Weekend reading links

1. Large is not always good. Marc Levinson writes how the latest giant container ships have, instead of lowering transport costs and raising efficiency, has increased costs, reduced speeds, and created a host of other problems.

Discharging and reloading the vessel took longer as well, and not only because there were more boxes to put off and on. The new ships were much wider than their predecessors, so each of the giant shoreside cranes needed to reach a greater distance before picking up an inbound container and bringing it to the wharf, adding seconds to the average time required to move each box. Thousands more boxes multiplied by more handling time per box could add hours, or even days, to the average port call. Delays were legion... The land side of international logistics was scrambled as well. At the ports, it was feast or famine: Fewer vessels called, but each one moved more boxes off and on, leaving equipment and infrastructure either unused or overwhelmed. Mountains of boxes stuffed with imports and exports filled the patios at container terminals. The higher the stacks grew, the longer it took the stacker cranes to locate a particular box, remove it from the stack and place it aboard the transporter that would take it to be loaded aboard ship or to the rail yard or truck terminal for delivery to a customer. Freight railroads staggered under the heavy flow of boxes into and out of the ports. Where once an entire shipload of imports might be on its way to inland destinations within a day, now it could take two or three. Queues of diesel-belching trucks lined up at terminal gates, drivers unable to collect their loads because the ship lines had too few chassis on which to haul the arriving containers.

2. Gautam Bhan writes about the lop-sided nature of urban land distribution,

Despite the language of “encroachment” and widespread “land grab,” bastis (slums) are on a minute portion of city land — less than 0.6% of total land area, and 3.4% of residential land in the 2021 Delhi Master Plan. This tiny percentage supports no less than 11-15% but possibly up to 30% of the city’s population, most settled for decades. One example shows how skewed this number is. In 2017, parking Delhi’s 3.1 million cars used 13.25 sq km of land, or 5% of all residential area. Cars, then, have more space than the housing of workers, residents, and families.

3. Obituary in FT of Lee Kun-hee, Samsung's Chairman. Lee was a real business titan and a force behind South Korea's economic transformation.

Samsung, which pulled away from Hyundai to become the biggest of South Korea’s chaebol, or industrial groups, by a wide margin. The company is the largest maker of memory chips, smartphones and electronic displays, Samsung C&T built the world’s tallest building in Dubai and Samsung Heavy Industries is the world’s third-largest shipbuilder by sales. Other subsidiaries’ range from theme parks to insurance. It is for the transformation of Samsung Electronics, however, that Lee will be most remembered. Samsung was a minor player in the global technology industry when he took the helm in December 1987, succeeding Lee Byung-chull, his father and the group’s founder... Within five years, Samsung was the world’s biggest producer of memory chips underpinned by billions of dollars of annual investment, even during downturns. Despite this success, shoppers around the world continued to view Samsung’s consumer electronics as poorly designed and undesirable. Lee’s aggressive interventions to change this perception have now become legend. The most famous came in 1995, after the humiliation of finding that Samsung mobile phones he had given as gifts did not work. Two thousand Samsung employees at a phone manufacturing factory south of Seoul were instructed to don headbands marked “quality first” and gather outside. Thousands of phones and other electronic devices — with an estimated total value of $50m — were incinerated on a bonfire and the ashes were pulverised by a bulldozer.

As I blogged earlier, Samsung's spectacular success breaks the mould on several scared tenets of modern business organisation and management techniques. See this from The Economist.

3. Chandra Nuthalapati et al have a good study that informs significant gains for vegetable farmers from selling directly to supermarkets,

Even after controlling for differences in quality and other relevant factors, we found that imputed farmgate prices that farmers receive in supermarket channels are around 20% higher than the prices received in traditional channels for most of the vegetables considered. For some of the vegetables, price differences are even higher. We also found that selling to supermarkets involves lower transaction costs for farmers than selling in traditional markets, as supermarket collection centers are located closer to the villages and involve lower commission fees Higher prices seem to be needed as an incentive for farmers to deliver to supermarket collection centers, because supermarkets do not offer any other incentives to farmers. In other countries, where supermarkets often procure vegetables from farmers through contracts, farmers benefit from lower price risk or from inputs and extension provided as part of the contracts. In India, supermarkets procure vegetables without contracts, so that higher mean prices are important to ensure regular supplies. We found significant price incentives for comparable qualities. In addition, higher quality grades are rewarded in supermarket channels, which is often not the case in traditional channels. Our data showed that farmers who supply supermarkets typically sell their highest-quality vegetables in supermarket collection centers, whereas they sell lower-quality produce in traditional markets.

While this will surely have some positive effect, these are excessively big effects. Something going on here about the study.  

4. Bihar sugar mill industry fact of the day,

Around 1980, Bihar accounted for 30% of the country’s sugar production, and 28 functional sugar mills. It has now come down to less than 5% of the production, and has 10 mills... At the end of 2016-17, only about 2,900 of Bihar’s estimated 3,531 factories were operational, employing on an average 40 people each. The national average is nearly double, 77 workers. The average salary per annum per worker in Bihar then was Rs 1.2 lakh, again less than half of the national average of Rs 2.5 lakh.

5. FT has a long read on the emerging geo-political struggle in the Middle East between UAE and Turkey, motivated by ambitions in both countries to influence politics in other countries across the region. Their frontline is in Libya, where Turkey is supporting the UN-backed government and UAE is supporting the rebels led by Gen Khalifa Haftar. 

The UAE accuses Mr Erdogan of colonial delusions, supporting Islamist groups and forming a hostile axis with Qatar, its Gulf rival. The belief in Abu Dhabi is that wealthy Qatar provides the funding, and Turkey the muscle as Mr Erdogan seeks to position himself as a leader of the Sunni Muslim world. “Turkey has many things to answer for, with its long-term attempts — in concert with Qatar and the Muslim Brotherhood — to sow chaos in the Arab world, while using an aggressive and perverted interpretation of Islam as cover,” Anwar Gargash, the UAE’s minister of state for foreign affairs, wrote in the French magazine Le Point in June as tensions over Libya soared. Sheikh Mohammed, known colloquially as MBZ, is spearheading the Arab push against Turkey’s influence... The UAE, which has an indigenous population of just 1.5m but is one of the region’s wealthiest countries, has long punched above its weight. Since the 2011 Arab uprisings rocked the region, Abu Dhabi has deployed tens of billions of petrodollars to bolster allies across the Middle East and Africa through trade, aid and the use of military resources. The Gulf state’s foreign investment and bilateral aid to eight countries including Egypt, Pakistan and Ethiopia, has totalled at least $87.6bn since 2011, according to the American Enterprise Institute, which analysed publicly available data.

