Saturday, February 28, 2009

Ricardian Equivalence!

Great graphic from Greg Mankiw (taken from here)!

Update 1
Mark Thoma points to a discussion on Ricardian equivalence here.

Credit crunch - a primer for kids!

Tim Harford explains the credit crunch with this parable

Once upon a time, there was a blameless girl called Consumerella, who didn’t have enough money to buy all the lovely things she wanted. She went to her Fairy Godmother, who called a man called Rumpelstiltskin who lived on Wall Street and claimed to be able to spin straw into gold. Rumpelstiltskin sent the Fairy Godmother the recipe for this magic spell. It was written in tiny, tiny writing, so she did not read it but hoped the Sorcerers’ Exchange Commission had checked it.

The Fairy Godmother carried away armfuls of glistening straw-derivative at a bargain price. Emboldened by the deal, she lent Consumerella – who had a big party to go to – 125 per cent of the money she needed. Consumerella bought a bling-bedizened gown, a palace and a Mercedes – and spent the rest on champagne. The first payment was due at midnight.

At midnight, Consumerella missed the first payment on her loan. (The result of overindulgence, although some blamed the pronouncements of the Toastmaster, a man called Peston.) Consumerella’s credit rating turned into a pumpkin and Rumpelstiltskin’s spell was broken. He and the Fairy Godmother discovered that their vaults were not full of gold, but ordinary straw.

All seemed lost until Santa Claus and his helpers, men with implausible fairy-tale names such as Darling and Bernanke, began handing out presents. It was only in January that Consumerella’s credit card statement arrived and she discovered that Santa Claus had paid for the gifts by taking out a loan in her name. They all lived miserably ever after. The End.

And Axis Monday on Credit Default Swaps

"Billy wants to buy a pack of baseball cards. However, baseball cards are a dollar and Billy doesn't have a dollar. So Billy goes to his best friend Jamie and says, can I borrow a dollar? Jamie says, sure, but only if you pay me a dollar and a nickel back. Billy says okay, because he plans to sell the cards for two dollars. Jamie writes an IOU because he only has a quarter. Jamie isn't sure that Billy can pay him back, so he decides to sell a credit default swap. Jamie goes to Sally and says, I owe Billy a dollar and Billy owes me a dollar and a nickel back. Can I give you a penny a day in exchange for you signing your name on the IOU I gave Billy? Sally doesn't know Billy, so to her this proposal looks like a bargain. Besides, Sally just got ten dollars for her birthday so even if Billy can't pay back she can easily cover Billy's debt. Repeat this process 70 trillion times."

(HT: Freakonomics)

Obama budget gets thumbs up!

Refreshingly enough, in an age when cutting taxes, during both good times and bad times, has become the norm, President Obama has gone against conventional wisdom for nearly three decades, despite the economic recession, and proposed raising taxes on the rich and lowering it for the poor in his first budget. Commentators like Paul Krugman and Robert Reich have hailed this and the proposed changes in health care (by reducing the wastefully high insurance premiums and medicare costs) and education (increasing federal financial aid and simplifying the myriad of aid programs) as laying the foundation for reducing inequality after three decades of widening disparities.

The CBO has estimated (full site here) that over the last three decades, the pre-tax incomes of the wealthiest households have risen far more than they have for other households, while the tax rates for top earners have fallen more than they have for others. As a result, the average post-tax income of the top 1 percent of households has jumped by roughly $1 million since 1979, adjusted for inflation, to $1.4 million. Pay for most families has risen only slightly faster than inflation. Lawrence Summers had likened this to each family in the bottom 80% of the income distribution effectively sending a $10,000 check, every year, to the top 1% of earners.

The top two federal income tax brackets would rise to 36% and 39.6% from 33% and 35%, respectively. The budget proposes imposing the stadard income tax rate of 39.6% on those who work for hedge funds or private equity firms and were paying only a 15% capital gains tax rate on much of the money they take home. But all the tax proposals would start from 2011-12 only.

However, the tax measures and spending proposals have sent the budget deficit soaring to stratospheric levels, and is estimated to touch an unprecedented $1.6 trillion for 2009-10.

And as the figure below indicates, the propsects for future does not appear bright without substantial tax increases and spending cuts looming large.

Update 1
The forecasts on GDP growth and unemployment made in the budget are much more optimistic than those of private agencies and stress test worst case scenarios. The last quarter forecasts on GDP contraction by a record 6.2% only adds to the woes.

More on the taxation proposals here.

Update 1
Defense and international security, social security, and medicare and medicaid take up 62% of the US budget spending (or here).

Update 2
See also this for more graphics.

CDO reality check!

The FT has more justification for the deep uncertainty surrounding how much more the markets have to fall before normalcy returns. It is also a ringing indictment of the credit rating agencies.

"From late 2005 to the middle of 2007, around $450bn of CDO (collateralized debt obligations) of ABS (asset backed securities) were issued, of which about one third were created from risky mortgage-backed bonds (known as mezzanine CDO of ABS) and much of the rest from safer tranches (high grade CDO of ABS). Out of that pile, around $305bn of the CDOs are now in a formal state of default, with the CDOs underwritten by Merrill Lynch accounting for the biggest pile of defaulted assets, followed by UBS and Citi.

The real shocker, though, is what has happened after those defaults. JPMorgan estimates that $102bn of CDOs has already been liquidated. The average recovery rate for super-senior tranches of debt – or the stuff that was supposed to be so ultra safe that it always carried a triple A tag – has been 32% for the high grade CDOs. With mezzanine CDO’s, though, recovery rates on those AAA assets have been a mere 5%... this is easily the worst outcome for any assets that have ever carried a "triple A" stamp. No wonder so many investors are now so utterly cynical about anything that bankers or rating agencies might say these days."

(HT: Paul Krugman)

Friday, February 27, 2009

Stress test semantics and the fight to stave off the N-word!

The request by Citigroup for additional capital which would raise the government stakes from the present 8% to about 40%, and also the conversion of the non-voting preferred share stake of government into common stock, has triggered off a debate about the exact nature of how government capital infusions should be classified. The always incisive James Kwak sets the stage superbly here, and goes right at the heart of the matter - define capital in a manner that the "zombie banks" can somehow be continue to be propped up with capital infusions till the markets get back to normal!

