Financial Derivatives - Devil in disguise?

Recently RBI decided to develop a market for CDSs (Credit Default Swaps) in India. The underlying thought being the importance of Credit Derivatives for the growth of Financial Markets. Well, good thoughts on the regulator's mind to encourage growth of financial markets, But were CDSs not the force (or non force) behind the financial debacle which we witnessed in recent times in Developed markets? We did hear and read about how CDSs and CDOs brought the market down and that these instruments were the real culprits?

No argument can be farther from the truth. First and foremost, any instrument designed by a system and used extensively cannot by itself be an evil or faulty. If it was, then how come it had such a huge market for itself? Second, all of that market was legal and complaint. Then why does many in India have such aversion to these derivatives?

Contrary to what many believe, India was spared the horrors of Financial meltdown not because we forbade certain type of transactions but mostly because one, as a financial market we are not so well developed and second, we are slow to understand and adopt these new age products. And our inability to quickly get on top of these instruments kept us insulated and nothing else. However, even the regulator is smart enough to understand the importance of these instruments in building a robust financial structure of the country.

Let me try to bring more clarity here. CDSs (Credit Default Swaps) are nothing but insurance provided by a party to insulate a buyer of bonds from default of the issuers. The price of the Insurance depends on the Risk profile of the bonds. It is a simple risk reward structure, which we are aware of, even before commerce came about in this world any any avatar. Then how can they create havoc? Like any financial product worth its salt, CDSs can be traded. And the trade price is again a clear manifestation of weighted risk. A buyer needs to be sure of the intrinsic value of the underlying bond and the risk weighted price. This can only be done through extensive research on each and every trade which can turn out to be humongous due to the sheer volume (trade could be in Billions of dollars). So the trader/risk manager would depend on another "dependable" source in the financial services industry, Credit Rating Agencies. It is the job of these agencies to rate the underlying bond and the price of the instruments is basis the ratings. Now imagine a situation where the CDSs have changed multiple hands and is lying with Bank X. The trader who bought this at the Bank X has allocated a price to it based on his assessment, which is predominantly the Credit Rating Agencies' ratings. She is depending on someone to tell her that the underlying bonds of the CDSs she has bought is of quality for which the price equation was right. What if the underwriter who rated these bonds at rating agency did not do the job well and in a rush or due to the sheer volume adopted a shortcut and rated the instruments wrongly? Or maybe the understanding of the risk reward model was not up to mark? The entire basis of the risk reward equation is wronged. And here we are developing a classic situation of not enough forensic done before rating an instrument. This is further fuelled by the fact that the trader is also looking to trade the CDSs further at the opportune time, in the process putting the risk on someone else' balance sheet.

What happened during the recent meltdown was shortchanging of process in each and every step. The ratings agencies shortchanged and the fundamentals of underlying bonds did not support the ratings. The Insurance increased with every default instance on the bonds and hence the price of CDSs fell drastically. With falling prices the insurance amount increases further and on continued the death spiral. And the one left holding the CDSs in the end bore the brunt of the default as happened with Merril Lynch.

Similarly, CDOs (Collateral Debt Obligations) are also trade able instruments where the underlying instrument was the Mortgage payments. So the price of the derivatives was based on the streams of monthly payments. Rating agencies failed here again. This behaviour of rating agencies led to low quality acquisition as the acquirer of the loan was confident of passing on the risk in the form of CDOs. As a professional employed with an organisation which can provide you all the tools, why would someone not do the required research to ensure the trade price reflects the true risk of the underlying instrument? In a world where the big fat earnings are in the form of Bonus, the endeavor to deliver results in the short terms takes control. ( I have written about the short term Vs Long term decisions in my blog earlier). Hence acquisition/trade in low quality mortgage backed CDOs backed by higher ratings by the rating agencies. Show numbers and earn ever higher bonuses. 