Turkey is today the hub for the region's dissidents, especially Islamists, who pose an existential threat to the monarchical autocracies. UAE's normalisation of relations with Israel should be seen in this backdrop - an attempt to ingratiate itself in the West, against Turkey.

A related issue is the intensification of the stand-off between Armenia and Azerbaijan over the Armenian enclave of Nogorno Karabakh in Azerbaijan. One important reason for the breakage of the Russia-brokered truce which has held since 1994 has been Erdogan and Turkey, which have aggressively armed and supported Azerbaijan, thereby emboldening it. A humanitarian disaster is now unfolding which has displaced nearly half of the enclave's population. 

6. From Ananth, this article by Norman Doidge on the problems with RCTs in medicine,

An important review of RCTs found that 71.2% were not representative of what patients are actually like in real-world clinical practice, and many of the patients studied were less sick than real-world patients. That, combined with the fact that many of the so-called finest RCTs, in the most respected and cited journals, can’t be replicated 35% of the time when their raw data is turned over to another group that is asked to reconfirm the findings, shows that in practice they are far from perfect. That finding—that something as simple as the reanalysis of the numbers and measurements in the study can’t be replicated—doesn’t even begin to deal with other potential problems in the studies: Did the author ask the right questions, collect appropriate data, have reliable tests, diagnose patients properly, use the proper medication dose, for long enough, and were their enough patients in it? And did they, as do so many RCTs, exclude the most typical and the sickest patients?

7. The reality with Uber's misleading minimum wage adherence claim.

Drivers will be guaranteed earnings — 120 per cent of the local minimum wage — though with a significant caveat: Uber won’t count the time drivers are waiting to be matched with a passenger. When you factor in that period, a Berkeley study suggests that Uber’s promised $15.60 minimum an hour instead becomes, on average, just $5.64, once adjusted for driver expenses such as fuel.

8. This shocking story of the flight of ABC's Beijing Correspondent from China tells everything about today's China, which clearly does not abide by any rules applicable for civilised nations.  

9. A rare example of expose of corruption in the defence forces, which is without doubt at least a pervasive as elsewhere (perhaps even more given the lack of external oversight). The problem though with dragging CBI, CVC etc into investigating works, especially those done in places like Ladakh during the ongoing stand-off, is that it could backfire badly and end up delaying and derailing even those critical and time-bound works. 

10. Talking of burying your head in the sand, and Eugene Fama, in this interview, is a great exhibit. The level of obduracy on financial markets, negative rates, private debt, impact of central bank policies, business concentration and so on is stunning. Virtually every paragraph is an exercise in denial of reality. Evidently Fama is living in a different world. 

11. Economist hails Aditya Puri as the world's best banker!

The attributes are very old-fashioned,

First, Mr Puri’s management style, which features a clear vision, microscopic attention to detail, blunt speaking and a knack for retaining talent... The second factor is strategic discipline. Mr Puri intuited that Indian consumers and firms would be a consistent money-maker and has stuck to that view. He took the sophisticated processes used by foreign banks and used them to target local retail and commercial clients. The result is a large branch network, half of which is outside cities. The firm’s cash-machine and credit-card networks are the largest among India’s private banks. Mr Puri stayed away from foreign ventures and investment projects, avoided lending to India’s indebted oligarchs, and financed HDFC’s balance-sheet through deposits rather than debt... The final element is HDFC's approach to technology—though not a pioneer, it is a fast follower.

12. A Livemint story of the PLI scheme for mobile phone manufacturing, which has a five year allocation of Rs 41,000 Cr. This about the success of the segment as well as the distance to be travelled, 

India had two mobile manufacturing units in 2014. By 2019, there were over 200. The number of mobile handsets produced shot up from 60 to 290 million in the same period; the value of handsets produced jumped 10 times to $30 billion... China exported phones worth over $100 billion in 2019; Vietnam over $35 billion. India exported less than $3 billion in 2018-19.

Even with the PLIs, India stays below Vietnam and China on cost-competitiveness,

Assuming that $100 is the cost of producing a phone without subsidies, China can make it at $80 after factoring in the incentives the country provides. Similarly, the cost of manufacturing a phone in Vietnam. The PLI scheme bridges some of India’s deficit. The manufacturing cost, after factoring in PLI and other subsidies, totals $92-$93.

Interesting thing about the extent of subsidy, which is very significant,

The scheme is also a massive discount on India’s current value-add, the advisor mentioned above explained. Manufacturers in India import most of the components and the assembly value ranges between 8% and 15%. “If 15% is the assembly price, an incentive of 6% is almost a 50% discount," he said.

These are very instructive numbers. If even with assembly, India is not able to compete with Vietnam and China, that's disturbing. But perhaps, this underscores the need to localise component production to become competitive. That will hopefully happen in due course and the PLI scheme will expedite. But till then, the incentive is a massive subsidy cost being incurred. If it does not catalyse component manufacturing, then this can just as well be described as a corporate freebie.

13. The IPO of Ant Financial to raise about $35 billion, the world's largest ever, has attracted a staggering $2.8 trillion of orders from more than 5 million individuals, a sum which exceeds the value of all stocks listed on exchanges in Germany or Canada. For retail investors, the simultaneous listing at Shanghai and Hong Kong was oversubscribed more than 870 times. The company has a billion users and more than $17 trillion in yearly payment volumes.

14. Gillian Tett points to the alarmingly low CDS recovery rate projects with the recent corporate bond auctions. 

Most CDS contracts stipulate that financiers need to know what a company’s cheapest available bond will be worth at the point the company defaults. That’s because CDS contracts make investors whole by paying them the bond’s original face value minus its market value. When a company goes bust, financiers hold an auction to determine the market price, and the resulting prices offer one guide to what creditors think the company’s remaining assets are worth. Over the past decade, the average CDS auction prices have moved in a band between 10 and 60 cents on the dollar, but have generally been between 30 and 40 cents. However the nine US auctions conducted in the year to August produced an average price of just 9 cents — and just 2.4 cents if you look at the worst four: Chesapeake, California Resources, Neiman Marcus Group, and McClatchy.

Worsening matters, bondholders are being continuously shortchanged, 

And because loans take priority over bonds in a bankruptcy, the practice has also weakened bondholders’ claims, sparking fights in some bankruptcies... Bondholders’ claims have been further undermined by debt exchanges and stealthy asset transfers, including one known as the “J-Crew trap door”. Named after the recently bankrupted US retailer, it refers to a manoeuvre pulled off by the company’s private equity owners in 2016 in which they transferred intellectual property rights across to new lenders, out of the reach of the original creditors. Similar tactics have emerged at other troubled groups such as Travelport.

