Tuesday, September 30, 2008

United States of China!

Here is the map of the 34 Chinese provinces compared on population terms with different countries of the world.

Shiller on a "financial democracy"

The "always ahead" Robert Shiller outlines four features of a financial democracy.

1. Handle moral hazard better. The present bailouts pose a major moral hazard problem with long term consequnces. We need to define a new generation of financial contracts, with a continuation of our evolving thinking about moral hazard, reflecting greater enlightenment, greater understanding of human psychology and the means to deal with financial failure. For example, I have proposed replacing the conventional mortgage with what I call the "continuous-workout mortgage" - one that would spell out in advance the conditions under which borrowers would see their debt reduced in a rocky economy. These conditions would be designed to minimize moral hazard: The borrowers would not be able to make the debt reduction happen deliberately.

2. To limit risks to the system, build better derivatives. Some kinds of derivatives, such as those maintained by futures exchanges using procedures that effectively eliminate the risk that the other party in the agreement will default, are more useful - and far safer - than others. It is high time to redesign derivatives to avoid what Buffett called "mega-catastrophic" risks.

3. Trust markets, not Wall Street titans. We need to learn to trust people and markets rather than institutions. This means developing better markets that will allow us to hedge against the kinds of risks that dragged us into this crisis, such as real estate gambles.

4. Ideas matter. People still seem to want to trust businessmen who have made bundles and have a huge investment bank behind them, rather than listen to experts who are thinking about the fundamentals of risk management. We would have been better off this month if we'd been ignoring the former and listening to the latter.

The first and second points are increasingly going to happen, while I am not sure about fourth, and the third is surely not going to happen!

Update 1

Shiller has been an advocate of a Rising Tide Tax System that seeks to usher in a taxation system that would address the widening inequality challenge. The system involves indexing inequality to partially insure against future increases in after-tax inequality. Tax rates would endogenously adjust to changes in inequality to dampen changes in the after-tax "Lorenz curve".

Bailout homeowners!

Instead of bailing out financial institutions holding mortgage backed assets, Ben Stein advocates making govedrnment the buyer of last resort for houses themselves, thereby stabilize the home markets and mortgage debts! He also favors annulling Credit Default Swaps (CDS) contracts. Felix Salmon contends that this may not be a good idea.

CDS are derivative contracts, with bundles of mortgage backed securities as the underlying asset, which seeks to effectively insure against default risk on claims on the assets. Since they are not strictly insurance contracts, they have prospered unregulated, running up a massive $62 trillion market, compared to a mere $1 trillion in sub-prime mortgages and just over $3 trillion in sub-prime mortgage backed securities. They have even moved into other areas like leveraged loan bonds, student loan bonds, credit card bonds and so on.

Monday, September 29, 2008

Moral hazard in infrastructure contracts

The recent concession agreement (here and here) signed between the Maytas Metro Ltd (MML) and the Government of India to build, operate and transfer a 71 km long, Rs 12,132-crore metro rail project in Hyderabad raises important contractual questions.

Of the four bidders, three demanded government support, whereas MML offered to pay up a massive Rs 30,311 crore over the 34 year concession period. It even declined an option to access a Rs 2300 Cr Government of India's viability gap funding support for PPP projects. The reverse annuity promised by MML is a major surprise given the well acknowledged fact that such mass public transit are not considered commercially viable, even in developed economies. There are apprehensions that MML, with no expertise in the sector, outbid its competitors to grab the 269 acres that came along with the package.

This development has to be seen in the backdrop of numerous instances of contract or concession agreement re-negotiations in infrastructure projects. Starting with the failed Enron, this list includes major projects in power, water (ViWSCo), real estate development (satellite townships in Hyderabad) and roads (Delhi-Gurgaon expressway), and is growing. Especially a cause for concern is contracts in power sector. Even though none of the merchant power projects and those bidded out on competitive tariff based bidding have started functioning, most of them have already undergone re-negotiation. In fact, many of them were re-negotiated even before the Power Purchase Agreements (PPAs) were signed!

These precedents carry strong moral hazard signals. With re-negotiations becoming a norm, contracts and concession agreements appear to have lost their sanctity. Potential bidders realize that they can bid low in order to bag the project, and then re-negotiate more favorable terms later. With expectations becoming entrenched and technical pre-qualification being diluted, there arises strong possibility of fly-by-night operators and cherry-pickers grabbing these projects. The large land holdings that come with many of these projects are an attraction for those looking at quick wins.

The floodgates have been opened and it may be difficult for the government to rein in expectations. But it is important that such expectations be rolled back by strong legislative and regulatory signals against contract re-negotiations. In the absence of such action, the PPP and other projects in infrastructure will fail to achieve their objectives and degenerate into land grabs and asset stripping.

Update 1
Michael Walton has this to say on incomplete contracts, "According to a World Bank data base some 74% of water and sanitation and 55% of roads contracts were renegotiated by the early 2000s. Over 60% of renegotiations were initiated by the operator, and a majority were resolved in favour of the private company... Initial bids may have been low in the expectation of holding up the government later, with bribes or other means."

The crisis and US economy

NYT has this excellent snapshot that places the bailouts from the perspective of the economy as a whole.

Wall Street expresses its gratitude!

Barry Ritholtz has this memo from Wall Street which summarizes the events of the past two decades leading upto the present crisis.

Sunday, September 28, 2008

United states of the world!

Here is how 50 US states could have been substituted for different independent countries.

(HT: Teeming Multitudes)

New inflation index in India

The Government of India is proposing a new Wholesale Price Index (WPI), with 2004-05 as the base year, from January 1, 2009. The recent surge in inflation and the need to move into a system which reflects the changing economic reality more accurately is seen as being behind this change.

The existing WPI series, having 1993-94 as the base year, covers 435 commodities, which include 98 "primary articles", 318 "manufactured products" and 19 "fuel, power, light & lubricant" items. The proposed 2004-05 base series will have 1,224 commodities. While the "primary articles" and "fuel" groups will have more or less the same number of items — 105 and 19, respectively — there would be as many as 1,100 "manufactured products". The prices of each of these individual commodities is proposed to be fixed by taking atleast five price quotations.

Unlike other major economies, where inflation figures are published on a monthly or quarterly periodicity and the focus is on WPI, India has weekly figures with focus on CPI. The new arrangement proposes to switch over to the practice being followed elsewhere. The reduced weights for food items (4.09 proposed against 5.01 now) are necessitated by the need to differentiate between core and headline inflation. While the former discounts for the sharp variations that generally mark food and energy prices, and conveys a more accurate representation of the economy.

It is feared that with the reduction in weights of essential commodities, the impact of inflation on the common man may not be accurately captured. Do not also be surprised with allegations of tempering with figures to suit political imperatives in an election year.

Update 1
There is also a strong case that even the CPI, unchanged since 1988, does not accurately reflect the changing consumption patterns of the average Indian consumer. So it has been argued that the weights in CPI should be changed to more accurately reflect the consumption pattern as indicated by the more dynamic Private Final Consumption Expenditure (PFCE).

Update 2
Nice summary of the inflation index debate by Deepak Mohanty

Update 3 (7/4/2010)
India has more inflation measures than most other countries. There are four consumer price indices (CPIs), and one each of Wholesale Price Index (WPI), gross domestic product (GDP) deflator and personal consumption deflator derived from national income accounts. CPIs and WPI are monthly, while the two deflators are quarterly. Many countries have a producer price index (PPI), but India doesn’t.

Contrary to popular misconception, WPI and PPI are not the same: Apart from coverage, the key difference between the two is that WPI reflects changes in the average cost of production including mark-ups and taxes, while PPI measures price changes of transacted goods at the gate excluding taxes. PPI is a better measure than WPI.

While almost all countries focus on CPI inflation for policy perspective, India prefers to focus on WPI inflation. In India’s case, WPI ends up doing the job done by CPI in most other countries, despite its bias, since the rate of change in WPI is normally bigger than that in CPI. Changes in international commodity prices are more quickly and more completely captured in WPI than in CPI.