As Kwak explains, capital can span the whole spectrum from common stock to preferred stock to deferred tax assets (credits you gain by losing money in one year, which you can apply against taxes in future years where you make money). Whereas Tier 1 capital includes all the three, Tangible Common Equity (TCE) consists of only common stock. Since the latter is smaller than the former, the capital adequacy ratios calculated using the latter is smaller.

The stress tests will seek to evaluate the strength of banks based on among other things, their capital adequacy ratios. Capital adequacy (ratio of capital or equity to the total assets) measures the "ability of the bank to withstand losses before its ability to pay off its liabilities starts getting compromised" or how much "my assets could fall in value by upto and still I would be able to pay back my depositors". Regulatory requirements specify certain minimum standards for capital adequacy ratios. The Treasury Secretary has declared that the stress tests being dones as part of TARP II will assume TCE as capital. This raises interesting challenges for those receiving bailout money in the form of preferred shares, as the Citi's predicament shows.

The government has so far put into Citi $45 billion in cash and got $52 billion in preferred stock (the $7 billion difference was the fee for the guarantee on $300 billion of Citi assets). The preferred stock was designed to be much closer to debt than to equity - it pays a dividend (5% or 8%), it cannot be converted into common stock (so it cannot dilute the existing shareholders), it has no voting rights, and it carries a penalty if it isn’t bought back within five years.

The present interest in converting the preferred stock stake of the government into common stock stems from a need to boost the TCE, and thererby increase the capital adequacy ratio to meet the minimum standard. Further, it would relieve Citi from the close to $3 bn per year dividend payouts and the the obligation to buy-back the preferred shares in five years. All this would benefit the bank’s bottom line, and hence its common shareholders, even with the attendant dilution of stakes as the government stake squeezes the existing owners. But with the current market capitalization of Citi's shares at just $12 bn, a conversion of all of the $53 bn government preferred shares to common stock would leave the government holding 80% of Citi! As Kwak explains, any purchase at higher than the market price, would be a straight subsidy to the existing shareholders.

However, as Kwak argues, the more important issue for consideration may not be the minutiae about how the government stake should be classified or which measure of capital should be considered, but how the government can manage its stake with management control but without controlling day-to-day operations, while at the same time ensuring that tax-payers money is most efficiently deployed. And the experience with AIG, where government owns 80%, shows how the government ends up with the worst of both worlds by dilly-dallying on the crucial aforementioned issues.

Or more preferably when faced with a banks with more liabilities (debt) than all capital (Tier I), as Paul Krugman says - seize the bak, clean out stockholders, pay off some of the debt, and re-privatize the entity - same as FDIC receivership or nationalization!

There is one another thing which lends credence to the view that these semantic quibbles may be irrelavant. The Modigliani Miller theorem claims that under certain conditions, 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. All these debates about the exact nature of government stakes also assume (or hope) that the share prices will rebound once normalcy is restored to the markets, so that government can exit without too much cost to the tax payer. So the issue at hand is to get the normalcy restored by getting confidence back in the banks and thereby stem the decline in asset values, and not debating capital structure!

One cannot but help concluding that in the final analysis, all this gymnastics about conversion of preferred shares and stress test details is an exercise in avoiding nationalization and continue propping up zombie banks. Ben Bernanke, (full text here) in his testimony before the Senate two days back, had ruled out nationalization or anything where "the government seizes the bank and zeros out its shareholders". Simon Johnson and James Kwak sums up the context in light of Ben Bernanke's ambiguous and hope-filled testimony and the confusion surrounding the bailout dynamics,

"This is another sign of the serious brainpower that has been expended on finding ways to avoid or minimise government ownership of banks, and to avoid the slightest possibility of offending shareholders – shareholders whose shares have positive value primarily because of the expectation of a further government bail-out.

The government's percentage ownership of a bank is a red herring. The key economic realities are: the government is already responsible for a large portion of bank liabilities, through insurance on deposits and new bank debt; the government is the only source of new capital for banks; and the government stress tests will determine whether banks are allowed to continue in operation and under what terms. The only purpose served by artificially minimising government "ownership" is to limit the potential upside available to taxpayers."

Adam Posen (and here) sets the historical context by drawing parallels with the Japanese lost decade,

"The guarantees that the US government has already extended to the banks in the last year, and the insufficient (though large) capital injections without government control or adequate conditionality also already given under TARP, closely mimic those given by the Japanese government in the mid-1990s to keep their major banks open without having to recognize specific failures and losses. The result then, and the emerging result now, is that the banks’ top management simply burns through that cash, socializing the losses for the taxpayer, grabbing any rare gains for management payouts or shareholder dividends, and ending up still undercapitalized. Pretending that distressed assets are worth more than they actually are today for regulatory purposes persuades no one besides the regulators, and just gives the banks more taxpayer money to spend down, and more time to impose a credit crunch."

Update 1
Economix has a nice sum up of the stress test scenarios here, and the "more adverse" case scenario is by no means as bad as being predicted by many. Does this mean that the stress tests will let off many banks lightly and then see them come back repeatedly for more assistance?

Update 2
NYT reports that the Treasury is considering conversion of the government’s existing loans to the nation’s 19 biggest banks into common stock, and give the government a large ownership stake in return. Paul Krugman and James Kwak feel that this conversion is only a "swap among the junior stuff, with no impact further up the line". And an analogy on the conversion here.

Why lending rates are not coming down?

The reluctance of banks to lower retail and commercial lending rates despite the steep rate cuts by the RBI remains a big concern for the Government. There are a number of reasons adduced for this reluctance - high cost of capital, global financial market turmoil induced counter-party risk perceptions etc. Here are a few other reasons.

The graphic below, which captures the yield movements of the ten year government securities, 91 day T-Bills, and Commercial Paper (the upper bounds of the rate ranges) issued by corporate India to finance its regular operations, reveal a few things about this reluctance. As can be seen, not only have both the rates been increasing, the spread too has been widening alarmingly.

1. The yields on 10 year G-secs, an indicator of the medium term inflation prospects, have been hovering in the 7-8% range. Conventionally, this should be in the range between the repo (5.5%) and reverse repo (4%) rates. This indicates that the markets have priced in higher inflationary expectations, which does not portend well for the longer term interest rates.

