This book describes how the 1997 Asian Financial Crisis transpired.
Only 2 of these three conditions can be allowed to be true without causing inflationary recession
Fixing the currency exchange rates against other reserve currencies
Control over domestic interest rates
Control over capital inflow
On foreign capital flows
huge volume of foreign capital flows into a country
economic growth rate increases
inflation rate stays low
huge volume of foreign capital flows out of country
economic growth rate decreases
inflation rate goes up
Common pattern across countries
The build up
Long periods of high export lead GDP growth attracts high levels of foreign investments. Huge volume of foreign funds originated from Japan which was having a very loose monetary policy
Countries peg their exchange rates to reserve currency to ensure stable prices for both imports of raw materials and exports value added products
Countries currencies are not reserve currency, hence foreign loans were denominated in foreign currency
Excessive leverage within the country by domestic parties who take on short term loans denominated in foreign currencies at lower interest rates to finance long term projects that generate returns in domestic currencies
Stocks are purchased with borrowed money. These stocks are then further used as collaterals to borrow more money
Real estate are purchased with borrowed money. These real estates are then further used as collaterals to borrow more money
Moral hazard due to corruption of financial system
banks are arm twisted to finance projects that are not financially viable by governments and politicians
The economic headwinds
countries face increasing export market pressure
Competition at the low end of the export markets from China
Competition at the high end of the export markets from Japan
Japanese government instructs central bank to tighten monetary policy to reduce real estate. This severely restricted liquidity from Japan and reduced availability of short term foreign loans to affected countries
Borrowers within these countries increasingly experienced difficulties rolling over their foreign denominated short term loans to finance their long term illiquid domestic projects
Many of them started defaulting on their loans
Foreign investors started getting spooked and started withdrawing their funds or refusing to allow their loans to roll over
Non-performing loans builds up amongst banks within these countries
Capital flight continues causing downward pressure on the exchange rates of these countries
Countries continued defending their exchanges rates by buying up their own currency and selling off foreign reserves (assets held in foreign currencies)
Countries deplete their foreign reserves and are unable to uphold their exchange rates. Since most debts are denominated in foreign currencies, they are not able to print money to pay off these loans.
The economy grinds to a halt and hyper-inflation occurs within their financial system at this point
domestic production stops and locally produce foods is no longer available for sale
due to shortage of foreign reserves imported products become very expensive in local currency
Countries approach IMF for loans to tide through this liquidity crunch.
IMF steps in and with a lack of understanding of the economic patterns imposes these requirements:
Countries required to impose high domestic interest rate. It has the effect of further reducing the money supply within these countries causing more defaults domestically.
Countries will reform the financial systems to remove cronyism lead financing
Riots ensures and Anti-establishment governments get elected in some countries
IMF releases the misstep in policies and relents
Countries lower their domestic interest rates to increase liquidity within their financial system
Countries allow their exchange rates to float freely
Relatively cheap asset prices within these countries starts attracting foreign investments again
For us to be able to successfully apply artificial intelligence on any domain, the following needs to be true
The behavior the system to be modeled must not be stochastic
The state of the system must be decipherable by the data scientist
it should be possible to understand the state in which the system is at through interpretation of data gathered
The domain can be modeled
the parameters for modeling the domain must be well defined
Only when all three premise are true can we determine where the adjustment should be made when a model fails to predict an outcome
The financial markets is stochastic in the short run.
The underlying parameters are constantly changing and thus hard to model due to the emergent nature of impacts caused by human activities. The data is qualitative and thus hard to convert into clean quantitative datasets.
While the price movements are obvious it is hard, it is hard to attribute impact to the various parameters.
As such, it requires human neural networks that consumed all these qualitative data to perform the prediction/decision making.
After the 2008 financial crisis, legislations like the Volcker Rules to inhibit big banks from behaving like hedge funds. They are no longer allowed to engage in any forms of trading or financial innovation which leads to excessive multiplying of money supply leading and excessive leveraging within the banking systems.
Their income is thus restricted to investment banking commissions and net interest incomes.
This book documents the series of regulatory missteps from the 1980s to the 1990s that lead 50% of savings and loans in the US to insolvency. During this period the total number of savings and loans decreased from 3,234 to 1,645.