It is not clear what portion of WPI inflation RBI can actually control through its monetary management. There is not much RBI can do about the food composite index (26.9% weight in the WPI basket). The fuel-related sub-index (14.2% weight in WPI) has a component that is administered (for example, petrol and diesel) and a component that is free to adjust to international prices. RBI’s monetary management has little effect on both, as the price elasticity of demand of the free component is typically low, while the government decides the administered component. That leaves the non-food manufacturing component that has a weight of 52.2% in the WPI basket. This has a large component that is affected by global prices, not to mention the broader push on physical infrastructure by the government

Shrinking Wall Street!

Here is a graphic which captures the decline and demise of investment banking as we have known it for decades!

Roubini on Paulson Plan

Nouriel Roubini has this scathing denuciation of the Paulson Plan. He writes,

"Specifically, the Treasury plan does not formally provide senior preferred shares for the government in exchange for the government purchase of the toxic/illiquid assets of the financial institutions; so this rescue plan is a huge and massive bailout of the shareholders and the unsecured creditors of the firms; with $700 billion of taxpayer money the pockets of reckless bankers and investors have been made fatter under the fake argument that bailing out Wall Street was necessary to rescue Main Street from a severe recession. Instead, the restoration of the financial health of distressed financial firms could have been achieved with a cheaper and better use of public money.

Moreover, the plan does not address the need to recapitalize badly undercapitalized financial institutions: this could have been achieved via public injections of preferred shares into these firms; needed matching injections of Tier 1 capital by current shareholders to make sure that such shareholders take first tier loss in the presence of public recapitalization; suspension of dividends payments; conversion of some of the unsecured debt into equity (a debt for equity swap).

The plan also does not explicitly include an HOLC-style program to reduce across the board the debt burden of the distressed household sector; without such a component the debt overhang of the household sector will continue to depress consumption spending and will exacerbate the current economic recession.

Thus, the Treasury plan is a disgrace: a bailout of reckless bankers, lenders and investors that provides little direct debt relief to borrowers and financially stressed households and that will come at a very high cost to the US taxpayer. And the plan does nothing to resolve the severe stress in money markets and interbank markets that are now close to a systemic meltdown."

In simple terms, the fundamental problem is that the Fed and Treasury thinks the mortgage backed securities are underpriced and they can create a market by recapitalizing the institutions holding these assets. It is hoped that this will lead to major upward revaluations, thereby allowing them to find their true value. As Paul Krugman and Roubini above argues, the problem is clearly one of too little capital in the market.

Update 1
Linkfest on the bailout from Big Picture.

Universal plug points?

In this age of cell phones and laptops, one of the biggest sources of inconvenience facing international travellers is the vast variations in shapes and sizes of plug points. An Indian visitor to US faces a problem in converting the circular points in his instruments to the American flat plug sockets. Given the transaction costs associated with them, it may be time to come up with a universal plug point standard!

Saturday, September 27, 2008

Modigliani-Miller theorem

Greg Mankiw, through a "smart friend", has invoked the Modigliani-Miller (MM) theorem to argue against government taking an equity stake in the firms selling distressed assets.

He writes, "MM implies that the price of the asset (again,assuming the auction gets it right) will adjust to offset the value of any warrants Treasury receives. In this case of a reverse auction, imagine that the price is set at $10. If Treasury instead demands a warrant for future gains of some sort, then the price will rise in the expected amount of the warrant - say that's $2. Then the price Treasury pays for the asset will be $12." He therefore feels that neither the firm nor the equity holders do not gain anything extra by equity warrants.

The MM theorem states that in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does not matter if the firm's capital is raised by issuing stock or selling debt, or what the firm's dividend policy is.

The problem with the aforementioned plan is that the assumptions may (will) not hold. There surely is information asymmetry between the bailee and the Treasury. About efficient markets, with the events of the past few weeks, do we need to say any more? An alternative plan would be to get issued warrants whose value is an increasing function of the loss Treasury books when it sells off the bailee's assets.

Friday, September 26, 2008

Nudging on civic issues

Littering, regular payment of taxes, maintaining clean sewerage systems, eliminating wastage of water, reducing electricity consumption, maintaining surroundings clean, are all some of the major civic challenges facing policy makers. There are no regulatory solutions to such issues. Some of these problems are so severe that we cannot wait for an adequate level of social responsibility and civic sensibility to develop over a period of time.

Here is a model. Residents Welfare Associations (RWAs), which are fairly strong in many urban residential colonies, have inherent social deterrence and peer group pressure values. This can be leveraged to create an appropriate incentive system that encourages or nudges individuals to more socially responsible behaviour. These RWAs can by themselves or through third-party certitification agencies evalaute households on these parameters and then grade them. These grades can be in the form of marks or category classification.

Peer pressure is a very effective social nudge in middle and upper class residential colonies. The marks or grades received by each household can be displayed alongside the door or plot number plate. This will spotlight attention on the poor performers - large energy and water consumers,or those who do not maintain their surroundings clean, and the attendant social stigma is likely to nudge them towards behaving more responsibly.

In order to avoid conflicts of interest, these agencies can be paid by the Municipal Corporation directly. The cost of this service will be a small fraction of the total property tax receipts from the area. Certification process can be tendered out based on the fraction of property tax rates quoted.

Taking the experiment one step ahead, it may be possible to even impose some type of monetary penalty on the worst offenders. To make it easier to administer, this penalty may be collected along with the property tax (or even electricity or water charges), as a penal premium. The higher tax will have to be paid by the offending household till their scores are revised.

Hanky Panky!

Alan Blinder has described the sub-prime bailout plan as "Hanky Panky". The lack of clarity on many important things has raised serious apprehensions about the final cost to the taxpayer.

Briefly, under the Plan, through reverse auctions, aspiring sellers of the hard-to-sell securities would compete to offer the securities to the government. The auctions are supposed to jump-start the market for these securities and allow investors to value them on balance sheets. It is presumed that once banks’ balance sheets are cleansed of toxic assets, they would be able to tap fresh capital.

In the final analysis the plan's success or otherwise will be decided on how effective it will be in containing the crisis and how much it will cost the tax payers. The later will in turn depend on the prices at which the distressed assets are purchased and that at which they are finally sold off. Unfortunately on this and a few other thigs, the plan does not inspire confidence.

Section 8 of the plan reads, "Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency."

Some of the major omissions from and apprehensions surrounding the plan are

1. The plan has nothing to say about how the bad assets will be priced. Given the difficulty in even locating the deeply embedded risks in many of these securities, there are very few price discovery options. Unlike stocks, mortgage backed securities (each of them tied to thousands of individual mortgages, most of which are going bad as home prices continue to fall) are not traded on any exchange and the market for them is opaque - traders do business over the telephone, and days can go by without a single trade.

These debts originated as home mortgages issued by mortgage lenders, who bundled mortgages and sold them to investment banks, who in turn re-packaged them into bonds and sold them off to other investment banks, PE firms, hedge funds, and insurance companies. Many Wall Street firms then sliced and diced these bonds into structured products like Collateralized Debt Obligations, which ended up dispersing risks far and wide. And all of these were transacted as private placements.

In the hope that the government would hold these investments till markets recover, Fed chairman Ben S. Bernanke told Congress that the government should avoid paying a fire-sale price, and pay what he called the "hold-to-maturity price"(or the price that investors would bid if they expected to keep the bond till it was paid off). This raises many moral hazard concerns.

It is arguable that the present market prices (of the collaterals) are not a reflection of the underlying assets. Further, any effort to recapitalize these entites at fire-sale prices, is also likely to rebound as it will generate a cascade of downstream effects (margin calls etc) on the entire financial system. This would defeat the very purpose of the bailout exercise. Overpaying for these assets will benefit the greedy and reckless financial institutions at the expense of the tax payers.