2. The CP rates have been going up continuously since April 2008, a fair representation of the credit risk perception inherent in the market. However, in keeping with the flight to short term T-Bills and the declining short-term inflationary trends, the yields on the 91 day T-Bills have been showing downard trend. Most ominously, the spread between the 10 year G-Secs and CP have been widening sharply, and is well past an alarming 10%, reaching 11% plus by end of January. Without this spread closing gap, there is limited possibility of the credit squeeze easing and banks opening their lending taps to normalcy.

Thanks to Amol Agarwal for pointing out the mistake about the G-sec yields hardening being an indication of inflation. Actually, it ought to have been "G-Secs have hardened in anticipation of higher interest rates in future".

He also makes two other important points
1. The declining yields enabled many banks to profit substantially. But with yields hardening since January, the profit cushion dispappears, and may make banks even less willing to lend.
2. CP yields have risen due not only to credit risk, but liquidity risk, as the lower trading in these instruments has incrased the liquidity premium.

Thursday, February 26, 2009

Epitaph for the present times...

... Dickens sounds very appropriate

It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us...

Charles Dickens

My Mint op-ed on electricity sector deregulation

Here is my Mint op-ed on the problems facing electricity sector deregulation.

Dangers of estimating the bottom

One of the fundamental premises behind all the different financial sector bailout plans is the hope that some amount of estimated capital infusions and credit guarantees will be able to stem the downward spiral in asset values and get market confidence back on the institution and collectively normalcy restored in the credit markets. However, the stories of AIG, Citigroup and the Detroit automakers sounds a note of caution to the aforementioned premise and raises the strong possibility that tax payers money is being poured down a near bottomless put. Consider these

1. AIG, in which the government took over 80% stake, has moved from one bailout to another and there is no end in sight even after receiving capital infusion of $153 bn in three tranches. It is trying to raise an estimated $60bn more in additional capital to stay afloat.

2. Citigroup is negotiating another round of assistance, over and above the initial $45 bn, which is set to increase government stake in the firm from 8% to as much as 40%. It is also negotiating the conversion of the non-voting preferred share stake of government, which has dividend payouts, into common stock.
3. General Motors and Chrysler are seeking another $22 billion on top of the $17 billion already granted to them. And their woes continue to pile up.

So even as TARP II or FSP gets underway, new questions will be raised as to whether the assistance provided is enough to bail the firm out. The stress tests will provide a more firmer basis for evaluating the needs of those receiving the bailout money. But given the difficulty of estimating risks and uncertainty surrounding a fst deteriorating economy, many of the assumptions can easily go wrong.

Do we heave a short time horizon moral hazard here - banks trying to under-play their bailout needs, so as to avoid atleast some of the controls sought to be imposed by the new bailout plan? Since the "too-big-to fail" arguement has been publicly embraced by the government, where is the need to showcase all your rotten eggs in one basket, but stagger it over a time, so as to negotiate a better deal? Follow the path AIG has shown!

Update 1
Fannie Mae ques up again, claiming another atleast $15.2 bn to off-set record $59 bn losses last year. Freddie Mac has hinted at another $35 bn bailout assistance.

Update 2
Paul Krugman and many others, here and here, doubt the rigour in the stress tests (FAQ here), especially given the assumptions and feels that the Treasury and Fed may be grossly under-estimating the losses.

Update 3
Even as the government announced its decision to dramatically increase its stake in Citigroup from 8% to 36%, the markets gave a thumbs down sending the share prices down by 36%. It is now being reported that despite the previous two multi-billion bailouts, and the present one, Citi may need atleast another round of assistance. Citi's share price has plunged from $55 a year ago to a mere $1.56 bn, making the company virtually worthless as an entity.

Here is a chronicle of the practices that led Citi to its present fate.

Update 4
AIG gets its fourth round of bailout, as the federal government agreed to provide an additional $30 billion in taxpayer money and also loosen the terms of its huge loan to the insurer, even as the insurance giant reported a$61.7 billion loss, the biggest quarterly loss in history. The government already owns nearly 80 percent of the insurer’s holding company as a result of the earlier interventions, which included a $60 billion loan, a $40 billion purchase of preferred shares and $50 billion to soak up the company’s toxic assets. Floyd Norris calls AIG a "bottomless pit", and Joe Nocera the "rottonest financial institution"! Nocera says bailing out AIG is like "propping up a house of cards"!

Update 5
Economix examines the worst case scenarios of the US economy and the Obama administration predictions here and here.

Benefits of early childhood education

Economix draws attention to studies pointing out the importance of early childhood, pre-kindergarten, education in development of cognitive and non-cognitive (perseverence, motivation, risk-aversion, time-preference, self-esteem, self-control etc) skills that are critical in influencing later day outcomes.

It has been found by numerous studies that good education in the 3-4 year periods, especially lacking in the children from weaker economic strata, has direct effects on wages, schooling, health, performance on achievement tests, crime, teenage pregnancy, smoking etc. It has large positive externalities too - better outcomes in schools adding to the schools quality, lower risks of crime and teenage pregnancy, higher earnings and resulting higher tax revenues, and local economic effects like increased labor-force participation of parents.

James Heckman estimates that better pre-school education has an average annual rate of return of 12%, and claims that "learning begets learning". It has also been claimed that it produces greater social economic return than business subsidies. More on the benefits of early childhood education is found here, here, here, here, and here. Critics have pointed to the failings of the Head Start program for 4 year olds in the US in support of their opposition to the iportance of early childhood education. Here is a strong case made out for keeping assistance for Head Start in the fiscal stimulus bill, which was deleted in the final $789 bn compromise Bill.

In light of all these findings and in view of the fact that private schools are fast replacing (or have already replaced) public schools as the dominant choice for even children from poor families in the urban centers of India, it may be appropriate if governments in India start looking at early childhood education in atleast a few cities. One way to start off is to build-up and improve on the existing anganwadi centers.

Update 1 (21/6/2011)

A recently released study of 1,000 poor children who benefited from Chicago’s Child-Parent Center Education Program (which includes intensive preschool, parent training and support for students through third grade), suggests that every dollar spent on the program yielded nearly $11 to society, including increased tax revenue and reduced spending on child welfare, special education and grade retention. Read Nancy Folbre here.