And all this is being driven by the search for yield among investors,

Indeed, four-fifths of US loans issued last year were “covenant-lite”, that is they had little or no control over borrower behaviour, up from one-fifth at the start of the decade. That is because investors are so desperate to chase returns in a zero-rate world that they no longer dare to impose covenants. Indeed, the hunt for returns is so frenzied that junk bond yields have plunged from 12 per cent in March to below 6 per cent. Cheap money, in other words, is enabling some zombie companies to stagger on, even as creditor value shrivels — until they collapse.

15. Fascinating article about the QR Code, the low-profile but functionally valuable invention in 1994 by Masahiro Hara to track components in car factories. Its use took off with its adoption by Ant Financial to make mobile payments through Alipay, and has not looked back. It was the crucial link which enabled the use of mobile phones for digital payments. It's now being used for everything from digital payments to browsing dinner menus online. 

Mr Hara worked at Denso Wave, part of a components group allied to Toyota, which used barcodes to label components in plants. But the barcode, first used in an Ohio supermarket in 1974, could be hard to use — as anyone who has tried to scan a bag of frozen peas will know — and did not hold much information. He solved the data constraint by making the QR code a two-dimensional square instead of a horizontal strip, allowing it to store up to 4,200 characters compared to 20 on the barcode. His team also conquered the time-consuming awkwardness of barcodes — every QR code includes three squares at its corners that help scanners to focus rapidly (hence, quick response). Japanese carmakers found it very useful: it saved some workers from having to scan up to 1,000 barcodes a day. 

This is one more to the point I've been making that Alibaba is a more entrepreneurial e-commerce engine than Amazon,

The QR code enabled Ant to pioneer mobile payments in China through its Alipay super app. The renaissance of QR codes, after years of half-baked efforts by US advertisers and retailers to use them for marketing campaigns and shopping vouchers, shows that it takes time for the strengths of some inventions to emerge.

And this is interesting, an illustration of how non-patenting of such general purpose ideas can have large positive externalities,

But Denso Wave realised that the QR code had greater potential and did not enforce its patent rights. That enabled others not only to use it free but make variations for their industries. The invention knocked around for a decade without finding another compelling use until Alibaba, the Chinese ecommerce group co-founded by Jack Ma, realised it could be used for payments. Shopping in the US and Europe, both online and in stores, is mostly done with payment cards, but the QR code offered an alternative.

It was the industry's good fortune that the QR Code was not invented in the US by the likes of Apple, who would have immediately patented it. 

16. A summary of the changes incorporated in the regulations proposed to implement the new labour codes in India. 

From hope to despair in a week?

It was just a week back that the markets were celebrating a much debated deal to bailout Greece in return for structural reforms and austerity and provide liquidity support for beleaguered European banks. Then on Monday, faced with strong public opposition, George Papandreu stunned everyone by deciding to call for a referendum on the austerity and bailout deal agreed with the other Eurozone members.

For all practical purposes, this referndum would be a vote on whether Greece should stay or leave the Eurozone. In fact, the Times quoted the German Chancellor Angela Merkel who has described the referendum as "about nothing else but the question, does Greece want to stay in the euro zone, yes or no?"

It heightens the risk of a sovereign default by Greece and even a possible Euro-exit and return to Drachama ending a 10-year experiment with the Euro. The big question facing policy makers in Athens and Brussels is whether the benefit of having a cheap currency under Greek control would outweigh the costs of defaulting on its debt and abandoning the euro. More worryingly, it threatens to unravel the comprehensive debt deal reached last week to shore up Eurozone economies and thereby endangering the Italian economy with potentially catestrophic consequences for the world economy itself.

Over five of the most volatile trading days, Greece has seen the best and worst of financial market volatility. Greek CDS spreads fell from 5500 points to 3100 points and then has risen to 5600 points, all in the space of five trading days.



The yields on 10 year Greek bonds too have risen steeply, cancelling off gains from the debt deal.



Update

From despair, there arises some hope as the Greek Prime Minister musters opposition support for the debt deal and calls of the proposed referendum, thereby taking his country away from the edge, atleast for the time being. Adding more cheer for the markets, the ECB, under its new President Mario Draghi, cut its benchmark rates by 25 basis points to 1.25%

Euro distress signatures

Here is a comparative assessment of the panic affecting Greek, Portuguese, and Italian government debt instruments. The spreads between the 10 year sovereign bonds of each of these countries and the German Bund had started widening since April and has gathered momentum since July.



The yields on ten year sovereign bonds too have increased sharply over the past month or so.



The cost of insuring Greek, Portuguese, and Italian debt, reflected in the 5 year CDS spreads, too have followed much the same pattern, exploding in the past two months.

Too Big To Fail fact of the day

Zero Hedge quotes the latest report from the US Office of the Currency Comptroller and writes about the extreme concentration of derivatives risk in the US financial markets,

"Of the $250 trillion in gross notional amount of derivative contracts outstanding (consisting of Interest Rate, FX, Equity Contracts, Commodity and CDS) among the Top 25 commercial banks (a number that swells to $333 trillion when looking at the Top 25 Bank Holding Companies), a mere 5 banks (and really 4) account for 95.9% of all derivative exposure... The top 4 banks: JPM with $78.1 trillion in exposure, Citi with $56 trillion, Bank of America with $53 trillion and Goldman with $48 trillion, account for 94.4% of total exposure."

And more worryingly, the TBTF problem keeps getting worse, posing even greater systemic risks,

"The biggest banks are not only getting bigger, but their risk exposure is now at a new all time high and up $5.3 trillion from Q1 as they have to risk ever more in the derivatives market to generate that incremental penny of return."

Debt Contagion Fears - Is Italy next?

Here is a grapical representation of European national debts, with countries sized in proportion to their respective sovereign debts.



Notice that, excluding Greece, Eurozone's third largest economy, Italy, has the highest debt-to-GDP ration among these economies. And as expected, exacerbated by domestic political uncertainty, markets appear to be forming expectations about Italy following Greece, Ireland, Portugal and Spain into the troubled periphery of Eurozone, thereby completing the complement of PIIGS.

Admittedly, Italy's banks never speculated in a property bubble and are sound, its budget deficit at 4.6% of GDP looks low when compared to the sinners, and unlike other PIIGS Italian own more than half the country's debt. But as interest rates rise and with economy not likely to get back into high growth path anytime soon, it does not require much for the markets to tip the balance against Italy. And the indications look ominious.

As this Bloomberg ticker shows, the cost of insuring Italian sovereign debt against default have zoomed to its highest ever.



Italy is the largest issuer of government bonds among Eurozone economies and its 10-year Bond yields shot up alarmingly, again to its highest in recent history. And if rates exceed 6%, Italy will start experiencing the same repayment and new debt raising problems as others.