Many economists have suggested the use of auctions and even reverse auctions to price them. The Treasury is veering around to conducting reverse auctions, so as to find which bank would sell the MBS at the lowest price, and hope that the competition among sellers would drive the price close to the actual value of the asset as judged by the banks. In any case, the pricing mechanism would be critical in determing the success of the plan.

2. The plan lacks clarity on the government role and the price that will be incurred by the existing shareholders. Any such plan should seek to minimize the costs to the tax payers and have an exit strategy that would recoup a substantial share of the tax payers money. One way to maximize shareholder returns is by taking equity stakes in the firms selling distressed assets.

Faced with a similar ciris in early nineties, the Swedish government forced the distressed banks had to write down all their losses and issue warrants to the government (options to buy the bank stocks), thereby effectively making government the owners. State guaranteed all bank deposits and creditors of the nation’s 114 banks, and two new agencies were formed - one, to supervise institutions that needed recapitalization, and another to sell off the assets, mainly real estate, that the banks held as collateral.

3. It is silent on how the homeowners will re-finance their mortgages, given the sharp declines in home values and tighter re-finance lending standards (like lending for only upto 80% of home values). The bailout plan addresses only the financial institutions and has nothing for the homeowners. This assumes importance given the fact that home prices continue to fall, and the market values of most homes have fallen far below the loan amounts. Without addressing this downstream issue, purchasing mortgage securities will only postpone a solution to the problem.

Update 1
Robert Reich describes the existing plan as a "blank cheque", and instead proposes five conditions. The conditions also includes giving bankruptcy judges the authority to modify the terms of primary mortgages, so that homeowners have a fighting chance to keep their homes. He also proposes a stimulus plan for Main Street, "It should extend unemployment insurance, freeze mortgage rates, and pass a stimulus package to create more jobs."

Allan Meltzer has another plan which proposes making loans which the financial institutions have to repay with interest. This was successfully tried out by Chile in 1982, and firms weren't allowed to pay dividends or employees and owners take their bonuses until they repaid the loans.

Greg Mankiw, one of the few mainstream economists to support the plan, quotes a "smart friend" in response to these issues. Pimco's Bill Gross, as expected of Wall Street opinion makers, argues that it is not a "bailout of Wall Street but a rescue of Main Street, as lending capacity and confidence is restored to our banks and the delicate balance between production and finance is given a chance to work its magic"! Responses to these are available here and here.

Here is a list of commentaries on the crisis by economists and commentators.

Update 2
More commentaries of the crisis here.

Update 3
Lucian Bebchuk of Harvard Law School has this plan, which proposes purchasing assets at fair market values and safeguards to protect tax payers.

Update 4
Finally SEC admits to regulatory and oversight lapses.

Update 5
Brad De Long supports Swedish style nationalization and not a bailout.

Update 6
NYT has this excellent overview of the actions that brought down AIG.

Update 7
Recapitalization of banks by direct injection of capital, as opposed to that proposed by the final version of the Paulson Plan (by purchasing distressed assets through reverse auctions), is likely to deliver much better bang for the buck. Because banks have debt-to-equity ratios of 10 to one or higher, a dollar spent buying an equity stake would support 10 times as many assets as a dollar spent buying up individual securities. Government could infuse capital by acquiring stakes in the form of common stock, preferred shares paying a specific dividend or some other form of equity. Further, in a declining market, price discovery becomes even more difficult and misleading.

Tuesday, September 23, 2008

Global equity markets

In the midst of the crisis affecting the global financial markets, BSE Sensex appears to be the best performing market (among the major economies), and China the worst over the last one year.

Monday, September 22, 2008

Outsourcing encumbrances

One of the biggest challenges with projects involving commercial development of government lands in India is that of resolving encumbrances associated with it. These encumbrances which include encroachments, lack of clear records, and multiple claims, result in litigation and numerous socio-political problems. All conventional approaches in resolving the resultant dead-locks have failed, thereby locking up large quantities of such lands. Here is a "second-best" approach to settling them - outsource it!

There are a large extents prime real estate with such encumbrances in all our cities, especially in the form of unauthorised slums, under sub-optimal utilization. Freeing them up would not only generate valuable revenue, but also substantially increase the stock of land available, thereby putting downward pressure on urban land and rental values. This would help in making urban housing more affordable and contribute towards urban growth.

The majority of these encroachments are very old and embroiled in some form of litigation. Evicting such encroachments would involve dispossessing large numbers of families and are therefore politically sensitive. Government agencies have tried to address this problem by negotiating with the encroachers, so as to resettle them and redevelop the lands. The resettlement proposal may be on the same land, elsewhere in government residential colonies, or sharing the newly built up area.

So here is a possible solution. Development of the land on a Public Private Partnership (PPP) mode, with the private agency being allocated (bidded out) the risk of negotiating the resettlement. The rehabilitation agreement can be anything - reettling them elsewhere or in a part of the same land, or payment of cash compensation, or allotment of a share of the developed commercial space, or another mutually agreeable arrangement.

The private developer will discount for the cost of resettlement and make his bid. A process of open competitive bidding process will help in price discovery in a transparent manner. It is true that in the inital stages, the bidders are likely to be conservative in their quotes. But once the market gets established and few successful examples come on board, more accurate approximations will emerge.

An Econ 101 detour here. Coase Theorem, developed by Nobel laureate Ronald Coase, argues that in the absence of transaction costs, bargaining will lead to an efficient outcome regardless of the initial allocation of property rights. It defines two pre-conditions for the arrival of an efficient outcome through bargaining - clearly defined property rights and obstacle free bargaining process. In practice though, both these conditions are difficult to achieve.

I will argue that the transaction costs are much higher and the two pre-requisites almost impossible (government cannot recognize the title right of the encroacher and obstacles to bargaining are varied and numerous) to achieve when government becomes a party to the negotiating process. However, it is possible to minimize transaction costs and have the requisite preconditions when the negotiations are held between two private agencies.

Government agencies, circumscribed as they are by limitations imposed by the framework of rules and regulations, do not have the flexibility required to negotiate and solve such problems. Further, negotiations with government most often gets politicized, resulting in brinkmanship and unreasonable demands. Rent seeking agencies enter the negotiations on behalf of the settlers, and transaction costs increase. Thanks to these external agents and the sharing of benefits with them, both the settlers and government get a sub-optimal deal. We therefore have an economically inefficient solution.

Private agencies, free from such constraints, are much better suited to arriving at a mutually agreeable, negotiated settlements. Further, private agencies have the flexibility and informal sources of power to manage the political and social fallout from such resettlements. The transaction costs can be minimized and the settlers can get a larger share of the benefits. In other words, government can outsource the settlement of difficult encumbrances.

Theoretically atleast, such mechanism should work, provided a framework for a Coasean bargain can be laid out. In most cases, thanks to the steep rise in land values in cities, the inherent value of these lands (for the developers) are many times higher than the value to the settlers. The value to the settlers come not so much from the value of their encroachments per se, but from the convenience (close to their places of work) associated with the location of such settlements. There are clear values that can possibly be attached to both.

I agree that there are many dangers associated with such solutions. Foremost, there is a strong possibility of the successful bidder using strong arm tactics to dispossess the encroachers or force a grossly unfair settlement on them. It is therefore important to build in appropriate provisions to protect the interests of those being displaced, especially those genuinely poor, and assure them a pre-defined basic minimum of rights. One way of reassuring the settlers is to incorporate an agreement between the settlers and the successful bidder, as an annexure to the agreement between the government and the bidder. However, the government should not be a party to the bilateral deal between the two private parties.

Atleast for the initial few projects, such arrangements are ideal for the projects on smaller extents of lands. Given the history of such disputes, it is useful to have an arrangement that has a better chance of success than the conventional route, whose history does not inspire any confidence.

America's world view!

(HT: Chris Blattman)

Sunday, September 21, 2008

Where is Bush and the Congress?

The distinctly striking thing about the ongoing crisis in the US is the star cast. The merits of it apart, Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke, with their support staff, and not President Bush and the Congress, are clearly managing the crisis.