So what have we now? Rating agencies with low credibility and traders with short term view being pushed to change the approach. This is the combination which pushed the markets to the brink and not the instruments themselves. Given to proper administration, the instruments do provide for enhancing the financial markets as it provides for better access to the scarce resource called Capital. What is required is spending enough time and effort to analyse each instrument to provide the right kind of risk weighted price. Rating agencies like many of the accounting firms are in a fix. They rate the same companies which provide them work. With rating agencies also taking up other lines of work, So it sometimes become difficult to maintain neutrality. So as has been said time and again, the rating agencies need to be regulated separately and the ratings business has to be stand alone. The agencies themselves need to be rated by the regulator basis their performance on ratings. And of course, the impact of long term solutions, needless to add.

So regulator surely needs to ensure our markets are exposed more and more to these instruments. Just the right kind of environment, both regulatory and monetarily to be provided to ensure the learnings of the financial debacle provide us with some much needed inputs.

Clapping - for making a choice?

Clap : to applaud (someone or something) by striking the palms of the hands together sharply.

There are many definitions of the word "Clap" when you look up the dictionary. I chose the above as that is the topic of my thoughts today.

Clapping is an activity which we witness multitude times during a day. In fact would be one of the most common activity for Mankind. But when was the last time we "really" clapped for someone? Clapped as a heartfelt reaction to a great performance/effort? Acknowledge that the recipient of the claps is worthy of it and it is heartfelt?

In many of us, I have noticed a certain hesitation/restraint while acknowledging the good effort of someone. The usual reaction I gather is "if I was given a chance I could have done better"!! So while I am in the audience clapping for the performer/achiever, I could have done a better job, if only I was given chance, or if I had chosen to do it when given a chance (here I am assuming that the chance to do the job was provided to the person in audience).

Let us further explore the two important points we see emerge here : 1) Provided a chance & 2) Choice to do the activity.

Is it a throwback to our good old days that the opportunities were not many for Indians to prove themselves. The sheer lack of facilities to make it big? Does not being provided a chance reaction emanate from there? As compared to developed nations, we Indians did not have the right opportunities for quite some time. And of course, we do have examples of people who made it big as opportunities were available to them? Do we not hear/read about these success stories? But then who writes about failures? Maybe there are many instances where opportunities were surely provided but the result was a failure. That apart, how many of us today are deprived of chances? I guess the generation which is right now entering colleges did have the chance/opportunity to excel. So then does this class of people applaud achievements/performances with "true" feelings? I would rather have you look for an answer here!!

The second point is on choice. And this is pertinent to the question I mentioned towards the end of the para above. Opportunities do exist but the choice was not exercised and hence being part of the audience and not on the stage. Typical reaction to being a audience. I did not chose to do this activity, else I would have done better than the performer!! I am better, just that I did not chose to take this path!!

I have seen some forums with people predominantly from the developed world, where I felt the appreciation was genuine. People were open with their admiration for the performer. Why? In these societies, the opportunity issue is no longer valid, usually. They do have the opportunities. (lack of opportunity yet high performance, does anyway calls for applause). So the question is all about choice. 

No success comes without hard work, a universal truth. Nadal, Federer, Hamilton, Tendulkar, the list could be big, have all succeeded, no doubts about that, but has that come without hard work? A good case study for us to easily identify with would be Tendulkar. He came into 'being" in a cricket world, not alone, isn't it? He was accompanied by a close friend of his, we all are aware of the name. But then how come Tendulkar is the name of the game? Hard work, discipline (we hear legendary stories about this).... The choice.. To take an easy way out and have good life or to slug it out and ensure long term success. Tendulkar chose the second option. And hence the importance of choice. 

So what do you clap for? I can again put together two options. 1) Performance despite chances. & 2) Performance because of the choice.

Option 1 anyways needs our heartfelt applause. If Sarath Babu makes it to IIMC while his mother sells idlis on the roads, it does call for applause of the true kind.

It is the appreciation of the option 2, which calls for the maturity. The applause is for the choice the performer had made. The choice of slugging it out. The choice of sacrifice. The choice to endure pain yet continue. So whichever way you look at things, I think a heartfelt appreciation, hear felt applause would be the right thing to do whenever we are in the audience and see a great performance being enacted and rewarded.

I have consciously avoided discussing a situation where we can claim that the award is due to 'situation management' and not truly an effort but my only thought here is that this also falls in the choice category. Maybe you did not choose to tread that path. Someone did.