A contagion spread to Italy would make Greece and Portugal look like boy-scouts. As the Timess reports, European banks have total claims and potential exposures of 998.7 billion euros to Italy, more than six times the 162.4 billion euro exposure they have to Greece. European banks have 774 billion euros of exposure to Spain and 534 billion euros of exposure to Ireland. American banks are also more exposed to Italy than to any other euro zone country, to the tune of 269 billion euros. American banks’ next biggest exposure is to Spain, with total claims estimated at 179 billion euros.

Update 1 (28/9/2011)

List of "Who Gets Smashed If Italy Goes Bust".

The Hellenic sovereign default draws closer

The inevitable sovereign default climax to the Hellenic tragedy appears to get closer with the downgrading of Greek debt by Standard & Poor to CCC. The three-notch downgrade makes Greece’s debt the lowest-rated in the world by S&P and Greece the lowest rated country in the world. This follows Moody’s Investors Service lowering Greece’s credit rating by three notches to Caa1.

Underlining this market belief about a sovereign debt default being only a matter of time, with 85% of respondents in a Global Investors Poll predicting a Greek default. Most investors also feel Ireland, with fiscal deficit at a staggering 32% of GDP in 2010, too will default and atleast one nation will leave the Euro by 2016.

Anticipating this, the Greek CDS spreads and 10 year bond yields have gone up. The CDS spread is close to 1600 points.



The benchmark 10 year government bond yield has touched 17%, shooting up from 13% at the begining of May. Two year bonds are at a staggering 26%.



On the macroeconomic front, Greece has an unemployment rate of 16.2% and fiscal deficit was 10.4% in 2010 and is set to rise. It has financing needs of close to 160 billion euros ($229 billion) through 2014. The government is struggling to get through the latest round of fiscal austerity measures.

It is amazing that Euro area policy makers have let things drift this far. For nearly a year now, even when the Greek bailout was engineered, it was amply clear that without significant restructuring, a sovereign default was only a matter of time. However, on ideological grounds and to avoid causing losses to its own banks (who have massive exposures in the peripheral economies), Germany and other major economies opposed all forms of debt restructuring. It was thought that austerity measures in these economies will bring back macroeconomic stability, increase revenues, and help them repay their debts. The bailouts, it was argued, will help reschedule the loans and insulate Greece from the credit markets for some time.

A year on, things have obviously got worse. The costs inflicted far outweigh the possible benefits of an early restructuring. The Greek economy has contracted far more and debt position worsened, not to speak of the damaging impact on Eurozone economies. A quick and decisive debt restructuring, while temporarily painful, would have avoided this prolonged hemorrhage.

Update 1 (17/6/2011)

Times writes about the steep increase in Greek CDS spreads, "An investor now has to pay about $2 million annually to insure $10 million of Greek debt over five years, compared with about $50,000 on the same amount of United States government debt".



Update 2 (6/7/2011)

Moody’s cut its rating on Portugal’s long-term government bonds to Ba2 from Baa1 or junk status and said the outlook was negative, hinting at more downgrades. Even though Portugal negotiated a $116 billion rescue package in May, the ratings agency cited the risk that the country would need a second bailout before it could raise funds in the bond markets again and that private sector lenders would have to share the pain. It expressed scepticism at the country's ability to meet the challenges it faces in reducing spending, increasing tax compliance, achieving economic growth and supporting the banking system.

The downgrade came a month after a general election in Portugal in which voters unseated the Socialist government of José Sócrates. Since then, the new center-right coalition government, led by the Social Democrats and Prime Minister Pedro Passos Coelho, have pushed ahead with austerity measures and other reforms pledged by Portugal in return for its bailout.

Portugal follows, where is the "confidence fairy"?

So finally, after months of speculation, and faced with spiralling borrowing costs, Portugal bows to pressure and follows Greece and Ireland in seeking an emergency financial bailout from the European Commission. It is being estimated that the country would need about 75 billion euros ($106.5 billion) in assistance and the conditions of the assistance is expected to be worked out soon.

The bailout became inevitable after the steep increases in Portugese borrowing costs in the past few weeks.



There have been repeated downgrades by credit-rating agencies (twice last month alone) which have sent yields on Portuguese government debt to their highest levels since the introduction of the euro. Last week Portugal sold 455 million euros (about $646 million) in one-year Treasury Bills at an average yield of 5.9%, up from 4.33% since mid-March. Similarly, the yield on 550 million euros of six-month bills was 5.12% compared to just 2.98% in an auction in early March. The emergency financing will ensure that Portugal can meet its 20 billion euros of borrowing requirements for the year.

Last May, the European Ministers agreed to provide 80 billion Euros to Greece over three years as part of a package in which the International Monetary Fund provided an additional 30 billion euros. Then, in November, they also agreed to a rescue package worth up to 85 billion euros for the Irish government. Further, last month, following Greece's adoption of extensive austerity measures, they also agreed to cut the interest rate charged Greece to help ease its debt burden. However, Ireland's refusal to accede to French and German requests to raise its low corporate tax rate of 12.5%, has meant that no such benefits have been given to Ireland.

The bailout will be arranged from the eurozone’s €440 billion rescue fund, the European Financial Stability Facility, which was set up last year to meet such contingencies. It is being hoped that the Portuguese bailout request may help reduce the risk of contagion to other countries, most notably Spain, by ring-fencing the euro’s three weaker economies.

However, if Greece and Ireland are any evidence, the standard European prescription of fiscal austerity to get the "confidence fairy" singing again and the economy back on the growth track appears not to be working. In a clear indication that its fiscal austerity was not doing much, the sovereign ratings of Greece, which was already downgraded to junk status, was again lowered by S&P to BB– from BB+.

Also, the cost of insuring debts and cost of borrowing has been rising unabated for both Ireland and Portugal despite the severe austerity measures and the emergency bailout package. In fact, as the graphic shows, after a brief drop in the immediate aftermath of the May 2010 bailout, the 10 year bonds have risen from about 7.25% to 12.75 today, while the CDS spreads have doubled, touching 1000 points.



In case of Ireland too, the same story has been repeated with both bond yields and CDS spreads. In Ireland's case, the fiscal austerity, which has been much more severe and has been in operation for more than two years now. Inspite of this, the bond yields and CDS spreads have been rising unabated all the while.



However, fears about Spain being the next in the domino to fall may be slightly exaggerated, atleast for now. Its CDS spreads have fallen dramatically since the beginning of the year and bond yields too have remained stable, albeit at a high 5-5.5% range.

Update 1 (9/4/2011)

Underlining its hawkish stance on inflation, in an unanimous decision, the European Central Bank (ECB) raised its benchmark policy rate to 1.25 percent from 1 percent. Inflation in the euro area rose at an annual rate of 2.6 percent in March, up from 2.2 percent in February and above the bank’s target of just under 2 percent. Since October 2008, the ECB had, in response to the sub-prime crisis and Great Recession, slashed rates from 4.25 percent to 1 percent by May 2009.