Can we imagine a similar scenario in India - Mr P Chidamabaram and Dr D Subba Rao leaving Dr Manmohan Singh (or Sonia Gandhi) and the Parliament as bystanders?

Bailout plan concerns

The Bush administration announces a vast bailout (more here) of financial institutions in the United States, with unfettered authority for the Treasury Department to buy up to $700 billion in distressed mortgage-related assets from the private firms. This plan to buy up mortgage securities shunned by all banks, would raise the national debt ceiling to $11.3 trillion. And it would place no restrictions on the administration other than requiring semiannual reports to Congress, granting the Treasury secretary unprecedented power to buy and later resell mortgage debt.

Though the details of the plan are being worked out, it is clear that the US Treasury Department will now assume responsibilities similar to that of large debt restructuring institution. Of crucial importance would be the price discovery mechanism for the securities being purchased and the conditions imposed on the executives of the firms selling them. Besides determining the final cost of the bailout to the tax payer, it will also be critical in containing moral hazard dangers. The terms of the bailout contained in those details will have to send a strong enough message, punishing the greedy and reckless investors and their managers. As Gretchen Morgenson argues in 'Your money at work, fixing others' mistakes', the challenges facing the structuring of any such deal are formidable.

Identifying the beneficiaries of any such bailout is extremely difficult, even impossible. AIG had underwritten Credit Default Swaps (CDS) worth $441 bn, and many of the counterparties (localizing and identifying whom is impossible) to these derivatives contracts are wealthy and greedy investors, who now stand to benefit from this bailout at tax payers benefit.

Ironically, if this plan goes through in its present shape, Hank Paulson will be the best person to administer it. He would only have to cast off the cloak of a Treasury Secretary and don his previous role as head of Goldman Sachs. The only difference is that he would now be managing the tax payers money!

End of the bubble era?

David Leonhardt feels that the extraordinary events of the last week could be the climax of the decade and a half long serial bubbles, first in tech stocks and then in real estate, both fuelling another one in consumption.

He writes, "A guiding principle of economic policy in recent years has been that nobody is smart enough to diagnose a bubble until it has already deflated. This was one of Alan Greenspan’s mantras during his tenure as the chairman of the Fed... no matter how high stock prices rose relative to profits, or no matter how high house prices rose relative to rents, regulators deferred to the collective wisdom of the market... Pricking a bubble before it grew too large could stifle innovation and hurt other parts of the economy. Cleaning up the aftermath of a bubble is easier and less expensive. We’re living through that cleanup now."

The dot com crash at the turn of the millennium did not wring out the excesses of the nineties stockmarket bubble. The "Greenspan put" and a period of historically low interest rates, blew up another bubble in real estate and mortgage securities, which in turn limited the deflation of the tech stock bubble. All these created a "wealth effect" that triggered a "consumption bubble" which was in turn fuelled by a "savings glut" in emerging Asia and the voracious export appetite of China. These bubbles fed into each other, thereby linking up the real economy and the financial markets.

As the excesses built up, aided by the deregulation wave (repeal of the Glass-Steagall Act in 1999), the financial sector continued to grow at breakneck pace. As late as 2004, financial services firms earned 28.3% of corporate America’s total profits, double the share in the seventies and eighties. Of every dollar paid to the American work force in 2008, almost 10 cents went to people working at investment banks and other finance companies, up from about 6 cents or 7 cents throughout the seventies and eighties. An indicator that things may have retained some semblance of normalcy is the fact that the Price to earnings ratio has dropped from a historic high of 36 in 2000 to the post-war average of 17.

Saturday, September 20, 2008

IPO with a difference

Early this week, Do Something, a non-profit organization promoting volunteerism among teenagers in the US, launched an IPO to raise $8 million to double its activities by 2011. Unlike the typical IPO prospectus, this one does not pledge to make any profits, and claims that the "units offered in conjunction with this prospectus represent a perpetual interest in Do Something; this interest is strictly philanthropic, with no provision for cash returns at any time."

Do Something promises "a significant social return on investment", quarterly performance updates and a conference call with management. But none of these recent philanthropic IPOs actually gives investors voting rights, essential to ensuring management accountability and removing managers who fail to deliver on their promises. But this is surely something for atleast a few NGOs in India to imitate.

HT: Economist

Financial market reforms

Three of the top five investment banks in the US have failed, and the story is not yet over. Of the three, Bear Stearns and Merrill Lynch have fallen into the arms of universal banks (which marry investment banking and deposit taking) JP Morgan Chase and Bank of America respectively, and the late Lehman Brothers could end up in the Barclays stable. With mounting apprehensions on counter party risks, commercial banks have pulled back on lending and investment banks are facing a credit squeeze. A universal banking model becomes an attractive proposition.

Although the 1933 Glass-Steagall act, which separated investment banks and commercial banks, was repealed in 1999, the universal model is still viewed with suspicion in America. The fact that the crisis has left universal banking majors like UBS and Citigroup unscathed would be used as justification for the success of the universal banking model.

The Economist posits three arguements against the independent investment bank model
1. Investment banks have higher leverage than other banks (in America at least), which worsens the impact of falling asset values. They do not have the safety-valve of banking books, where souring assets can escape the rigours of mark-to-market accounting. And they lack the stable earnings streams of commercial and retail banking.

2. As a group, the pure-play investment banks have relied heavily on short-term funding, particularly repo transactions in which counterparties take collateral as security against the cash they lend. But with such collaterals (like asset backed securities) now under scrutiny, such lending will dry up. A shift towards longer-term unsecured financing would increase the cost of raising capital.

3. As well as dearer funding and lower leverage, the investment banks face the prospect of weakened demand for their services. As and when the market for structured finance revives, it will be smaller and less rewarding than before. Demand for many services will not go away, but in a world of scarcer credit, universal banks will be tempted to use their lending capacity to win juicier investment-banking business from companies.

The sub-prime crisis is also bound to raise questions about the securitization model under which lenders off-load assets from their balance sheets, leaving them to move forward with more lending. These debts are then securitized as complex asset backed securities with multiple tranches of structured debt obligations. In the process risk gets disperesed far and wide into the market, with the attendant problems of locating and pricing risks.

In this context, secured securities like covered bonds are likely to become popular. Covered bond is a form of senior debt that is paid back from the issuer’s cash flows but is also secured against a ring-fenced pool of assets, such as mortgage loans, in the event of default. That makes it safer than unsecured debt. But covered bonds also offer more protection to investors than asset-backed securities, because the issuer retains the credit risk, rather than securitising it away, and must also keep the cover pool up to snuff by replacing non-performing loans with performing ones. For extra safety, the pool contains more collateral than the value of the bond.

For jittery investors, these are instruments that offer safer exposure to America’s mortgage market. For issuers, the costs of funding are lower than raising unsecured debt, and issuance does not depend on the revival of the securitisation markets.

Update 1
In the recent boom years, investment banks have been increasingly moving away from their traditional focus areas of M&A advisory services and securities underwriting to proprietary trading using its own capital and borrowed money to make massive bets. Goldman Sachs, which houses some of the largest hedge funds and private equity firms, was the best example of this shift. From 1996 to 1998, investment banking generated up to 40% of the money Goldman brought in the door, whereas in 2007, Goldman’s best year, that figure was less than 16%, while revenue from trading and principal investing was 68%.

With nervous investors like hedge funds pulling out their monies and share price falling, the two remaining investment banking majors, Goldman and Morgan Stanley, decided to convert themselves to deposit-taking bank holding companies. Though this eanbles them to access banking funds, it also means stricter regulatory control by the Fed and Office of the Comptroller of the Currency, rather than the loosse and periodic audit by the SEC. Further, they would not be able to deploy leverage on a massive scale as before. Whereas banks like JP Morgan and Citigroup borrowed about $10 for every $1 equity, the ratio was 33:1 when Bear collpased and in the range of 20-30:1 for investment banks.