So next time you are in audience and see a good performance being rewarded, please stand up and Clap!! Someone would do the same for you someday!! 

Tough Calls - Enhancer or Limiter?

As the Telangana issue heats up again and makes life difficult in Hyderabad, I wonder, when Chidambaram announced agreement for formation of Telangana, was Govt taking the easy way out, that point of time?  With KCR on an hunger strike immediately after the death of a strong leader YSR? At least that is the overlaying thought, now that the issue continues to burn unabated.

This situation begets a question. As a leader which strategy would you adopt? Which strategy serves you in the long run? Bite the bullet and taking tough calls or win the popularity game by taking the easy and popular way out? Or even do a Narashima Rao by putting off taking any decision?

In the boom times, when the careers/roles in an organisation shorten to escape facing the impact a decision taken, what is the right thing to do from a career point of view? This is more so in the new economy companies as these have trailblazing growth rates which result in the employees having a similarly faster career growth rate. Many of the Old economy companies still have a middle to senior level employee putting in respectable years in the same role. So as the roles/careers in an organisation shorten, managers tend to escape the visibility of the impact of the decision and this can lead to the 'make it easy now" situation. These situations test the mettle of a manager. A crossroad situation... Let us explore the options in detail.

Option 1. Leader takes the role responsibility and decides to take a long term horizon of the decision impact. This might  call for some tough act. What say for the managers who are ready to take tough calls? Calls which in the short run would lead to tough situations. And with shorter tenures, the results of the tough calls having a longer horizon, the stint proves to be sub par. Impacting annual appraisals etc. So essentially, the decision might create value in the long run, but will surely not have a substantial short term impact.

Option 2. Popularity and soft situation is on your mind as a leader. So out goes the bullet biting. So the decision tends to be something which saves the day for today. Consequence of the decision might lead to future chaos, but then there would be someone else to clean the mess. The beauty here is that the cleaner of the mess too tends to get 'full credit' for cleaning the mess!! And everyone benefits, only the organisation loses.

You might say there would be more options which would be a mix of the above situations, but then I started off by laying the baseline to a crisis situation of Telangana. I am taking about similar situations in an organisations which are essentially not so frequent and also not so drastic as the T situation. However, what is important is the reaction of a leader to situation. And all kind of situations would have responses from leaders which essentially can be categorized into the ones I mentioned above.

So, how can an organisation foster the culture of tough yet right kind of decisions for the longer good of the organisations/employees and reward the manager doing so? A huge challenge.

While we do see some sporadic recognition for Narashima Rao (I do not come back to this example due to my sharing the birth state with him), but at least in some areas, he epitomised the tough call manager. While we are all glowing with glee on how the Indian economy has arrived at the World stage, the beginning were a tough call. Tough call taken by the then PM Narashima Rao and implemented by now PM Manmohan Singh. So what happens of him? How many still remember him? Some intellectuals do, but the masses have no memory of him. A few structures named after him (mostly in his home state AP). Else he is cleaned out from history. We have as a country not treated the tough calls manager well.

Ratan Tata took over the reins during one of the most testing times for the Tata group. So what was his style? Bite the bullet? You bet. Did he succeed? You bet. One of the most respected in the World. But then his name is Tata. He owns the empire. Or does he? I think he epitomises the true long-term-tough-calls-guy working silently despite media snubs early in his career. 

Let us also look at some short term popularity winning decision types. TN politicians? Anyone else? The issue with these leaders is you might have a short term great memory of the person but it fizzles out badly once the impact is felt. 

Most of the organisations which do well, tend to inculcate this culture of Leadership ready to take tough calls if the situation demands. Any organisation which fosters this culture would need to start with the corner office, which is where most of the tough calls start. The supporting functions like HR, Finance would need to have systems which reward the right decisions, whether short term or long term, tough or soft. The appraisal systems need to take that into account. The tenure of managers in a role need to have that span to facilitate the decision making. And if the tough calls are rewarded and the entire organisation sees it, the culture would be to do what is right, even if it is a tough call. Last but not the least, the organisation should have a system wherein if the leader can be recalled from a new role, to take care of the impact of the decisions taken in the previous one, if it is proved that the call was a suboptimal one taken consciously.