This is in contrast to the Federal Reserve, which continues to stimulate the American economy, as well as the Bank of England, which early this week left its benchmark interest rate at 0.5 percent despite higher inflation. In fact, like the $600 bn QE II in the US, the Bank of England too is continuing with its £200 billion ($325 billion) bond-purchase plan.

The rate increase could have dire consequences for Greece, Ireland and Portugal, where they are already having severe problems borrowing money at reasonable rates. More worryingly, the rate hike will also increase the pressure on Euro to appreciate, thereby weakening the competitiveness of European exporters.

This Economist article points to the fact that unlike Greece, Portugal does not have the problem of mountainous public debts or recklessly leveraged banks. Its problem is more structural - lack of competitiveness manifested in high input costs and excessive bureaucracy. It is inconceivable that austerity can do anything to overcome these problems.

Update 1 (15/4/2011)

The British austerity plan (aimed at lowering its budget deficit from a high 10% of GDP) appears to be having its predicted impact - retail sales plunged 3.5 percent in March, the sharpest monthly downturn in Britain in 15 years; a new report by the Center for Economic and Business Research forecasts that real household income will fall by 2 percent this year.

Update 2 (20/4/2011)

Nice graphic on the EU's emergency bailout fund.



Update 3 (4/5/2011)

Portugal has accepted an international (EC, ECB and IMF) aid plan of 78 billion euros ($116 billion). Under the three-year plan, the deficit would need to be lowered to 5.9 percent of gross domestic product this year, 4.5 percent in 2012 and 3 percent in 2013. Last year, Greece secured a bailout package worth 110 billion euros and Ireland 85 billion euros.

Update 4 (16/2/2012)

Times chronicles how austerity is leading Portugal down the cliff. See also this Room for Debate on Portugal.

More on the Celtic crisis

Paul Krugman makes an interesting comparison between the relative paths adopted by Iceland and Ireland when faced with similar financial crises. He describes the relative success, till now, of Iceland and the disaster looming on Ireland, as the triumph of heterodoxy over orthodoxy in economic policy making.

In both cases, the crisis could be traced to irresponsible lending by banks and borrowing by real estate and other businesses. And businesses and borrowers in both ran up massive amounts of external debts. When faced with their respective decision-moments, the responses could not have been starker.

Nearly 18 months back, Iceland responded by making "foreign lenders to its runaway banks pay the price of their poor judgment, rather than putting its own taxpayers on the line to guarantee bad private debts". The result was a number of private sector bankruptcies, which also "led to a marked decline in external debt". It also introduced capital controls to prevent sudden capital flight by foreign and domestic investors. It refrained from destabilizing its Nordic social welfare model with the standard fiscal austerity measures like spending cuts.

In contrast, faced with the prospect of huge losses for banks and their irresponsible foreign lenders, the "Irish government stepped in to guarantee the banks’ debt, turning private losses into public obligations". The result is that the debts got transferred from the banks to the Irish Government's balance sheet. At the first signs of trouble, it imposed a series of "savage fiscal austerity" measures in order to restore "market confidence". And followed it with more doses of the austerity medicine.

The "confidence fairy" has responded in the most unexpected manner to the actions of both governments. If the supporters of the "confidence fairy" hypothesis were correct, Iceland should have been ravaged by the bond-vigilantes and Ireland should have been ovewhelmed by a rush in market confidence. The results have been exactly the opposite. The bond markets continue to savage Ireland, whose bond yields and CDS spreads continue to rise steeply despite nearly three years of austerity. However, Iceland has made a smart recovery, both its economy and the financial markets, winning praise from even the IMF.

Its CDS spreads have fallen from 800 to less than 300, whereas Ireland's cost of insuring debt has risen precipitously from less than 200 to over 500 points.



In fact, a testament of its success and the problems of the EU peripheral economies is the fact that Iceland's CDS spreads have fallen below that of even Spain.



And, unlike Ireland, being out of the single currency zone meant that Iceland could indulge in significant currency devaluation to increase the competitiveness of its exports.

In this context, Simon Johnson points to the odds stacked against Ireland being able to emerge out of its debts any time in the foreseeable future. He points to the fact the fact that atleast 20% of Irish GDP is from 'ghost corporations', attracted by Ireland's 12.5% corporate tax rate, that have little or no real activity in Ireland. This effectively means that the real debt burden of Ireland is more than 100% of the GNP and could rise to 150% of GNP in the next few years.

The steep fiscal contraction by way of spending cuts, especially at a time when the economy is set to contract for the third year in a row, will amplify the real debt burden. In the absence of a national currency, it cannot even devalue and increase the competitiveness of its exports. And given the extraordinary rise in asset valuations - property prices rose four times - any chances of asset prices rising to reduce the real debt burden is remote.

Further, this year, the government will run a deficit of 15% GNP, and with nominal GNP falling, it could well remain that high next year, even if the government cuts spending by the 2 to 3% of GNP currently envisaged. In other words, Irish economy would have to grow at close to its highest ever growth rates just to ensure that its debt share stays the same.

In the circumstances, it is certain that Ireland cannot resolve its debt crisis without some form of debt restructuring that forces lenders to take substantial haircuts. But coming in the way of this is the significant exposures of European banks to Irish debt.

It is estimated that the claims of foreign banks on Ireland are at over $500 billion. German banks are owed $139 billion, which is 4.2% of German GDP British banks are owed $131 billion, or about 5% of Great Britain’s GDP, French banks are owed $43.5 billion, which is approaching 2% of French GDP, and Belgian banks are owed $29 bn, or 5% of its GDP. None of these countries are likely to support measures that would effectively force their own banks to take losses on their Irish exposures.

Update 1 (29/11/2010)
Ireland becomes the second country after Greece within the Eurozone to accept a bailout. The 85 billion euro ($112 billion) bailout plan, at an average interest rate of 5.83% (compared Ireland's 10 year bond rate of close to 10%), includes a contribution of 17.5 billion euros by the Irish government itself through money it has already raised. Of the rest, 22.5 billion euros will come from the International Monetary Fund. The remaining 45 billion euros will come from bilateral loans from European nations and two European Union rescue funds set up in the spring.

Of this €10 billion will be used to immediately to recapitalise the banks to bring them up to a core tier 1 capital ratio of 12%, with a €25 billion contingency. The remaining €50 billion will be used to meet the budgetary requirements of the State. Under the Plan, Ireland will reduce its budget deficit to 3% of GDP by 2015.

Update 2 (3/12/2010)
Barry Eichengreen has the best article on the prospects for the Irish economy. It is in one word - brilliant!

The Celtic Tiger is Museum piece?