Update 2
James Suroweicki sums up the crisis surrounding investment banks. He is spot on, "The entire edifice of Wall Street is built on confidence. Investment banks rely on short-term debt to run their businesses, and their businesses consist of activities—trading, dealmaking, money management—that depend on people’s faith in their ability to honor their obligations. As soon as the customers and creditors of a company like Lehman start to wonder whether it might collapse, they become less willing to lend or to trade, and more likely to demand their money back. The perception of weakness exacerbates the reality of weakness."

Friday, September 19, 2008

Government makes a comeback to financial markets!

The experiment with unregulated financial engineering is over, and government is making its biggest comeback into financial market in many decades. As Paul Krugman says, "The unthinkable — a government buyout of much of the private sector’s bad debt — has become the inevitable." Nationalization is no longer a dirty word! The "national credit card of the United States", operated by the Federal Reserve, is being used to takeover the sub-prime debt!

There have been numerous calls for a "comprehensive plan" to regulate the financial system. However, while these are undoubtedly important, they may not be the immediate priority. The urgent need is to reassure investors and prevent the crisis from spreading further. In other words, temporary steps involving damage control and crisis management. The Fed needs to buy as much time as possible, so as to give the ailing institutions breathing time to get some semblance of order back, dissipate the fear psychosis hanging over the markets, and for the real economy to adjust to the changed circumstances. The time for hard regulatory decisions of fundamental nature should come later, lest it upsets the delicately balanced applecart.

In such uncertain times, the low interest rates notwithstanding, credit gets squeezed out for even the real economy, as lenders, wary of counter-party risk "go on strike". That this is happening is borne out by the sharply widening interest rate spreads - the average interest rate on three-month interbank borrowing was 3.2%, while the interest rate on the corresponding Treasuries was 0.05%. Further, the spreads in the money markets (between interest rate charges overnight and those charged over a longer period), which indicates the health of the money markets and is a measure of whether banks are willing to lend to one another — and ultimately to consumers, have also been widening.

Given that the financial markets will now need help from a real economy to pull itself out of the deep crisis, it is imperative that conditions be maintained to ensure that the real economy remains robust and healthy. A credit squeeze would depress business spending, already starined by inflationary and recessionary expectations.

Worse still, fears of the crisis engulfing even safe investments like money market funds, certificates of deposit and asset-backed commercial paper, may prompt investors to pull out from these securities, thereby forcing a run on the issuing institutions. This would set off a domino effect on even the hitherto safer areas of the financial system, with catastrophic consequences. There is the danger of a "liquidation trap", with falling asset prices triggering off margin calls and distress sales, causing further asset sales and price declines.

These dangers will persist for atleast a few months, and the Fed should be dextrous enough to swiftly contain these fears and reassure investors. With the double effect of inflation and solvency crisis driving real interest rates (even the nominal ones are close to zero) virtually zero, the standard monetary policy levers have become ineffectual. In these extraordinary circumstances, the Fed will have to, as Mark Thoma and William Buiter suggested a few months back, assume the role of a "risk absorber of the last resort" or "market maker of last resort". The temporary fire-fighting options available include
1. Creation of an agency to buy up bad assets. This entity might purchase assets at a steep discount from solvent financial institutions and eventually sell them back into the market. Precedents include the Resolution Trust Corporation, a government-owned, asset-management company charged with liquidating assets of failed Savings & Loans (S&L) institutions in the eighties, and the Japanese government’s mass purchase of bad debts from banks during the 1990s.
2. Suspend short trading in the securities of embattled institutions.
3. Keep alive the emergency lending program, so as to enable access to credit for troubled insititions.
4. Dilute credit standards for emergency lending.
5. Extend guarantee umbrella to certain safer and liquid instruments like the $3.4 trillion strong money market funds.
6. Expand credit lines available for short-term borrowings by banks from the money markets.
7. Explore ways to relax capital standards and mark-to-market rules, so that bad debts are written down in orderly fashion rather than through panicked deleveraging that pulls down good assets too.

All these efforts should have costs clearly defined and back-ended and the institutions have adequate time to clear off their bad assets and repay the tax payer. Fixing an appropriate risk-adjusted price that penalizes the greedy investors and fund managers, while helping achieve the objective would be a challenge. In the absence of a clear idea of the extent and type of risks involved, the Fed or any other agency cannot hope to have any comprehensive detailed plan, but only respond to crisis in a piece-meal manner and hope that situation eases up. In fact, any comprehensive and general plan, would perversely enough accentuate moral hazard.

One of the biggest concerns is that over how the government will value the assets it takes onto its books. The conventional mark-to-market valuation method, which has been responsible for much of the crisis, is surely not acceptable. As the WSJ suggests, one possible avenue could be some sort of auction facility, so that the government would not have to be involved in negotiating asset values with companies. This would also ensure that the greedy financial companies are adequately punished with big losses.

Whatever the Fed and Treasury does now should be done with the objective of steadying the market so that investors regain confidence in financial institutions and resume conducting business normally with them.

Nouriel Roubini has a scathing indictment of the actions of the Fed and the US Treasury, describing it as "socialism for the rich", and the "biggest government intervention and nationalisations in the recent history of humanity"!

India and Olympic medals

The dismal performance of India in the recently concluded Beijing Olympics and the contrast with the exceptional performance of China, has been the focus of intense discussion and scrutiny. Explanantions have ranged from the absence of adequate facilities to the "un-sporting" character of the nation. Commentators highlight the Indian Olympic preparations which stand in stark contrast to the almost military discipline and focus behind the Chinese efforts. Here is one more possible explanation.

Most popular Olympic events - athletics, swimming, boxing, wrestling, gymnastics - carry very limited appeal for the Indian middle class, except as a spectator sport. I will stick out my neck and claim that not many Indian parents, even among those with some sporting inclinations, would willingly send their children to pursue a career in these sports. Even if they agree to their children pursuing sporting careers, they would prefer racket games, chess, and cricket. Adventure sports like sailing/canoeing and rifle shooting will always find enthusiasts among the burgeoning upper income class. Same with "lifestyle" games like golf, billiards and snooker.

The result is that the Indian representation in these popular Olympic events are predominantly from the poorer sections. This sets the stage for another example of the famous "poverty trap" at work - since participation in these events are dominated by the poor, public investments in them remain minimal! Further, these athletes are motivated by nothing more than a hope of getting a job on sports quota. Medals in Olympics and other international competitions are rarely ever an incentive driving these athletes, atleast during their initial formative years.

So the comparison between India and China (or the US) becomes superfluous and inaccurate. With the Indian middle class abdicating, the Indian Olympic delegation is a more accurate representation of the "poor" India than the country as a whole. A more meaningful basis for evaluating Indian sporting performance would be that in the aforementioned "middle class" and "lifestyle" games. The poor performance of the delegation is also reflective of the intense deprivation being faced by India's poor!

And as the Indian economy grows and the middle class expands, do not be surprised if there emerges more Arjun Atwals, Abhinav Bindras and Pankaj Advanis. Similarly there will be more of Saina Nehwals, Sania Mirzas, and Koneru Humpys, (the fact that all the three train in Andhra Pradesh should not be a surprise, for the state has in recent years emerged as arguably the most "sporting" state in the country!), not to forget Tendulkars and Dhonis! But do not expect Indian versions of Usain Bolts and Micheal Phelps in the foreseeable future.

Wednesday, September 17, 2008

The 'nationalization' of AIG

The US Treasury and Fed gave out two contrasting signals today. One the one hand, they furthered moral hazard by putting up tax payers money to engineer a $85 bn bailout of the troubled insurance giant American Insurance Group (AIG). In complete contrast, by refusing to lower the benchmark Federal Funds rate from 2%, the Fed appears to have come to the conclusion that continuously postponing the inevitable by ever-cheaper borrowing is no longer a solution.