Gaming the rules - power sector de-regulation

The electricity crisis in California at the turn of the century, characterized by high prices and rolling blackouts, and arising from un-restrained de-regulation (headlong plunge towards deregulation), has many lessons for policy making in electricity sector. With India embarking on an ambitious program of reforms in power sector to expand generation capacity and improve quality of supply, it is imperative that these lessons are closely borne in mind. However, recent trends in power sector reforms in the country raises cause for serious concern since in many respects, we may be following much the same path traversed by California in the lead-up to its disastrous climax in 2000.

An investigation into the crisis by the US federal Electricity Regulatory Commission (FERC), revealed that "supply-demand imbalance, flawed market design and inconsistent rules had made possible significant market manipulation... Electricity prices in California’s spot markets were affected by economic withholding and inflated price bidding, in violation of tariff anti-gaming provisions".

The Financial Express reports that the Prime Minister's Committee on "open access" (direct sales by generators to end-users through the existing transmission and distribution network on payment of open access fees) in power sector is contemplating making it compulsory for generators to sell atleast 3% of their total capacities through open access system. Such a mandatory provision opens up the very real possibility of cherry picking, as generators seek to enter PPAs directly with large industrial consumers, thereby robbing state distribution utilities of those their cross-subsidy sources.

Any proposal for making "open access" mandatory comes in the wake of similar short-sighted policies in generation and trading. The policy on merchant power plants had liberalized the norms on third party sales by Independent Power Producers (IPPs) entering into Power Purchase Agreements (PPAs) with distribution utilities, thereby opening up the doors for them to sell a bigger share of their generation in the spot market and through the newly formed power trading exchanges.

Unlike conventional rate-based power plants, whose sales are governed by long term Power Purchase Agreements (PPAs), merchant power plants are free to sell their generation to anyone anywhere. Setting up a merchant plant would necessarily mean balance sheet financing by the developer, as financial institutions and lenders may not be comfortable with projects that don’t have long-term PPAs.

Given the inability of generation to keep pace with galloping demand, severe peak power shortages are likely to remain a constant feature for the foreseeable future. The cost of peak power purchases, in the form of excess drawals over the allocation and at lower frequencies (other-wise called Unscheduled Interchange, UI), arrived at on an Availability Based Tariff (ABT) regime, today ranges from Rs 7 to Rs 10 per unit and even goes beyond this at certain times. In the circumstances, private generators can set up base-load and peaking plants, and make handsome profits by selling even a small share of the generation or running them for only a few peak hours. This opens up the possibility of private IPPs (and even state owned generating utilities, like the WBSEB) gaming the system by taking advantage of the peak shortages and exorbitant UI costs.

The most shocking example of such gaming is the case of Chattisgarh, where the State Government allocated coal blocks and entered into PPA with developers. The PPA committed the pithead developer to sell about 10% of production, based on the limited state demand, at a basement bargain price (less than a rupee) to the State and export the remaining using "open access" facility for spot sales through the exchanges.

It was hoped that the emergence of an active power trading market with an enabling open access framework, would go a long way towards ensuring more efficient allocation of electricity across competing consumers. However, in the context of peak shortages, and limited number of traders and tradeable power, power trading exchanges have only exacerbated the crisis and increased the burden on state power utilities. Peak power prices have shot up dramatically, with the UI charges touching Rs 10 and beyond. The distortions have become so grave that even some state power utilities are selling their low-cost power allocation from Central Generating Stations (CGS) and off-peak low cost purchases, at a huge profit to power-deficit states and private traders. The margins available are so large that some of the private traders have in turn intermediated this to deficit states at even higher prices.

All these reforms - mandatory open access, merchant power plants, and power trading - have had the effect of driving up the power purchase costs and opening up private profiteering opportunities at the cost of public resources. In many respects, this is a journey down the infamous path of the Californian electricity de-regulation, where the market liberalization proceeded far in excess of what was healthy and sustainable for the market.

A free-market pre-supposes competition and choice on both sell and buy sides, market depth and breadth, and an enabling regulatory framework that polices anticipated market failures. In an ideal world, scarce resources can be most efficiently allocated by a free-market based on price signals. In an ideal world trading permits movement of power from surplus to deficit areas, and benefits consumers everywhere. But we live in a real world, where governments find it politically suicidal to increase tariffs so as to permit anything close to cost recovery, nor do they have the resources to reimburse the massive costs incurred. The head-long plunge towards de-regulation in electricity has overlooked these pre-requisites and realities.

There are a limited number of traders, volume of traded power is meager, regulatory architecture is inadequate and flimsy, conflicts of interest between generators and traders are rife, demand is inelastic, and the supply-demand imbalance is considerable. We therefore have a liberalized free-market framework super-imposed on an extremely un-competitive and nascent market, a recipe for incentive distortions with catastrophic consequences. It is not possible to have a sustainable and efficient electricity market with a liberalized up-stream supply side and tightly regulated down-stream distribution side.

A market design where the wholesale prices are uncapped while retail prices are frozen by regulatory orders, especially in the context of demand-supply imbalance (in the aforementioned context), is bound to generate distortions that will ensure the ultimate collapse of the arrangement. As the experience of California shows, de-regulation will not only not reduce prices, but also open up ample scope for innovative gaming of the system to the detriment of public interest.

The absence of separate tariff policy for intra-state ABT on sales and purchases have had the effect of distorting the UI prices within states. The central and regional load despatch settlements take the state as a unit in the expectation that the states would in turn do the settlement on the discrepancies in the intra-state open access transactions between the different market participants within the state. espite clear instructions by the CERC, very few state governments have put in place a framework that governs intra-state ABT for UI transactions.

The absence of intra-state ABT for settlement of sales and drawals by open access generators and consumers, means that the additional costs incurred by the State as a whole by way of under-generation by such generators and over-drawal by such consumers, does not get passed on to them. These costs are in turn absorbed by the state distribution and transmission utilities.

