.
Now especially in India , the Wealth Managers or financial planners or Relationship Managers irrespective of their designations their main motive is earn high revenue for the company.
Of course its not wrong practice ,Every one have to work with profit motive , But it should not through misguiding and promoting illicit wrong advisory practices which leads to Investors Financial destructions. , they know they are not married to their companies but Profit with human touch is essential for long term sustainability of Relation & Business.
Customers and Investors are afraid and worried to go to Banks not of robbers , but because some one might do their financial planning !!. In reality these highly respected institutions doing their own financial planning but not customers. Recently one of my uncle asked me in surprise why my wealth managers from a reputed Bank is stopped suggesting Mutual Funds for investment, and only talk about Stock Portfolio Management Services (PMS) , derivative structured products and private equity products (P.E) .For some well known financial advisory firms irrespective of customer's needs & requirements wealth management means only Life Insurance since it gives highest revenue .
I am not against to any of these Financial advisory firms and persons , I have high regards and respect for the profession of financial advisory. But the problem lies in with most of the advisors and their prescription of products . We have clearly witnessed the lacuna in recent Citi Bank Gurgoan case and there are number of issues and instances which won't come to lime light because of illicit financial advisory . A communal terrorist might create destruction to the lives with their explosives and weapons . But the products these financial extremists carry in their bags like Derivative structured and high bandwidth financial products create greater destruction to your financial life and makes miserable if Investors are not educated on the risks associated with the same. Because of wrong advisory the entire life savings of a Investor will be evaporated in a single day
You don't get these destruction stories on print & electronic media as prime news to know .
In India there is no proper code of conduct to regulate , restrict and control activities of this financial advisory services .We have to blame all the financial regulators also for messing and perplexing the entire advisory activities. AMFI , IRDA,SEBI all the monetary & regulatory bodies are failed to construct , develop a standard uniform code of conduct for Financial advisory services . Since we are very well aware how these regulatory bodies acted in recent past
Ministry of Finance should take initiative to develop standard code of conduct for Financial advisory at base level as priority before they constitute Financial Stability and Development Council (FSDC) as super regulator . From Financial advisory firms perspective , they have construct and develop stringent norms to appraise products and stress on strong risk disclosure norms to customers before they distribute and sell Financial Products to prevent this fervid financial extremism & Extremists while advising financial products

Like (3)

Riks

Feb 24, 2012

Retail payments and all are just use of technology in financial transactions

Securitization has been the single biggest Financial Innovation in true sense over the last half century. It drastically reduced the cost of borrowing in economy by freeing up capital for lenders. Only, this was not done with prudence, as it should have been, for the moral hazard in such a case , as we saw, is really high.

Alfred Noble knew his invention wont have only peaceful uses, still his name is cherished by all the pioneers in world. Solomon Brothers had a very simple objective, make money by selling illiquid assets which cant be sold easily on a standalone basis, and thus came Mortgage Back securities. I am sure the Bankers knew what this might lead to, when they started trading in this product, but still the Agency theory rules. The inventors and early birds had their big fat bonuses and profits,which were justified at first , but then greed took over. It never was the fault of product,
Perhaps we humans should not be handed a tool which can be used as a weapon at all, even if it is twice as effective!!

Like (3)

sanjay

Feb 24, 2012

sir problem with this capitalist model is capital is supreme and human is not.when you are old you are thrown out and young get job with lower resposibility(overhead)so cheap labour.
with all disregard to human needs its jungle raj that is perported by this , usa model and greece model caring for human is loosing.
unfortunate for mankind.

Like (3)
  
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