Reversing all brave talk about refusing to use tax payers money to bailout greedy investors and letting Lehman Brothers fall into bankruptcy, Hank Paulson has blinked and announced the bailout that would give the government control of AIG. AIG with business interests across the globe, covering diverse sectors like mortgages and aircraft leases, was refused a $40 bn bridge loan request by the Fed last week. Coming only two weeks after the government takeover of mortgage financing giants Fannie Mae and Freddie Mac, this "nationalization" of AIG is another strong indicator of the fact that big government is back in the financial markets with a bang.

The Fed and Treasury officials were scared of a global financial "chain reaction" given AIG’s role as an enormous provider of esoteric financial insurance contracts to investors who bought complex mortgage backed securities. Faced with a ratings downgrade, AIG was forced to cough up more collateral to cover for the increased riskiness. Its efforts to raise $75 bn private capital debt(including from JP Morgan Chase and Goldman Sachs) to stave off a ratings downgrade failed, leaving a bailout as the only alternative to a collapse.

Under the rescue plan, the Fed will make a two-year loan to A.I.G. of up to $85 billion and, in return, will receive warrants that can be converted into common stock giving the government nearly 80 percent ownership of the insurer, if the existing shareholders approve. All of the company’s assets are being pledged to secure the loan. Existing stockholders have already seen the value of their stock drop more than 90 percent in the last year. Now they will suffer even more, although they will not be totally wiped out.

The credit default swaps (CDS) underwritten by AIG, effectively required it to cover losses suffered by the buyers in the event the securities defaulted. The CDS are not securities and are not regulated by the Securities and Exchange Commission. And while they perform the same function as an insurance policy, they are not insurance in the conventional sense, so insurance regulators do not monitor them either.

If AIG had collapsed — and been unable to pay all of its insurance claims — institutional investors around the world would have been instantly forced to reappraise the value of those securities, and that in turn would have reduced their own capital and the value of their own debt. Small investors, including anyone who owned money market funds with AIG securities, could have been hurt, too.

Update 1
Thanks to its acquisition of an 80% share in AIG by investing $85 bn and holding $29 billion in securities once owned by Bear Stearns, the NYT has a new description for the Fed - investor of last resort! It writes, "Instead of just setting monetary policy in its Ivory Tower-like setting, the Fed now must wear several hats — that of insurance conglomerate, investment banker and even hedge fund manager."

Update 2
Here is a snapshot of the liabilities taken over by the Fed so far.

Update 3
Freakonomics has this excellent brief on the "most remarkable period of government intervention into the financial system since the Great Depression" by Doug Diamond and Anil Kashyap.

Tuesday, September 16, 2008

Financial crisis primer

With Lehman Brothers and Merrill Lynch following Bear Stearns into the pages of Wall Street history, of the big five investments banks, only two remain - Morgan Stanley and Goldman Sachs. And of these two, the former may soon follow suit and the crisis is taking a heavy toll on the later.

Worldwide, financial companies have reported more than $500 billion in charges and losses stemming from the credit crisis — a figure some experts say could eventually exceed $1 trillion. NYT has this primer on the financial crisis.

The marriage of an investment bank, Merrill Lynch, and a commercial bank, Bank of America would be throwback to the pre-depression era. During the Depression, Congress separated commercial banks, which take deposits and make loans, from investment banks, which underwrite and trade securities. The investment banks were allowed to do business with less oversight, while commercial banks operated with tighter supervision. But after Congress repealed those Depression-era laws in 1999, commercial banks began muscling in on Wall Street’s turf.

As the new competition whittled down profit margins, investment banks used more of their capital to trade securities and also began developing financial derivatives to fuel profits. The low interest rates, real estate boom, and the proliferation of mortgage-backed securities aided this process. The finance industry’s credit market instruments increased more than one and a half times in the last decade, to $15 trillion last year, according to Moody’s Economy.com, and climbed at a pace that was two times faster than the growth of the broad economy.

All this has brought about a fundamental change in the global banking system. As Paul Krugman says "the old world of banking, in which institutions housed in big marble buildings accepted deposits and lent the money out to long-term clients, has largely vanished, replaced by what is widely called the "shadow banking system". (These) depository banks now play only a minor role in channeling funds from savers to borrowers; most of the business of finance is carried out through complex deals arranged by "nondepository" institutions, institutions like the late lamented Bear Stearns — and Lehman."

The good thing about the Lehman bankruptcy is the reluctance of the Fed (unlike in case of Bear Stearns when the Fed guaranteed JP Morgan with tax payers money to engineer a bailout) to use public funds to prop up failing financial institutions. But the Fed's decision to accept lower-quality assets, such as equities, as collateral for its credit lines, so as to cushion the markets against the shock will surely further moral hazard. On the other hand, the Bank of America may have bitten off more than it can chew by taking over Merrill with all its toxicity. Given what has happened so far, Kenneth Lewis, CEO of Bank of America, may be celebrating too soon!

Update 1
Banks have been forced to take big losses as the value of their holdings — mainly complex securities tied to home mortgages — has declined. Bank share prices have fallen precipitously as well. Since banks borrow against their assets — shareholders’ equity and holdings — and lend to customers, fall in their asset values reduces their leeway to lend, and increases the risk of insolvency. So it becomes necessary to inject fresh capital in the banks to add financial ballast and halt a downward spiral in asset values and lending activity.

NYT has this summary of the crisis and the bailout.

Mint op-ed

Here is my Mint op-ed on managing growth in urban centers.

Case for densification

The last Maharashtra Budget eased the Floor Space Index (FSI) restrictions for Mumbai suburbs from 1 to 1.33. FSI is the ratio between the total plinth area of the building and the total extent of the land. FSI is most Asian cities varies from 5 to 15 and in many western cities go upto even 25, while the highest permissible FSI in any Indian city does not cross 3.

That FSI restrictions have created numerous market distortions. An excellent study of these distortions in Mumbai is documented here.

In many ways the FSI restrictions are a tax on urban residents by forcing up rental and land values, keeping percapita operation and maintenance expenditures on civic infrastructure higher, and preventing the full realisation of the network effects that make cities so vibrant and enterprising. A case for higher FSI is made here.

The commonly held arguments against any FSI relaxation is that it would put unmanageable strains on the local infrastructure. They argue that in any case civic infrastructure in many Indian cities is so poor that, it will not be able to withstand such densification. Policy makers regard densification as being socially undesirable due to perceived social problems that come with it. Comparisons are made with the numerous crime-infested and poverty-stricken housing estates for the poor that dot the suburbs of many American and European cities.

Such arguementa are much like the regular chicken and egg story. It fails to acknowledge that both FSI relaxation and infrastructure improvement should go hand in hand. By refusing to relax the FSI beyond small tinkering, the Government is effectively restricting the development of infrastructure with higher carrying capacity. In fact, the massive civic infrastructure projects being implemented under the Jawaharlal Nehru National Urban Renewal Misions (JNNURM), with project life of 30 to 40 years, are all being built with the exisitng FSI assumptions. They cannot cater to any dramatic FSI revisions.

Further, most of our cities are facing severe land scarcity, driving up land and rental values to stratoshepric heights. Given the reality of increasing urbanization and the impossibility of finding new lands, the only alternative available is to go vertically up or to watch the urban sprawl grow. We need to both permit higher FSI and also incentivize re-development of sub-optimally utilized lands. In this context, one of the most important targets should be in-situ re-development of large urban slums. Such urban renewal projects have siginificant business value and can be more efficiently done on a Public Private Partnership (PPP) mode.

The Andhra Pradesh Government was the first to come up with regulations dispensing off with FSI restrictions and regulating development based on minimum plot size, road width, and setbacks. The regulations permit unlimited height for buildings constructed on large plots abutting 100 ft and above roads, with setbacks of atleast 16 m on all sides. While this will surely incentivize densification in the newer settlements, it is likely to have limited impact on the downtown areas as there are very few large sites which become eligible to utilize these relaxations. It also does not address the issue of redevelopment in any specific manner.