Wednesday, February 25, 2009

Question marks over carbon trading as prices fall

The European Union Emission Trading Scheme (EU ETS) set up as part of the Kyoto Protocol obligations to reduce carbon emissions is the world's largest multi-national emission trading market, covering 40% of EU's greenhouse gas emissions, and has often been projected as an example of how market mechanisms can help save the environment by making polluting fossil fuels unaffordable for industries. However, this blog has supported the view that carbon tax is a better alternative to reducing greenhouse gas emissions and has been inclined towards Greg Mankiw's contention that cap-and-trade schemes are a way of back door corporate welfare.

Julian Glover has an excellent article where he argues that the current low prices of Certified Emission Reductions (CERs) traded in the ETS has defeated the objective of reducing emissions. The low prices mean that the polluters can easily afford to purchase the CERs and continue to pollute, instead of switching over to more energy efficient and environment friendly technologies. As he writes, "Set up to price pollution out of existence, carbon trading is pricing it back in... Intended to price fossil fuels out of the market, the system is instead turning them into the rational economic choice."

The price of CERs (equivalent to a tonne of CO2) have fallen steeply from 31 euros last summer to just 8.20 euros. It is estimated that businesses can be incentivized to move to cleaner fuels only if the price of CERs stay beyond atleast 30 euros. Critics of the EU ETS claim that the EU gave away too many carbon emission permits to companies, thereby causing supply of CERs to outstrip demand.

Supporters claim that while additional permits were allocated to the big polluters so as to cover up for their expansion plans, the ongoing economic crisis had put paid to many of the plans, leaving the market with excess supply of CERs. Further, with factories cutting down on production, many traditional polluters and purchasers of CERs are left holding excess allowances, which they are in turn selling in the market. In any case, all these indicate the flawed nature of the market design.

Critics of cap-and-trade also point out that it is extremely difficult, even impossible, to monitor whether sellers of CERs in developing economies and elsewhere, adhere to their commitment to reduce their carbon emissions. Being associated with and aware of some of the projects which have been granted CERs, I am firmly convinced that it is virtually impossible to police the outcomes.

Supporters however claim that cap-and-trade is the only long-term solution to controlling greenhouse emissions and the present crisis offers valuable lesson to redesigning the market.

(HT: The Hindu)

Tuesday, February 24, 2009

RCTs are only one of the methods

Two leading economists, Angus Deaton and Martin Ravallion (and here), have recently made interesting, and very valid, observations about the obsession with randomized control trials, often to the near exclusion of other methodologies, to evaluating policy outcomes and tailoring development policies.

Angus Deaton makes several interesting points while expressing doubts about the utility of randomized controlled trials (RCT) and quasi-randomization through instrumental variable (IV) techniques or natural experiments, in identifying credible knowledge about what kind projects and policies can engender economic development. He argues "that experiments have no special ability to produce more credible knowledge than other methods, and that actual experiments are frequently subject to practical problems that undermine any claims to statistical or epistemic superiority."

A combination of mechanisms and context, both individually and interacting with each other, determines the outcomes of specific policy choices. RCT and IV techniques do not and cannot address the issue of the specifics of the mechanism that leads to the outcome nor the specificity of the context. Transplantation of experimental results to policy requires filtering through these aforementioned analysis. He also finds two important problems with these approaches - the misunderstanding of exogeneity and the handling of heterogeneity.

Prof Deaton does not agree with the randomistas' rejection of theory and their approach of experimentation to do a priori, without being informed by any theoretical considerations, evaluations of specific projects and then formalizing as to which projects work. He prefers, like the field experiments of behavioural economists (who cover such issues as loss aversion, procrastination, hyperbolic discounting, or the availability heuristic), designing experiments to test predictions of theories that can then be refined and generalized to other situations. As he writes, instead of seeing projects as the embodiment of the theory that is being tested and refined and field experiments as a bridge between the laboratory and the analysis of "natural" data, the proponents of RCTs see their object of evaluation in its own right.

He writes, "The collection of purpose-designed data and the use of randomization often make it easier to design the sort of acid test that can be more difficult to construct without them... this work will provide the sort of behavioral realism that has been lacking in much of economic theory while, at the same time, identifying and allowing us to retain the substantial parts of existing economic theory that remain genuinely useful."

His arguments against transplantation of experimental results to policy formulations are based on the following
1. Problem of generalizability or external validity (the ability to learn from an evaluation about how the specific intervention will work in other settings and at larger scales) - and RCT holds many things constant that need/would not be constant if the program were done elsewhere.
2. It only says "what works", but does not address the critical issue of "why that something works", which is critical in formulating a general policy.
3. Actual policy is always likely to be different from the experiment, for example because there are general equilibrium effects that operate on a large scale that are absent in a pilot, or because the outcomes are different when everyone is covered by the treatment rather than just a selected group of experimental subjects. For example, small development projects that help a few villagers or a few villages may not attract the attention of corrupt public officials because it is not worth their while to undermine or exploit them, yet they would do so as soon as any attempt were made to scale up.

Martin Ravallion adds these points of caution
1. Evaluations are inherently biased. Short-term impacts get more attention than impacts emerging beyond the project’s disbursement period. Evaluations of successes are more easier to publish than failures. The impacts of some types of interventions (notably transfers and other social sector programs) are easier to observe and quantify than others (such as physical infrastructure).
2. Randomization is also better suited to relatively simple projects, with easily identified "participants" and "non-participants".
3. Ethical issues like the fact that some of those to which a program is randomly assigned will almost certainly not need it, while some in the control group will; the evaluator can observe only a subset of what is seen on the ground etc remain unresolved.
4. Randomistas confine themselves to two parameters - average impact of an intervention on the units that are given the opportunity to take it up (intent-to-treat - ITT) and the average impact on those who receive it (average treatment effect on the treated - ATET). Other important issues - whether the intervention works as intended, which types of people gains and which loses, proportion of the participants who benefit, impact of scaling up etc - get sidelined.
5. Inferences are "muddied by the presence of some latent factor — unobserved by the evaluator but known to the participant — that influences the individual-specific impact of the program in question" (heterogenity).

Update 1 (4/4/2010)
Aid Watch examines the debate between supporters and opponents of RCTs.

Monday, February 23, 2009

Private schools and education

I had blogged earlier about the increasing importance of private schools in our education policies, especially in the urban areas where an estimated 55% children go to private schools. The graphic below only confirms this.