Sample this paean about the Irish economic model (in the context of which model Europeans should follow) by the high-prophet of globalization and other global mega-trends, Thomas Friedman, in July 2005

"It is obvious to me that the Irish-British model is the way of the future, and the only question is when Germany and France will face reality: either they become Ireland or they become museums. That is their real choice over the next few years – it’s either the leprechaun way or the Louvre... As an Irish public relations executive in Dublin remarked to me: "How would you like to be the French leader who tells the French people they have to follow Ireland?" Or even worse, Tony Blair... the other day Mr. Blair told his E.U. colleagues at the European Parliament that they had to modernize or perish."

For some years now, the Irish economic model, the Celtic Tiger, had been lauded as the way forward for other Europeans. The three major strands on which the Irish model stood were - focus on higher education and attracting knowledge-based industries, ultra-low corporate tax rates (at 12.5%, it is the lowest in Europe - France 34%, Germany 30%, and Britain 28%!), and financial market liberalization that went beyond even the US.

However, from hindsight, as the ongoing events highlight, apart from the first, the other two were mis-guided policies that have played a major role in taking Ireland to the precipice. Banks, which issued loans recklessly during the real estate boom, have accumulated losses of about €70 billion, almost half the country’s economic output. The low corporate tax rate, which effectively turned Ireland into an on-shore tax haven, also meant a dramatic drop in the country's tax revenues when recession took hold. The country's fiscal deficit is now at a stunning 32% of GDP and public debt is set to cross 80% of GDP. Unemployment at 12% continues on its upward climb. The country is set to experience its third consecutive year of economic contraction in 2010.

The bursting of the sub-prime mortgage bubble in the US and the global financial market meltdown that followed have devastated the Irish economy. Its real estate market crashed in an even more spectacular manner than in the US, leaving the Irish banking system in shambles. It also triggered off an economic recession that ravaged the government's fiscal balance.

The Government first stepped in with a bailout, guaranteeing the debts of the bankers. When this appeared to have little effect, in order to impress the "confidence fairy", the Irish government announced a savage fiscal austerity program. However, after some initial enthusiasm among the bond-vigilantes, the reality set in. The bond-vigilantes have rewarded the Irish austerity programs with a resounding thumbs-down - Irish 10-year bond yield is at 8.35% and the spread with 10-year German bond is has been steadily widening 544 basis points, and the 5-year Irish CDS spread has shot up to 523 points.



Early this week, after its fiscal austerity program failed to rouse the "confidence fairy", Ireland followed Greece in formally applying for a rescue package. The EU and the IMF are working on a $109-123 bn package to help Ireland bailout its banks, reschedule its debts, and thereby prevent a sovereign bankruptcy. The funds will come from a rescue mechanism worth roughly $1 trillion that was set up in May by the EU and the IMF to help euro zone countries spiraling toward default.

The bailout is expected to support the failing Irish banks and also enable the Government to repay its debts and run regular activities without having to approach the ballooning bond markets for the coming three years. About €15 billion is likely to go to backstop the banks, while €60 billion would go to Ireland’s annual budget deficit of €19 billion for the next three years.

The bailout to reschedule Irish debts will invariably be criticised as merely delaying the inevitable default. Critics will point to Greece, whose bond yields and CDS spreads have continued to climb despite the bailout and measures to rein in government spending.

Adding weight to this view is the magnitude of losses suffered by Irish banks, most of which have been taken over by the Government. The gravity of the debt crisis being faced by the Irish Government is borne out by its staggering primary deficit in excess of 10% of GDP. This means that even without paying interest on their debt Ireland will still spend more than it collects in taxes.

In the absence of any of the traditional channels - currency depreciation or lowering interest rates or even inflation - to emerge out of a recession and sovereign debt-crisis, the propspects for the Irish economy looks bleak. The strong austerity dose and the prevailing economic weakness among its EU partners only amplifies the problem. All this means that growing or exporting its way out of debt looks remote and some sort of actual debt relief or reduction becomes the only sustainable option.

In the circumstances, a partial default, by way of an organized restructuring of debt would have forced bond-holders to accept a haircut on their investments and reduced the amount of money owed. Coupled with fiscal tightening, it would have stood a more realistic chance of success. However, this approach also carries with it considerable perceived dangers.

Primarily, the fears of investor panic and another round of financial market collapse is the biggest deterrent against traversing this path. The possibility that imposing bond haircuts can make future market access expensive or impossible for an extended time and can create serious contagion effects elsewhere is another reason to not embrace debt-restructuring.

Finally, the fact that creditors are banks belonging to the major European economies may also be another factor behind it. In the euro zone, more than 2 trillion euros in sovereign debt belonging to Greece, Ireland, Spain and Portugal is held largely by German, French, British banks and, in the case of Greece, local banks and pension funds.

In any case, contrary to Thomas Friedman's prediction, after two years of financial and economic tumult and untold social suffering, it is the Celtic Tiger economic model, along with its current Government, that looks set to join the collection at the National Museum of Ireland! Ireland today looks like a Paradise Lost or a miracle turned mirage!

Update 1 (26/11/2010)

Portugal passes a fiscal austerity plan to bring down its deficit and reassure the debt markets. The budget plan for 2011 is aimed at re-assuring nervous lenders that the country could avoid a bailout by meeting its deficit-cutting targets. The plan is expected to cut Portugal's budget deficit from 9.3% of GDP last year, to 7.3% this year, and 4.6% in 2011.

Spain, with a budget deficit of 11.1% of GDP last year, too has pushed through austerity measures including spending cuts. However, given its size, Spain has emerged as Europe's "too-big-to-fail" country.

Meanwhile, Ireland has successfully resisted pressure from other EU members on any increase in its ultr-low corporate tax rate of 12.5%. The country is heavily dependent on foreign direct investments (FDI). About 70% its exports and 70% of business spending on research and development comes from FDI. Foreign-owned firms pay workers about $7.1 billion each year and provide one in seven of the country’s jobs, either directly or indirectly. Multinationals paid about 5 billion euros in corporate tax to Ireland last year, more than 50% of all corporate tax receipts.

Is Ireland heading for default?

Amidst all the attention on Greece, Ireland had fallen off the radar, especially after its much-praised embrace of fiscal austerity. However now, raising questions about the effectiveness of the austerity medicine, there are unmistakable signals from the Bond and CDS markets (via CR) that Ireland may be hurtling into sovereign default territory.




Markets appear clearly unimpressed by Ireland's very harsh fiscal austerity measures. As the Irish book closes, we may not need to wait three years to find out the outcome of Ireland's experiment with fiscal austerity.

Euroland crisis in graphics

The travails of the Greek economy resembles a Hellenic tragedy and, as Martin Feldstein recently wrote, default (or "restructuring") looks inevitable...



The 10 year Portugese bond yields have risen steeply, indicating that Portugal may be next on line to Greece ...



