What caused the financial crisis?

The US $ 700 bailout package proposed by the US government is one of the most extensive government interventions in the financial markets since the great depression. The bailout plan is similar to the 1933 Home Owners' Loan Corporation of the post-depression era. Way back in 1933 it helped in stopping foreclosures and refinance defaulting mortgages , and increasing liquidity. That a similar proposal is being considered indicates the extent of damage caused to the banking and financial services systems all over the world.
But how did the banks and investment banks create this crisis? Let's cut through the financial jargon and understand in simple words how this problem was created in the first place. The root cause for the current crisis seems to be the excessive use of leverage.

Excessive leverage:

To take an example, a company with a net worth of US$ 25 billion borrowed 26 times its net worth and creates leveraged funds of US$ 650 billion to invest or lend them. When a small portion of the company's investments turns bad, as is the norm for the industry, the company's capital is under threat. To put things in perspective a 3.8 percent misjudgment in their books was enough to wipe out their shareholders' capital of $ US 25 billion.

Bad lending policies:

In 2005-07 the property markets were on a high growth path. The property prices kept increasing. A sense of complacency had set in the real estate markets . It was assumed that the residential property prices would keep increasing forever. Mortgage lenders relaxed lending standards. Billions of dollars of sub-prime loans were to given borrowers with the sketchiest credit histories on recommendations of mortgage brokers who were more interested in their commission. Loans were structured very innovatively. Some gave borrowers the ability to skip repayments and some had interest rates that rose over the life of the loan. Lenders were not worried about repayments as defaults if any, on loans, could be recouped from the property itself.
Contrary to this assumption, the property bubble burst leading to sharp depreciation in property prices. As loans were given to people who could not repay it in the best of time, mortgage repayments defaults kept increasing, triggering off a chain of events that led to the bankruptcies of the hallowed institutions of Wall Street.

Financial engineering:

Now you may ask how investment banks of the Wall Street who generally deal in investments in stocks, bonds and commodities have anything to do with mortgage loans. To understand this we move into the realms of financial engineering. Wall Street investment banks purchased the mortgages from the banks. This freed up banks' funds to lend more and gave the investment banks an underlying asset to create their financial magic.
Using these assets as collateral, they created derivative instruments and sold them to various institutional investors like hedge funds, pension funds, mutual funds and banks in all parts of the globe, including Europe and Asia. The instruments were to be redeemed as and when mortgage payments were received from borrowers.
The mortgages were categorised according to their quality. The good ones were pooled together under one derivative instrument. After being highly rated by credit rating agencies and insured from insurance companies these instruments were sold to institutional investors. The second quality ones got lower ratings, but nevertheless could be sold off with higher interest rates. The investment banks decided to keep the junk quality ones with themselves under separate companies called special purpose vehicles (SPVs) paying them the highest interest rates.
In all there was approximately US$ 1 trillion invested in these securities. Things were cruising along as long as property prices were on an upward trajectory . Once the tide turned the echo of defaults were heard far and wide. The value of mortgage-backed securities fell sharply. All institutional investors that had bought these highly-rated bonds in large volumes expecting a good rate of return now faced complete erosion of capital.

The jigsaw puzzle:

So, now, if we look at it as a giant jigsaw puzzle we have many independent pieces. One, a home owner who borrowed a loan; second , a mortgage lender who sold off his loans as income streams; third, an investment bank that purchased and re-engineered them; fourth, an insurer who through credit default swaps insured these debtbacked securities; and finally a bond holder who invested in these highlyrated instruments.
Now, due to defaults by homeowners all institutions up the chain are already bankrupt or facing bankruptcies.

Bailout to the rescue:

This is where the bailout plan is expected to solve the problem. The US government wants to buy mortgages and bonds from these near bankrupt companies with taxpayers' money. The plan as of now seems to be, after acquiring them at steep discounts, to hold them till maturity.
If all mortgages are paid back in full, the government can earn a handsome return on the taxpayers' money. This move will also help banks remove these illiquid assets from their balance sheets and free up the funds to be lent again, hopefully to good borrowers.
While experts seem cautiously optimistic that this bailout will solve the credit crisis to a certain extent, questions remain on whether it can prevent more failures of banks and Wall Street firms.