Recognized private schools have contributed an overwhleming 95.7% to the increase in primary school enrolment in urban areas in the 1993-2002 period, and 71.7% to the increase in upper primary enrolment. The figures for rural areas were smaller at 24.4% and 23.2% respectively. The share of private schools in increase in high school enrolment is relatively less in both cities and villages. The figures for the rural areas may be an under-estimate given the presence of large numbers of unrecognized primary and upper primary schools. The prima facie conclusions are

1. Private schools have made spectacular inroads, in both rural and urban areas, and across levels of schooling. The progress has been highest in high schools, an indication of the fact that high schools are a remunerative business activity.
2. Private primary and upper-primary schools have displaced government schools as the driving force behind increasing primary and upper-primary enrolment in towns and cities.
3. Government primary and upper-primary schools continue to be vital in rural areas.
4. Expansion of high school enrolment, in both rural and urban areas, continues to be heavily reliant on government schools.

It is undeniable that private schools, atleast to the extent of primary and upper-primary schools in urban areas, have proliferated in large numbers and have become the most important determinants in basic schooling in our towns and cities. Poor children are paying fees ranging from atleast Rs 50 to Rs 500 per month, and attending private schools in large numbers.

All this raises a few important issues. Is it not time for a more focussed school education policy, which takes into account the role of private schools? Should the education department not be focussing more on its rural schools at all levels? Should government's primary focus be on running high schools in urban areas, while regulating private schools and prescribing standards in primary and upper-primary schools there?

None of this should be mistaken as an advocacy for government to abdicate from its fundamental role of delivering free education and to privatize education. The challenge is to leverage the existing resources, both private and public, in a more efficient manner to deliver universal and good quality education. The administration of a policy that factors these realities can be facilitated by using school vouchers and other incentives.

Manish Sabharwal in Financial Express draws attention to certain provisions of the Right of Children to Free and Compulsory Education Bill 2008, presently under discussion in the Parliament. It contains a provision for providing 25% reservation in all private schools for children nominated by Government. The author is right about many of the apprehensions that could possibly distort this provision.

But his is not without precedent. There are successfully administered ongoing schemes in states like Andhra Pradesh (Best Available School Scheme), wherein meritorious tribal students (selected based on written tests), at all levels, are selected and admitted to good private schools. The government pays the fees directly to the private school. State governments should take cue from such programs and use the 25% seats reserved in private schools to benefit meritorious poor students.

Nudging in pension savings

Mostly Economics draws attention to default choices in pension plans initiated under the New Pension Systems (NPS) formulated by the Pension Fund Regulatory and Development Authority (PFRDA). Under the defined contribution system of pension plans, the employees have the option of choosing between a bouquet of investment alternatives (equities, bonds etc) and apportioning the investments among the selected investment instruments. Sweden has been running such default savings scheme (research paper here) in its partially privatized social security plans.

It has been proved from research across the world that employees often find it difficult to make the choice between a whole host of competing investment portfolios. In the circumstances, appropriately tailored "default choices", which vary for people of different ages, assume significance. Under the NPS, funds that fall under auto choice should be distributed equally amongst Pension Fund Managers (PFMs) and those that perform better (low costs higher returns) should be replaced.

In this context, the PFRDA could go even further and look at the widely acclaimed example of the Save More Tomorrow (more here, here, and here) savings scheme formulated by Richard Thaler and Shlomo Benartzi that allows employees to allocate a pre-defined portion of their future salary increases toward retirement savings as a default option in their pension or savings plans.

Such social nudges achieved by appropriately tailoring the choice architecture so as to get people to do what they would want to (or are in their interests) but are not able to do, for various reasons, have been tried out in various other areas. Another example is the Give More Tomorrow program where people contributing monthly to some social or charitable causes are nudged to commit a small incrementally increasing sum.

Breaking the psychological gridlock

It is widely accepted that the global financial markets and economies are gripped by a psychological fear that has frozen lending and borrowing, spending and investing. The risks and uncertainties appear to be too over-powering for any particular fiscal or monetary policy initiative to overcome. As the world economy continues its steep tumble downwards, Ricardo Caballero has an interesting prescription to unfreeze the credit markets and get banks lending and raising capital and thereby stem the asset price declines and break the psychological fear over-hang

The government pledges to buy up to twice the number of bank shares currently available, at twice some recent average price, in five years.

I can't but help feel that this is precisely what one would call a form of "arms-length" nationalization! The government would effectively be holding long-positions in these banks or the banks would be buying put options on themselves from the government! The only difference would be that the tax-payers would be paying the effective cost of under-writing these options. Caballero hopes that in five years, the markets would recover and the prices would be beyond the strike price, thereby making the exercise of the options redundant. The success of such arrangements depends on how much immediate positive splash it can generate in restoring market confidence.

This proposal comes as a sequel to Caballero's initial proposal (here and here) for a universal, government-provided insurance for distressed assets, an effective insurance complement to TARP II. Caballero does not favour nationalization on the grounds that it will have to be universal, in which case it becomes too massive to manage, and the compex inter-linkages of the financial markets risks generating unfathomable systemic risks.

James Kwak agrees with the credit insurance proposal as a cheap way to get distressed assets off the balance sheet, but does not favor (also here) the first one, calling it "wishful thinking", on the grounds that the share prices are so undervalued that even a double price guarantee would not provide adequate cushion to raise the required capital.

Mark Thoma too does not agree with the "call option" proposal of Caballero, and prefers a "plan that has been tried before in some form and worked, perhaps not perfectly but a plan that did lead to clear improvement at a defensible cost" to blank experimentation.

James Galbraith has the answer - the existing law (Title 12, Sec. 1831o) mandating that banking regulators take 'prompt corrective action' to resolve any troubled bank. This law mandates that the administration place troubled banks, well before they become insolvent, in receivership, appoint competent managers, and restrain senior executive compensation (i.e., no bonuses and no raises may be paid to them). The law does not provide that the taxpayers are to bail out troubled banks. Nouriel Roubini agrees to a Swedish style receivership - take ’em over, clean ’em up and sell ’em back to the private sector, preferably in pieces!