Several State Governments across the country have tried to incentivize redevelopment of old buildings, older areas of cities, and slums, by providing additional FSI. But unfortunately, this incentive has been used mostly for road widening and not for urban renewal projects. Further, many of these efforts face opposition from environmental and other activist opponents and get derailed by court litigation.

The Andhra Pradesh State Government recently decided to amend the building rules in the high value Banjara Hills and Jubilee Hills areas for residential and commercial buildings. The height restrictions were increased from the existing 10 m and 15 m for residential and commercial buildings respectively, to 30 m. While this concession is only for those who have surrendered their lands free of cost for road widenings, it can be extended to other activities so as to incentivize densification.

The aforementioned examples are very limited and have been initiated to address the road widening land acquisition problem. Even the new Building rules of Andhra Pradesh is limited in its sope and does not explicitly address the real obstacles in the way of the densification process. What is remarkable is the persistance of widespread reluctance among policy makers to consider any meaningful enough easing of FSI relaxations.

There are a large number of small residential townships coming up in the suburbs of most Indian cities which are ideal testing grounds for higher FSIs. There is considerable logic in substantially easing FSI restrictions for these townships or colonies, since these are virgin settlements where it is easy to put in place basic infrastructure with higher carrying capacity to support such densification. Even here the FSI remains inefficiently low.

There is an interesting column by Paul Krugman which makes out a case for Americans to move out from car-dependent, suburbs to more densified population centers with good public transport facilities and plenty of local shopping.

Update 1
More on the demise of the suburban culture with its McMansions, in the US.

Monday, September 15, 2008

Lehman and Merrill falls

The inevitable finally happened as Lehaman Brothers files for Chapter 11 bankruptcy protection. In another stunning development, iconic brokerage firm Merrill Lynch became the latest victim of the deepening sub-prime mortgage triggered financial crisis, as it announced selling itself to Bank of America for roughly $50 billion. Insurance giant American Insurance Group (AIG) appears set to follow suit, as it has sought a $40 billion lifeline from the Federal Reserve, without which the company may have only days to survive.

Lehman, a 158 year old firm, will be the largest failure of an investment bank since the collapse of Drexel Burnham Lambert 18 years ago. Because of the harsher treatment that federal bankruptcy law applies to financial-services firms, Lehman cannot hope to reorganize and survive.

Merrill Lynch, founded in 1914 and one of the first Wall Street firms to go public as early as 1971, has so far taken more than $45 billion in write downs on its mortgage investments. Merrill moved aggressively into the mortgage market and became one of the top issuers of investment vehicles linked to subprime mortgages and other risky forms of debt. It has been the largest brokerage house in America and its purchase will make Bank of America the biggest brokerage house and consumer banking franchise. Merrill’s brokers would be combined with Bank of America’s smaller group of wealth advisers into an entity called Merrill Lynch Wealth Management.

The crisis management has also gone into overdrive with a group of 10 banks that includes JPMorgan Chase, Goldman Sachs and Citigroup gathering a $70 billion fund to help ensure market liquidity by lending to those in trouble. Central Banks across the world have responded to the ripple effect on the global financial system by injecting fresh doses of liquidity to the credit starved markets. The European Central Bank distributed 30 billion euros to major banks, and the Bank of England issued £5 billion, or about $9 billion in loans. The Federal Reserve said it would accept a broader array of collateral, including stocks, in exchange for large loans to securities firms.

Barry Ritholtz has an excellent summary of the lessons learnt from the ongoing crisis. His concerns about the moral hazard unleashed by all these bailouts are very real, and the global and especially American financial market may take a long time to recover from it. If your company is big enough to bring down the entire financial system, then you have a license to throw caution to the winds in your investments and lendings! As they say, "If you owe $100 you have a problem, but if you owe $100 bn everyone else has a problem"!

With financial institutions falling like nine pins, there emerges an excellent opportunity for enterprising hedge funds - short the shares of these firms!

Administrative Reforms II

This post will focus on couple of critical systemic challenges and limitations facing governance and administration at the district level in India.

The original Indian Civil Service (ICS) under the British rule had clearly defined the role of the District Collector as maintaining law and order and land administration, including maintaining land records and collecting land revenues. Besides, he was also responsible for performing statutory functions like holding elections, census, and attending to disasters and emergency relief. This was understandable since the role of the State under the British rule was essentially a regulatory one.

After independence, the State took on more developmental responsibilities in addition to its regulatory ones, and has became increasingly omnipresent and all encompassing. This benevolent developmental State assumed responsibilities as varying as providing welfare services like education and health care, to building roads and irrigation dams. Naturally, the responsibilities of the District Collector expanded to cover these newer functions. As a development administrator, the District Collector came to monitor the activities of the numerous functionally specialized line departments. Increasingly, the developmental State displaced the regulatory one as the primary focus of the District Collector.

Even as the role of State expanded in scope beyond recognition, the basic framework of administration has remained the same. The District Collector became the administrative head of all Government departments in the district, both regulatory and developmental. The line departments have their own full-fledged administrative machinery, with District heads and subordinate staff who implement their annual action plans and various departmental schemes of both the State and Central Governments.

Both the State and Central Governments find it convenient to monitor important departmental schemes through the generalist District Collector, and not the professionally competent Head of Department in the district. This has led to the systematic erosion of the independence and motivation of the line departments. Given this loss of authority and responsibility, the HoDs now see a limited role for themselves and many even use this opportunity to pass on the buck. On the other hand, the District Collector has become too heavily over-burdened to make effective enough interventions in the functioning of various government departments.

To go back to the Economist article, it is something similar to Ms Helen Clark running New Zealand as a super Prime Minister, holding all the Ministerial portfolios herself! Ironically, the more powerful and omnipresent the institution of the District Collector has become, the greater has been the decline and atrophy of the line departments!

The second area of concern relates to the functional and operational flexibility of the line departments. The line departments implement their regular annual action plans and specific schemes and programs of the State and Central Governments. The implementation of these schemes and programs is governed by pre-defined norms and components, most often designed for the entire country or state, and without any consideration for the specific local needs and requirements.

The financial allocations are generally made based on population distribution. The sectoral and geographical allocations within the program, the beneficiary selection criteria, the implementation mechanism, executing agency and delivery channels are all pre-defined within the program guidelines. The role of the department is limited to implementing the scheme in accordance with the prescribed guidelines.

Surely, the Agriculture or Animal Husbandry departments cannot have the same roles and strategies in areas as widely different as Telengana and coastal districts of Andhra Pradesh. Similarly, there cannot be the same straitjacket of guidelines under PMGSY for Kerala or Tamil Nadu and Himachal Pradesh or Jammu and Kashmir. The health care and education priorities of Kerala and Tamil Nadu are vastly different from that of Uttar Pradesh and Bihar.

This one-size-fits-all approach to delivering development, consistent with the regulatory ethos of the bureaucracy, denies even the minimum operational flexibility to the departmental heads. What exacerbates the problem is that the weakened HoDs at the district level, used to free riding on the Collector's, rarely pay any attention to the preparation of even their regular departmental action plans. A mechanistic process of regurgitating some routine programs is the result.

Sunday, September 14, 2008

Dani Rodrik on export-led growth

Even as the race to emulate the export-led growth model of East Asian economies and China continues, Haravrd professor Dani Rodrik has now cast doubts on the prospects for this development model.

He finds two militating factors against it in the developed economies - the weak economic conditions and the growing discontent against the manifest consequences (job losses/migration etc) of high trade deficits. Given the relatively similar nature of products and the high import tariffs, he sees limited prospect for developing economies exploiting the massive opportunities presented by the emerging markets.

On closer scrutiny, both assumptions are questionable. The slowdown in US and Europe may be not be as deep as assumed, and with commodity and energy prices falling, the rebound may be faster than expected. Further, developed economies will not suddenly stop buying basic consumer durables like toys, clothes, electronic goods, shoes and cosmetics, which form the major share of developing country manufacturing exports. The outsourcing of services to emerging economies is vital to the competitiveness of American companies, and any effort to roll back the process will adversely affect the productivity of these firms.