Bankrupt

Sorry for going offtrack, but could not help. From the day I started preparing for my B School Interviews in 2003, I was fascinated by the world of M&A's (Mergers & Acquisitions). There was a surge in M&A since 2003 an euphoria, what I call an urge to merge. I remember feeling elated and excited on reading the frenetic pace with which M&A activities were on, Sony buys MGM, AOL buys Time Warner. It made me proud to hear Ranbaxy buying a host of foreign drug companies and Tata buying Tetley and ofcourse the JLR (Jaguar Land Rover) deal was a crowning moment of India Inc. I would keep track of the different multi billion dollar deals, I would marvel at the way cash was produced on demand. As my interest in this area kept waxing, I started reading the different ways in which organizations would fund their acquisitions. It also brought me to a very interesting book by the name "Barbarians at the Gate" which detailed how RJR Nabisco was destroyed by a few greedy managers.
Today there is a lot of destruction in value; GM files for Bankruptcy, Lehman Brothers files for Bankruptcy, Meril lynch may be acquired. It is surprising that times change so fast. Lehman brothers, the favored destination for all the budding i bankers. The organization which only takes the best and the brightest of the Management graduates has failed to manage itself. Is it the subprime crisis, Is it an inability to weigh the risks? I am not sure, The euphoria has melted down and the only lesson that I take from this episode is to keep your feet firm on the ground as you try to reach for the stars, but do reach for the stars...

Negotiating by Phone

Negotiating by phone has both similarities and differences with negotiating in person.  Therefore, there are some special rules that you must apply when negotiating by phone.  These rules may sound too simple.  But don't dismiss them.  These little things can make a big difference in your negotiation success.

 

Don't Shortchange Your Preparation - Yes, negotiating by phone is different than negotiating in person.  But you must prepare just the same.  Know, in advance, what your target terms are; what you will say to persuade your supplier to agree to those terms; and how much you are willing to concede.  You must also be prepared for the questions your supplier counterpart may ask you.  Whether you stumble in your speech in person or stumble on the phone, you always weaken your negotiating position when you stumble.  So be prepared!

 

Always Initiate The Call - Negotiating successfully requires focus.  If you are caught off-guard by a supplier calling you, your focus will not be as strong.  If you pick up a ringing phone and there is a supplier representative on the other end and she wants to discuss terms, ask to call her back in five minutes.  Use that time to review what you prepared and then call the supplier.  Initiating the call gives you more control.

 

Turn Off Your Screens - In today's connected world, we expect ourselves to multi-task.  That's great.  But not during a negotiation.  Checking email during a negotiation will dull your focus and could result in your failure to object to terms that the supplier is introducing.  Eliminate the risk of such a distraction and just turn off your computer screen or Blackberry.  Your email will be waiting for you when the call is over.

 

Promptly Transcribe Your Notes - In-person negotiation discussions are easier to remember because you remember what you see, hear, and write.  In phone negotiations, you have one less sense for your memory to depend upon.  As you negotiate by phone, you probably scribble down notes about your conversation. They will make sense to you when you read them.  Until tomorrow. Type up your notes immediately after your call so that you can have a clear recollection of the negotiation outcome later.

Subprime Crisis

The last post promised a detailed discussion on the sub prime crisis. However, I felt that a discussion on the same is beyond the scope of this blog. While a personalised discussion is welcome, I have felt that the subprime crisis would be going to far from the world of sourcing. The treatment given in the last post, would I believe suffice for all the managers connected with sourcing. However, for those of you who would like to know more, Please click on the title. The hyperlink would redirect you to wikipedia where a detailed discussion is available. The treatment is comprehensive. In case it fails please click on the link below or copy paste the url in your web browser.

http://en.wikipedia.org/wiki/Subprime_Crisis

I have referred a diagram showing the causes, Effects and response put in a comprehensive manner by wikipedia here.