David Warsh nicely sums up the various opinions.

Sunday, February 22, 2009

Snapshot of corporate greed

NYT has this excellent interactive graphic of the executive compensation paid out by the largest Wall Street firms in the 1998-2007 period.


Update 1
In the most cynical manifestation of corporate greed the American International Group (AIG), which has received more than $170 billion in taxpayer bailout money from the Treasury and Federal Reserve, revealed plans to pay about $165 million in bonuses to executives in the same business unit that brought the company to the brink of collapse last year. The bonus plan covers 400 employees, and the bonuses range from as little as $1,000 to as much as $6.5 million. Seven executives at the financial products unit were entitled to receive more than $3 million in bonuses. This evoked strong reaction from the Obama administration, which initated efforts to stop the payment of the bonuses.

In another shocking example, Citigroup revealed that it gave Vikram S. Pandit, its chief executive, a compensation package valued at more than $38.2 million for 2008, even as the bank posted five consecutive quarters of multibillion-dollar losses and turned to the government three times for help.

Update 2
CEO compensation in top banks of the world compared with their market capitalization for 2008.

Update 3 (25/3/2010)
In their study, "The Wages of Failure: Executive Compensation at Bear Stearns and Lehman Brothers 2000-2008", Lucian Bebchuk, Alma Cohen and Holger Spamann, examined the cash flows derived by the top five executives of the two firms using data from Securities and Exchange Commission filings, and find that, notwithstanding the 2008 collapse of the firms, the bottom lines of those executives for the period 2000-2008 were positive and substantial. They write,

"The firms’ top executives regularly unloaded shares and options, and thus were able to cash out a lot of their equity before the stock price of their firm plummeted. Indeed, the top five executives unloaded more shares during the years prior to their firms’ meltdown than they held when disaster came in 2008. Altogether, during 2000-2008, the top executive teams at Bear Stearns and Lehman cashed out about $1.1 billion and $850 million (in 2009 dollars), respectively.

Combining the figures from equity sales and bonuses, we find that, during 2000-2008, the top five executives at Bear Stearns and Lehman pocketed about $1.4 billion and $1 billion, respectively, or roughly $250 million per executive. These cash proceeds are substantially higher than the value of the holdings that the executives held at the beginning of the period. Thus, while the long-term shareholders in their firms were largely decimated, the executives’ performance-based compensation kept them in positive territory.

The divergence between how top executives and their companies’ shareholders fared raises a serious concern that the aggressive risk-taking at Bear Stearns and Lehman – and other financial firms with similar pay arrangements – could have been the product of flawed incentives. The concern is not that the top executives expected their aggressive risk-taking to lead with certainty to their firms’ failure, but that the executives’ pay arrangements – in particular, their ability to claim large amounts of compensation based on short-term results – induced them to accept excessive levels of risk."

SBI leads the way

The State Bank of India (SBI) may have set the proverbial cat among the pigeons and laid the stage for un-freezing the credit markets with its audacious recent decisions to lower interest rates on car and home loans, and working capital loans to micro, small and medium enterprises (MSMEs).

Early this month, it decided to offer loans to home and MSME borrowers, irrespective of the amount, at 8% for a period of one year. And now it has announced that it will offer for a year, new car loans at 10% and loans to farmers against cold storage and warehouse receipts at 8%. All these loans will be re-calibrated by linking to the existing Prime Lending Rates (PLR) after the first year.

The rate cuts may have the desired effect for two reasons - SBI is too big a player and the size of the cuts too large for it to not influence the market. The rate cuts have opened up a large differential between the rates offered by SBI and its nearest competitors in all the four sectors. If this decision draws in consumers, it could play a substantial roile in reviving demand in important sectors like construction and automobiles. In many ways, it offers more potential for raising aggregate demand than any fiscal stimulus measure till date!

Don't be surprised if a few months down the line, analysts will look back at this decision as that which kick-started the credit markets!

Arianna Huffington sets the stage for Oscars!

Best Picture: Slumdog Millionaire
Worst: Bailout Billionaire

Best sound effects: Wall-E's singing.
Worst: Wall Street's begging.

Best editing: Elliot Graham, Milk
Worst: George W. Bush, The Constitution

Best adaptation: Simon Beaufoy, Slumdog Millionaire
Worst Adaptation: George W. Bush, U.S. Constitution

Best sex scene: Kate Winslet and David Kross in The Reader
Worst: Eliot Spitzer and Ashley Dupré in Client #9

Best rip off: the compromising photo stolen in The Bank Job
Worst: the $50 billion Bernie Madoff stole from his hapless clients

Best return on investment: Slumdog Millionaire, which cost $15 million to make and has grossed over $130 million worldwide.
Worst: the $350 billion we gave to Wall Street banks - with nothing to show for

Best sequel: The Dark Knight, Christopher Nolan's brooding follow up to Batman Begins
Worst: TARP II, Tim Geithner's vague follow up to Hank Paulson's Bailout Begins

Best performance in a drama: Mickey Rourke's soulful comeback in The Wrestler
Worst: the banking CEOs trying to act contrite in front of Congress

Best performance by a rodent: Matthew Broderick as the fearless mouse in The Tale of Despereaux
Worst: Rod Blagojevich as the Senate seat-selling rat in A Tale of Desperation

Best mega-buck action fantasy: Iron Man
Worst: Self-Regulation on Wall Street

Best Funny Performance: Jim Carrey says "Yes" to everything in Yes Man
Unfunny: Republicans say "No" to everything in Congress

Best Song: M.I.A.'s "Paper Planes," Slumdog Millionaire
Worst: G.O.P.'s "Barack the Magic Negro," Scumdog Millionaires

Best Achievement in Sound: The Dark Knight
Worst: Rod Blagojevich recorded trying to sell a Senate seat

Best farce: War, Inc.
Worst: (tie) Iraq War, Afghanistan War, War on Terror, War on Drugs

Best rude character: Dane Cook, "Tank" in My Best Friend's Girl
Worst: Dick Cheney "VP" in The Torturista

Best costume design: The Duchess
Worst: Sarah Palin's $150,000 wardrobe

Best overblown performance by a Diva with a dubious sense of right and wrong : Meryl Streep in Doubt
Worst: Sarah Palin in Doubt She Has Any Business on the Ticket

(HT: Huffington Post, here and here)

"Buy American" as industrial policy!