The savings and loans are a special group of banks that are encourage to grow by the US government to enable affordable housing after the world depression.
They take in short term savings deposits at lower interest rates and lend out long term mortgages at higher interest rates. They profit through the net interest income generated between the short term interest rates and the long term interest rates.
Events leading to massive failure
During the Vietnam war, inflation which drove short term interest rates increase. This cannibalized SnLs’ profit margins.
De-regulation of short term interest rates which lead to increased competition by other banks for deposits. This lead to the inability to attract deposits at feasible rates to finance SnL’s long term illiquid mortgage loans.
The US government instead of recapitalizing these insolvent SnLs opted to de-regulate by allowing them to enter into other high yield investment instruments. This is in hopes of they will be able to rebuild the capital and thus minimize the amount of burden to be imposed on tax payers
Entrance of new entities
mutual funds competed for deposits
Freddie Mae and Freddie Mac competed for mortgages
SnLs ventured out of their areas of expertise and started buying into high yield corporate junk bonds and unsecured commercial loans.
With minimal equity stake in the game due to years of erosion and an implied government guarantee for a bail out in case things go south, SnLs began aggressive leveraged into these positions.
The US government reversed it stance and past regulation against SnLs holding high yield investment instruments. The forced liquidation of relatively illiquid positions further exacerbated the situation.
Government meddling in market mechanism to further political agenda is generally a recipe for disaster
Venturing beyond circle of competence in search of high yield is generally a recipe for disaster
Overt or implied guarantee of government bail out is a source of moral hazard that leads to excessive leverage by operators which is definitely a recipe for disaster
This book documents the series of events leading up to the successful leverage buyout (LBO) of RJR Nabisco.
Mechanism of an LBO exercise
Figure out the cheapest possible price to acquire the asset and its future cashflows while keeping transaction costs low
The acquisition team access the business to decipher potential cashflow, areas for cost savings and parts that could be sold off
The acquisition team raises private money to do the acquisition
During this period of time bandwidth of law firms and banks are fully engaged
Competing offers should be expected once a public announcement of an LBO buyout is made
Law firms and investment banks will charge fees even if the hiring party does not win the bid
Methods for financing an LBO exercise
issue of junk bonds
raising from private investors
issue of shares to directors to drive down level of cash required for the purchase
payment through cash
utilization of legal loop holes to reduce taxation on the LBO transaction
Motivations for an LBO exercise
The management team:
a option to exercise when the market is persistently undervaluing the shares of the business
free up value to reward themselves and their share holders
the CEO being the typical Type A personality got bored and restless from running his day to day business
The investment banks:
when the market is down but they still need to figure out ways to make money through business transactions
some needed an opportunity to enhance their prestige so as to attract future opportunities. Securing a prominent position in the transaction has that effect
Lessons from the LBO exercise
The inability to sit in a room and doing nothing is the source of most trouble.
The CEO ended off worst off than he did before the LBO event
Having inside support matters
Having support of the management team provides knowledge of where cost savings could be had in the operations
Just when you think shit will not happen, it usually does.
The management team was expecting an uneventful transaction. Unfortunately, the operation quickly escalated out of control when competing bids surfaced.
When money is cheap, Wall street gets creative
the Federal reserve provides cheap money which cannot be put to real economic use, LBO is just another method Wall Street utilizes to make a profit from this cheap money
When egos start getting involved, its no longer about making a profit
the successful acquirer ended up defaulting on a lot of the junk bonds issue
what started as an initial USD76/share bid quickly escalated to USD106/share
When an opportunity as large as this becomes available, the services of lawyer firms and bank credit becomes scarce and it is hard to gain access to such facilities as a new comer to the table
Companies actively manage Wall Street expectation
RJR Nabisco actively engaged in wasteful activities to project a steadily advancing year over year profitability and thus share price. It could have operated efficiently and have the share price reflect the actual value on day one
The core business will falter overtime when the operators get distracted by other activities and are no longer engaged and connoisseur of their own products
early employees of Reynolds cigarettes are themselves enthusiast smokers. They released a new product only when it passes their own taste test
later management were focused on milking the cash cow and started changing the culture as such
the senior financiers will generally play the diplomat (good cop)
the junior and middle level financiers will be in charge of hashing out the details (bad cop)