Secret behind the price hike of Caustic Soda

In my last post I promised to discuss the reasons behind the price increase of Caustic Soda & Soda Ash. Let me devote this post to the price hike of Caustic Soda. Caustic Soda is NaOH, Somebody suggested why don't we just take an aqueous solution of Common Salt (NaCl) & electrolyse it and produce NaOH. Ofcourse this seems to be a logical process. As I browsed through web pages I found that NaOH is actully produced in the way described above. However, the main product is not NaOH but Chlorine. Caustic Soda is a byproduct of the chlor-alkali process. Therefore, the supply of Caustic soda is dependent on the demand of Chlorine.
The price of Caustic Soda is supposed (actually)to have gone up due to the non availability of the product. It is the supply- demand game that is playing out. If the supply of Caustic Soda has gone down, it is assumed that the demand of chlorine must have gone down. The demand of chlorine is supposed to have gone down due to the subprime crisis.
The obvious question is, What is the subprime crisis ? The answer to this is beyond the scope of this post. However, we will be discussing the same in the next post. For now briefly; The crisis is evolved due to Mr. Bush exhorting the American public to spend their way out of the recession of 2002. Banks started giving loans, housing loans to the general public who carried a credit risk i.e those who may not be able to repay the loan due to unstable incomes, low income or a host of other factors. These were the subprime guys. When the real estate prices crashed due to oversupply of houses, these people found that the net repayment was higher than the market rate of the houses. Therefore there was a mass default of the loans. Meanwhile the banks had bundled the subprime loans and started selling the same to different financial institutions, as instruments. The defaults led to a revaluation of the price of the instruments which pulled the value of the instruments down. (Keep watching for the next post for a detailed discussion). The cascading effect was both a drop in demand for houses or new projects as well as huge losses creeping into the books of the financial institutions.
Going back to the second paragraph, Chlorine produced from the chlor alkali process described is primarily used in the manufacture of polyvinyl chloride resin which is again primarily used by the housing industry. With demand for housing falling, consequently demand for polyvinyl chloride resin fell and consequently the demand for chlorine. This led to a drop in the operating rates of the chlor alkali plants leading to a drop in the supply of caustic soda and with it the hike in prices of caustic soda. Phew... that was one hell of a chain reaction...

A bleak picture turning rosy ?

Companies are raising prices at break neck pace. The rising input costs has painted a gloomy scenario for the procurement function. The industry is faced with two dilemmas:

• Either it increases the prices of its products in response to the increase in key input commodity prices & thereby risk losing the market.
• Continue to hold on the price increases and risk diminishing margins or possibly bleed.

Also a degrowing market has not helped the cause. The problem is compounded in the Indian pharmaceutical industry faced with a triple whammy.

1) With the Olympics due in China, China would want to present itself as a country which is conscious of the environment in which it lives. Therefore, all the chemical firms (supplying intermediates) that were flouting the global environmental norms are being forced shut. This has led to a huge supply crunch. The output has dropped to 40% of the previous year, leading to
unprecedented hike in input costs.

2) The crude story is well documented and would not need much elaboration. However the key reasons identified for the increase in crude price are: (order depends on where you live & who you are)

a) Falling dollar (due to sub prime crisis)

b) US Iran standoff

c) Increasing consumption of oil by third world countries

d) No increase in production

e) Excess Speculation

f) Rising costs of oil exploration & development

3) Key pharmaceutical product prices are controlled by the government (whoever talked of liberalization). Prices of essential drugs are fixed by the government and are revised only through a lengthy, time consuming process. To quote an example, Ibuprofen is considered an essential drug and the government fixes the price of the finished product marketerd by the companies. Ibuprofen was hovering at around Rs 400/- when the government last fixed the price (about six months back) and today the same is hovering at around Rs 500+. To make matters worse the cost of the input Ibuprofen represents 90% of the cost of the finished product, & 65% of the Average selling price. Therefore if the price of the key active pharmaceutical ingredient rises by 25%, the pharma company starts bleeding. This is the reason why many of the pharma products are going of the shelf.