In a reflection of the challenges faced by Italy, the spread between Italian and German bonds have widened sharply...



Spain is the other big concern, as reflected in the steep increase in CDS spreads...



The surge in CDS spreads of Spanish and Portugese banks are a reflection of the increasing probability of a haircut for their debt holders...



This excellent graphic illustrates how heavily exposed German, French and British banks are to Greek, Italian, Spanish and Irish debts. And Greece looks positively puny in comparison to Spain, Italy or even Ireland.



See more graphics on the impossible situation facing Greece in restructuring its debts without generous support from Euroland members and IMF. See also this debt map of Europe.

Unfortunately, the uncertainty surrounding the resolve of Euroland members, especially Germany and France, to restructure Greece's debt has only served to accelerate the steep decline in market confidence on Greek debt. With every passing day, as the cost of insuring Greek debts increases, the prospects of successfully restructuring its national debt recedes. And even more damagingly, it may have also triggered off the ongoing runs on the debts of others on the margin like Portugal, Spain and Italy.

All CDS spreads are calculated based on insuring five year debts.

Update 1 (6/6/2010)

The graphic shows that foreign banks and other financial companies have lent nearly $2.6 trillion to public and private institutions in Greece, Spain and Portugal.

The skeletons from the Goldman cupboard

It was slightly long in coming, but had to happen. The Goldman Sachs enigma (the "perpetual money making machine") has finally been uncovered as the Securities and Exchanges Commission (SEC) in the US filed a civil law suit accusing it of defrauding its customers who had purchased risky mortgage related debt that were secretly devised to fail.

There were whispers all along that Goldman had been bundling and selling mortgages and other debts to unsuspecting investors while simultaneously betting against the same debts. Interestingly, despite the widespread knowledge of such practices, this is the first instance of action by the SEC against a Wall Street deal that helped investors capitalize on the falling sub-prime mortgage market.

The instrument in the SEC case, called Abacus 2007-AC1, was one of 25 deals that Goldman created so that it and select clients could bet against the housing market. The buyers of Abacus 2007-AC1 bonds - synthetic CDOs, created by packaging bundles of CDS (that insure against default of underlying mortgage bonds) - would keep receiving regular payments so long as the underlying securities stayed healthy, but would have to pay up the full insured amounts (or their full investments) if the securities failed.



In the instant case, Goldman created Abacus 2007-AC1 in February 2007, ostensibly through an independent deal manager ACA Management (who identified and packaged the mortgage bonds) for investors, but actually at the request of John A. Paulson, a prominent hedge fund manager who earned an estimated $3.7 billion in 2007 by correctly wagering that the housing bubble would burst. Though investors were told that ACA was selecting the bonds impartially, Goldman let the Paulson fund select mortgage bonds that they believed were most likely to lose value.

Unknown to both ACA and its investors (foreign banks, pension funds, insurance companies and other hedge funds), at the same time the Paulson fund and Goldman's proprietary trading desks were betting against the same bonds (so as to cause the bonds to default and the CDS's to kick in and make good the insurance contracts).

In fact, Goldman had let the Paulson fund pick and choose the underlying bonds, ones that it knew was likely to default. As the Abacus deals plunged in value, Goldman and certain hedge funds made money on their negative bets, while the Goldman clients who bought the $10.9 billion in investments lost billions of dollars.

Such deals were triple-wins for Goldman Sachs

1. It would buy the CDS's on sub-prime mortgage bonds at cheap prices (in view of their high risk) and then repackage them, get it rated AAA and sell it at better terms (lower premium payouts to holders of the CDS) to investors. Through this, they were able to arbitrage the market for such insturments.

2. Its proprietary trading desk would bet on these bonds defaulting (by either selecting those bonds that they know are most likely to default or by taking up short positions on them and driving down prices and forcing events like a ratings downgrade or margin calls) and keep making the premium payments to the investors in the CDOs. Once the underlying bonds finally defaulted, the CDO investors lost their all their investments which get paid out by way of insurance redemption. And Goldman and its select clients shared this.

3. Finally, Goldman made large money from fees for arranging all these deals - both with investors and the clients.

Steve Waldman has this superb summary of the scandal

"Investors in Goldman’s deal reasonably thought that they were buying a portfolio that had been carefully selected by a reputable manager whose sole interest lay in optimizing the performance of the CDO. They no more thought they were trading 'against' short investors than investors in IBM or Treasury bonds do. In violation of these reasonable expectations, Goldman arranged that a party whose interests were diametrically opposed to those of investors would have significant influence over the selection of the portfolio. Goldman misrepresented that party’s role to the manager and failed to disclose the conflict of interest to investors. That’s inexcusable. Was it illegal? I don’t know, and I don’t care... But the firm’s behavior was certainly unethical. If Goldman cannot acknowledge that, I can’t see how investors going forward could place any sort of trust in the firm. Whatever does or does not happen in Washington D.C., Goldman Sachs needs to reform or die."

Though Goldman has denied all these allegations and has vowed to vigorously defend itself, Wall Street hammered Goldman shares by more than 13%. This incident may have irreparably damaged Goldman's "reputation and its ability to keep its hands on so many sides of a trade — a practice that is immensely profitable for the firm". It could also trigger off a cascade of law suits against Goldman by its investors, especially the major banks like ABN and IKB, who lost their investments in these Abacus instruments. Interestingly, John Paulson or his fund are not part of the civil suit filed by SEC.

See also this Times debate and Joe Nocera on the scam. Paul Krugman points to George Akerlof and Paul Romer who had highlighted the possibility of financial institutions taking excessive risks at the expense of the society and tax payers if they sensed profit opportunities and if the incentives were also so aligned.

Though the case against Goldman appears very clear, it may be the loudest testament to the virtual paralysis of financial market regulation in the US that there exists the real danger that Goldman may escape relatively unscathed. As Yves Smith writes, "This case should be a slam-dunk, but years of deregulation have narrowed the ground for lawsuits." It is an indictment of the whole system that instead of expressing such doubts we should have been asking, as Prof William Black writes, "Why have there been no criminal charges?"

The one silver lining in the cloud is the fact that, as Mark Thoma writes, it provides a great opportunity to silence the conservatives and Republicans and push through the financial market regulatory reform proposals currently being debated in the US Congress. In fact, the supporters of reforms should ride the momentum generated by the populist backlash against Goldman and drive home strong regulatory reforms in the Bill. It is important that they act immediately in view of the limited public memory horizons.

Update 1 (20/4/2010)
Goldman's earnings rose 91 percent in the first quarter of 2010, to $3.46 billion or $5.59 a share, up from $1.81 billion or $3.39 a share in the same period last year. Revenues increased 36 percent to $12.78 billion, up from $9.42 billion in the quarter a year ago.