In any case, high trade deficits are not new to American economy - Japan in the late eighties is a previous example. Despite all the protectionist sentiment against Japan, the massive trade deficit continues. The large deficit with China may narrow slightly, but not by much.

Friday, September 12, 2008

Doing Business Survery 2009

The World Bank has released the "Doing Business 2009" survey (overview here), which tracks the ease of doing business in 181 economies across the globe. The most heartening highlight of this year's report is the performance of many African countries, with numerous successful examples of reforms involving simplification of procedures for registering property and starting business.

Singapore, New Zealand, US, Hong Kong and Denmark are the five most business friendly destinations, while India fell two notches down to the 122nd place. Eastern Europe and Central Asia were the top performing regions in initiating reforms to facilitate entrepreneurship, while South Asia and sub-Saharan Africa were the least friendly ones.

Doing Business ranks economies based on ten indicators of business regulation that record the time and cost to meet government requirements in starting and operating a business, labor regulations, accessing credit, trading across borders, paying taxes, contract enforcement, and closing a business. The rankings do not reflect such areas as macroeconomic policy, quality of infrastructure, currency volatility, investor perceptions, or crime rates.

Update 1:
Here is an excellent comparison of how India stacks up against the best in the world in different parameters related to opening and running businesses.

Update 2
More from The Economist, here and here.

Wall Street losses update

Here is the latest scorecard from the sub-prime mortgage-gate.

And Lehman Brothers, once the top under-writer of sub-prime mortgages, looks certain to go the Bear Stearns way. The only question is whether the Fed will guarantee a part of Lehman's troubeld assets, especially if the buyer is a foreign financial institution.

Wednesday, September 10, 2008

CCT and bus passes

In order to reduce the high school dropout rate, especially among rural children, the Karnataka Government has decided to offer free passes to students up to seventh standard all over the state on all its buses for a distance of 50 km. For girl children, the passes will be issued at a discount of 25% till they reach tenth standard. This is a classic example of a subsidy tailor made for being delivered as a Conditional Cash Transfer (CCT).

The Karnataka government's proposal suffers from two major deficiencies. First, a free (or differential) bus tariff distorts the market, opening up opportunities for misuse and free riding which cannot be regulated. Second, apart from the targetting problem, it does not provide for any direct link with the desired outcome of getting children to school. There are other administrative problems related to estimation of the amount to be reimbursed to the State Road Transport Corporation.

Here is another way to transfer the subsidy. The student will have to pay the full bus fare, but will be reimbursed to the extent of his or her attendance. The money can be transferred, once a quarter, to an account opened in the name of the child or the parent. In order to dovetail this scheme with other social objectives(like formation of Self Help Groups (SHGs)), the payments can be transferred to the account of the SHG of which the students' mother is a member.

This arrangement is economically efficient and ensures better targetting of the subsidies. The market in bus travel is now freed of any incentive distortions. Besides, the subsidy is transferred conditional to the achievement of the desired social goals/objectives.

The logistics of opening masssive numbers of bank accounts and transferring the amounts periodically, is not as difficult as it seems, and is not without precedent. Welfare Pensions and National Rural Employment Guarantee (NREG) scheme are two recent successful examples of such cash transfers. Further, opening of bank accounts for everyone is in keeping with governments' objective of achieving Total Financial Inclusion (TFI). In any case, these accounts can be used for transferring cash directly in other CCT schemes.

Monday, September 8, 2008

Fannie-Freddie bailout

In an extraordinary federal intervention, the Bush administration finally bit the bullet, and placed the crisis-ridden mortgage organizations, Fannie Mae and Freddie Mac, in a government conservatorship, much like a bankruptcy reorganization.

The bailout, which could become one of the most expensive financial bailouts in the US history, was justified by Treasury Secretary Hank Paulson as vital to restore stability in the financial markets, "This turmoil would directly and negatively impact household wealth: from family budgets, to home values, to savings for college and retirement. A failure would affect the ability of Americans to get home loans, auto loans and other consumer credit and business finance. And a failure would be harmful to economic growth and job creation."

The plan also commits the government to provide as much as $100 billion to each company to backstop any shortfalls in capital. It enables the Treasury to ultimately buy the companies outright at little cost. It also eliminates dividend payments to current shareholders while protecting the principal and interest payments on the debt, now held by foreign central banks, financial institutions, pensions funds and others. Further, for the first time ever, the government plans to buy significant amounts of their mortgage-backed securities on the open market, beginning with the purchase of $5 billion worth this month.

For long, these two organizations which buy mortgages from commercial lenders (and sell most of it to investors as morgage backed securities and some held in the two companies portfolios), have dominated the federal mortgage finance market (both guarantee nearly 70% of all new home loans) by borrowing at low interest rates capitalizing on their implicit government guarantee. They have consistently faced criticisim from free-market enthusiasts for crowding out private financiers by leveraging advantages like maintainance of only a tiny sliver of capital to protect them from nasty surprises like the recent sharp decline in housing prices and rise in foreclosures.

Though the shareholders of the two giants are certain to take massive hits as the share prices continue to fall, many of the companies outgoing executives are likely to go out with handsome paychecks, despite the crisis their actions and leadership has spawned. The reasons for the crisis has been covered in an earlier post here.

Sunday, September 7, 2008

Africa in perspective!

Two perspectives on Africa - one, from popular stereotype, and the second, highlighting the gravity of the challenge.
(HT: Chris Blattman)

Saturday, September 6, 2008

Nudging on Health insurance

Cass Sunstein and Richard Thaler argue in their recently released book "Nudge" that the "right to sue" (for negligence) available to patients, leaving doctors vulnerable to malpractice suits, has the effect of increasing insurance costs. However, they claim that there is enough evidence to prove that this liability does not provide any deterrent value and does little to protect patients from doctor's negligence. They therefore suggest that patients should be given the choice of waiving off their right to sue, and benefit by way of lower insurance premiums. I have two objections to this contention.

First, it is highly unlikely that insurance premiums are going to come down by foregoing this right. For a start, "right to sue" costs are not an itemized part of the insurance costs. Even assuming that the waival of such rights reduces the insurance premiums, it is most likely to result in sharing of only a very small share of benefits with the patients. In all likelihood, the insurance companies will end up knocking off a disproportionately larger share of the reduced costs. Further, those who opt to retain their right to sue will immediately experience an increase in their premiums.

The insurance companies would ultimately benefit in both ways - from a larger share of the reduced costs from the former and higher premiums from the later. In any case, the history and reputation of the health care insurance industry does not inspire any confidence that the benefits of reduced extent of insurance will be passed back to the patients.

Second and more importantly, any increasingly differentiated basket of claims in a market like that of insurance, which is characterized by information assymetry problems like moral hazard and adverse selection, will only end up increasing transaction costs and adversely affecting those who are most disadvantaged. It needs to be borne in mind that the most optimal (in terms of lowest transaction costs and insurance premiums) insurance market is one which covers everybody (the full spectrum of natural risks) and which does not offer differentiated services.

A differentiated services market will incentivize cherrypicking, thereby making it attractive for those with the wherewithal to mitigate the risks arising from foregoing the right to sue, will do so. In contrast, the vulnerable categories like poor, uneducated and underprivileged, end up being badly affected. In many cases, those requiring such insurance the most will get priced out of the market, thereby negating the very purpose behind the insurance scheme.

Critics will argue that such universalization-led absence of choice will be economically inefficient and militate against the principles of libertarianism. The arguement against this would be that the evidence from comparing universal with differentiated basket insurance markets conclusively points towards better outcomes in the former. After all there are significant social benefits and a net economic welfare to be gained by minimizing the uncertainties associated with lack of a universal health care insurance. Further, it is no more libertarian to make a few people better off, while making the large numbers of people worse off.

In other words, providing for dispensing with the right to sue, is more likely to be a nudge towards making the health care system surely more inequitable and ineffective, and most likely also economically inefficient.