However, all is not lost. China is expected to revive production in a short while and all the pharmaceutical organizations are waiting with bated breath for the olympics to be completed & factories to resume operations. Crude is expected to soften on the back of anticipated production from Brazil, Canada & Central Asia and also due to softening of demand. The government is expected to revise the pricing norms in a shortwhile based on the stable conditions expected to arrive in a short while.

Now you maybe wondering the reason why I have not mentioned the ever so ubiquitous inflation as one of the three reasons. Well inflation is an effect of these three, atleast in the pharma industry. There are other minor factors too like the rise in the prices of Soda ash & Caustic soda. I will be discussing the same in another post. Till then keep your fingers crossed, pray for the early completion of the olympics, discovery of more oil fields and revival of the global economy.

Europe Catches e Sourcing Fever

This is a post from the European Procurement Leaders Network which has been reproduced here for the viewers of this blog.

Tim Minahan of Ariba

Compared to North American firms, European procurement organisations have been reluctant to embrace online sourcing approaches. Their long-time reticence has stemmed from resistance to e-sourcing methods both internally and from suppliers, as well as from a general misunderstanding that e-sourcing = e-auctions. (It doesn’t.)
Yet, private conversations and public presentations at Ariba LIVE Brussels offered hope that e-sourcing (including online auctions) is fast becoming standard operating procedure on the Continent.
Over a dinner and bottle (or two) of fine French wine, a procurement executive from a European aerospace manufacturer, told me that he directs his team to use e-sourcing for every sourcing project. And he prefers that they run a reverse auction. “We are of the mindset that you can auction anything. We’ve auctioned everything from IT to legal services. I refuse to accept that something can’t be put out to bid.”
His gusto was matched by the head of sourcing for a European oil and gas company: “We now align [buyer’s] incentives with how much of their spending is sourced online. We view e-sourcing as the sourcing process, not a subset of it.”
Listening to Telefonica CPO Juan Carlos Montejano Dominguez deliver the Ariba LIVE Brussels keynote the following morning, it was easy to see why European procurement leaders have caught e-sourcing fever.
Over the past year, Telefonica ran more than 35,000 e-sourcing projects for nearly €17 billion in goods and services — a more than 1,500% volume increase since 2003, the first full year of the e-sourcing program. And the telecommunications giant is far from finished. Dominguez is pressing his team to hit a run rate of 70,000 e-sourcing projects per year — a third of which will involve e-auctions.
Why is Telefonica so bullish on e-sourcing? Simple: results. As the below chart clearly indicates, Telefonica has yielded far greater returns from its e-sourcing than offline sourcing projects. And returns from e-auctions are even better.

Dominguez reported that e-sourcing has yielded considerable benefits beyond negotiated savings. Since launching its e-sourcing program five years ago, Telefonica has:

Cut sourcing cycle times in half.

Reduced management cost per awarded amount by more than 27%

Increased the amount of spend managed per FTE by more than 85%.

In addition to these benefits, Dominguez said e-sourcing has actually improved supplier relationships. “e-Sourcing has introduced a new level of integrity and transparency into the process,” said Dominguez. “It increases competition and objectivity in award decisions.”
To back up his assertion, Dominguez shared the results of a recent survey of Telefonica suppliers. Some key findings:
77.3% of suppliers felt e-sourcing “promotes competition and equality of opportunities”
80% said e-sourcing “increases transparency of the purchasing process”
And, more than 70% of suppliers reported that “e-auctions are a transparent method of contraction and they guarantee equal opportunities.”
Feedback and results like these underlie why e-sourcing is finally being widely adopted across Europe.