This Times article explains why the case against Goldman, while clear cut for the layman, may not be as easy to prove legally.

Update 2 (24/4/2010)
More evidence, from emails, that Goldman made massive money betting against mortgages is available here. See also this NYT story that examined emails traded by Goldman Sachs executives saying that they would make 'some serious money' betting against the housing markets. See also this from Goldman hearings.

Update 3 (4/5/2010)
James Kwak on synthetic CDOs like Abacus.

Update 4 (21/7/2010)
Goldman Sachs agrees to pay $550 million to settle federal claims that it misled investors in the Abacus subprime mortgage product as the housing market began to collapse.



Update 5 (23/6/2011)

Slate has an article that examines the claim that Goldman Sachs misled its clients by continuing to promote and sell them securities backed by sub-prime mortgages even as its trading desk was betting on the sub-prime mortgages going bad and declining. It writes,

"Starting in late 2006, Goldman Sachs made trades that would pay off if the housing market tanked. Was this a massive bet that the housing market was going to crash, as Goldman's critics maintain? Or was it merely a hedge, an attempt by the firm to reduce its risk, as Goldman claims?"

Goldman obviously claims the later.

Update 6 (15/3/2012)

Greg Smith's sensational resignation letter where he accuses Goldman of a culture which puts making money for the firm at the cost of client over anything else. He was Goldman Sachs executive director and head of the firm’s United States equity derivatives business in Europe, the Middle East and Africa.

Making clients pay for losing their invesments!

We are used to having investment banks charging their clients large sums for maanging their investments. But among the many wonders of the modern financial engineering, which rose to prominence as the sub-prime mortgage bubble got inflated and subsequently burst, were instruments that ended up forcing investors to pay their fund managers for even losing their investments! Heads I win, tails I win!

Times has this nice story of how Wall Street giants like Goldman Sachs placed unusually heavy bets against mortgage securities (shorting them), even as it was packaging and peddling securities based on them, like Synthetic Collateralized Debt Obligations (CDOs), to its clients.

CDOs are made up of credit default swaps (CDS) that insure against default of mortgage bonds (as against the bonds themselves in case of normal CDOs). Sellers of CDS would receive regular payments as long as the underlying mortgage securities stayed healthy. Sellers in turn sold them off to Wall Street investment banks, who packaged them off as synthetic CDOs to their large clients. The proprietary trading desk of these firms then bet against the mortgage bonds by themselves purchasing insurance in the form of CDS and paying premiums for it. When the mortgages sour, the investors lost the right to their investments even as the swaps pay out to those who bet against them. Exercise the swaps, liquidate the short positions on these bonds by market purchases, and book handsome windfall profits! In other words, your clients pay you for losing their investments!!



Unlike conventional CDOs, where investors took losses only under extreme credit events, when the underlying mortgages defaulted or their issuers went bankrupt, the synthetic CDO holders would have to make payments to short sellers under less onerous outcomes, or 'triggers' like a ratings downgrade on a bond. This meant that anyone who bet against such CDOs could collect on the bet more easily. Regulations were progressively gamed to favor those betting against these CDOs.

At the peak of the sub-prime mortgage bubble, even as its trading and portfolio management arm was selling synthetic CDOs to unsuspecting clients, carried away by the "irrational exuberance" of the boom, the proprietary trading desks (which uses its own capital) of firms like Goldman Sachs were betting against the same underlying instruments by shorting them. When the bubble burst, the investors were left holding suckers while Goldman made windfall gains on its bets.

Goldman's version of such mortgage linked securities, whose underlying was not the mortgage bonds but the related CDS's, were called Abacus. The NYT story nicely captures how Goldman's traders were aggressively selling Abacus, trying to make its assets more attractive than they actually were, without encouraging their clients to hedge agianst these instruments going bad.

In effect, these firms were simultaneously selling securities to customers and shorting them because they believed they were going to default - "buy protection against an event that you have a hand in causing". Incidentally, worried about a housing bubble, Goldman Sachs had decided in December 2006 to change the firm’s overall stance on the mortgage market, from positive to negative, though it did not disclose that publicly. One of the sources of the Times report put such instruments in perspective,

"When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else’s house and then committing arson".

Update 1
From John Cassidy's excellent chronicle of the sub-prime crisis.

"CDS aren't really swaps at all, they should be called credit insurance contracts... In 1997, a group of math whizzes in Morgan's derivatives department took $9.7 bn in loans that it had issued to about 300 corporations, placed them in a SIV, and distributed tranches of the SPV to investors. This sounds like routine securitization, but it came with a twist. The investors - insurance companies and other banks, mainly - didn't get to own the loans, which remained on Morgan's books; they merely agreed to take on the risk of Morgan's borrowers defaulting.

In return, Morgan agreed to pay them what were effectively insurance premiums. As long as the borrowers kept making their interest and principal payments, the investors would receive a steady stream of income - some $700 m a year in total. But if some of the borrowers defaulted, the owners of the SPV stood to make up the full value of the loans. These mutual obligations were defined in legal agreements, which were called CDS.

The deal accomplished several things : it removed $9.7 bn in credit risks from Morgan's balance sheet, freeing up capital the firmm could use elsewhere; it transferred these risks to other financial institutions that had more of an appetite for them; and it created securities that could be traded, this allowing investors to get exposure to an asset class - bank loans - that they had previously been excluded from."

Update 1
It is widely acknowledged that unregulated, over-the-counter (OTC) derivatives like an option to buy a stock in the future at a fixed price set today and credit-default swaps (a form of insurance against the future default of a bond) played a critical role in the sub-prime bubble. Now Goldman's CEO Lloyd Blankfein has himself acknowledged the need to regulate them by standardizing the contracts and making them trade in exchanges.

William Cohan has a nice account of how Goldman Sachs made massive money by betting against the sub-prime mortgages, while AIG lost money betting against sub-prime mortgages falling.

Update 2 (6/11/2011)

Citigroup sold securities to investors and then turned around and shorted these same securities. The bank not only believed the securities would decline in value, but it actually spent its own money to make money off the terrible product it had sold to customers. The transaction involved a $1 billion portfolio of mortgage-related investments, many of which were handpicked for the portfolio by Citigroup without telling investors of its role or that it had made bets that the investments would fall in value. Bruce Judson has call it a classic swindle.

The SEC recently announced a $285 million dollar civil settlement with Citigroup involving both compensating the victims and penalizing the firm.

The unfortunate aspect of this settlement was the relatively light nature of the punishment given to Citigroup despite this malafide transaction being clearly established. The $95 mn fine is a relative pittance for Citigroup, whose Q3 2011 profits are estimated to be $3.8 bn. As Judson writes, "these settlements have become simply a "cost of doing business" for our increasingly monopolized financial sector and are unlikely to impact its behavior".