"We are behind other countries in solar and wind turbine technology, and Buy America is an incentive for American companies to catch up. It is not just trade protection but a form of industrial policy", says Robert Pollin, an economist at the University of Massachusetts at Amherst and a consultant to the Alliance for American Manufacturing.

Pollin could have taken these words out of the mouths of Commerce Ministers of any developing country, against bitter opposition from the counterpart US Commerce Secretary not so long ago! How quickly have the roles changed!

Update 1
Edward Glaeser puts in perspctive any plan, industrial policy, to bailout the Big Three automakers.

Are Buddhists and Hindus the most scientific?

(HT: Pew Research Center)

Saturday, February 21, 2009

Are investors fleeing US assets?

Finally it seems to be happening. Foreigners are losing their appetite for US financial assets! We all know the story of the Central Banks and other investors in emerging economies, with their under-developed financial markets, favoring the liquidity and relative safety of American securities in parking their surpluses, despite its low yields, and how this cheap money import fuelled the American consumption binge and global macroeconomic distortions.

Now, with the world economy tethering on the brink of a recession-threatening-to-turn-into-a-depression, and the US requiring this global "savings glut" at cheap price more than ever, the tap appears to be running dry. The graphic below tells the story.

The steep increase in the inflows into T-Bills, with maturities less than a year, is a reflection of the deep uncertainty facing the global economy and the absence of other alternative safe investment opportunities to the risk averse investors, and can be expected to be a temporary phenomenon, lasting till the economy shows the first signs of recovery. This influx into T-Bills mirrors the surprising appreciation in the US dollar in the immediate aftermath of the crisis.

As the NYT writes, the foreign investors who flooded into the long-term securities like that of Fannie Mae and Freddie Mac, with its implict government guarantee, and corporate bonds, are now not only reluctant to make any fresh investments but are also pulling out in large numbers. While the effect of such de-leveraging can be disastrous for the embattled US economy, it is not likely for a number of reasons.

For a start, there are very few other safe investment alternatives available, in other places and currencies, including Europe and Euro. Any mass de-leveraging can result in steep falls in asset prices, further eroding the values of these already diminished securities. And any repatriation of proceeds will put upward pressure on the domestic currencies of these emerging economies, something they can now ill-afford.

Observations on increase in government borrowings

Faced with increasing demand for a third round of fiscal stimulus and declining tax revenues, the Government of India have decided to borrow an additional Rs 46,000 Cr between February 20 and March 20. This would take the overall borrowings of the Government for the financial year to Rs 2,71,000 Cr, as against the budget estimates of Rs 1,35,000 Cr. A few observations on this

1. The "liquidity preference" of banks, with the resultant flight to government securities, means that there will be no dearth of buyers for this debt. In the natural course, this demand for safe government securities, coupled with low and declining inflation, should have meant lower yields on them.

2. The RBI has been purchasing government securities in large quantities in recent weeks as part of its liquidity injections to un-freeze the credit markets. This too has acted to raise bond prices and lower yields.

3. However, the announcement of additional borrowings elicited an immediate response from the debt markets, driving up the yields on long term Treasuries in expectation of higher future interest rates. In recent weeks, the yields on the benchmark ten year government bonds have risen steeply from a very low 4.86% in January to 6.43%, well outside the repo rate (5.5%) and reverse repo rate(4%) band, another indication that the markets are pricing for expected higher interest rates in the future. It is being estimated that this benchmark rate could stabilize above 7% for the medium term atleast, thereby anchoring inflationary and interest rate expectations. This signal is not desirable as it would immediately generate negative expectations among businesses about borrowings and investments.

4. The higher long term yields will, at some time in future, also have the effect of crowding out private borrowings, as businesses get put-off by the higher cost of capital. This is not so much a problem now as the economy slows down, given the reluctance of private businesses to make investments. During such times, only government investments can bring the idle resources and capacity to full use.

5. There is also a self-fulfilling dimension to this. Higher yields only makes government securities even more attractive for already risk averse banks, thereby "crowding out" private borrowers even more.

6. The high level of borrowings required are yet another reason for the RBI to lower interest rates. Besides reducing the immediate debt service burden, it would also give it enough room to manouevre when it comes to rasing rates as inflationary signals invariably show up sometime later.

7. The borrowings will drive the fiscal deficit, including the states and off-balance sheet entities, well past 10% of GDP (Some predict it to be around 13%, including all off-balance sheet liabilities). This raises questions about how the government will unwind the debts it is running up. The prospects of higher interest rates in the future bodes ill for exiting from this debt burden. Further, in such uncertain economic times, such macroeconomic imbalances can be heavily penalized by the markets, with potentialy disastrous consequences on the rupee exchange rate and our external balance.

8. It is therefore necessary that these costly borrowings be spent on those measures that deliver the largest bang for the buck. And tax cuts, by way of which the government has already doled out over Rs 50,000 Cr in corporate welfare to boost the bottom-lines, are surely not the most effective way of stimulating the economy. More so developing economies like India where the price transmission belt is riddled with imperfections.

Apprehensive of driving down long term bond prices, the Government have announced that it will not raise the additional Rs 46,000 Cr by market borrowings or overseas borrowings. It has also ruled out private placement by the RBI. Therefore the only options left are to either monetize by printing money or to draw from the account created to keep the rupee funds collected by issuing bonds under the Market Stabilization Scheme (MSS) (the bonds were issued to sterilize the rupees released on forex market interventions to keep rupee from appreciating). Of the two the latter looks are more plausible alternative since it would not have any immediate "crowding out effect".

The borrowings are not likely to have any adverse immediate impact in crowding out private borrowings or raising interest rates. The credit market freeze and anemic economic expectations means that both the banks are not coming forward to lend and the businesses are not willing to make investments by borrowings. Further, the low and declining inflation means that there will be no pressure to raise interest rates. To this extent the Government is blessed with favourable macro-economic environment to sustain large borrowings. The challenge will be to unwind these positions once the economic growth picks up and inflationary pressures start showing up.

Update 1
As expected the Government have entered into an MoU with the RBI to de-sequester the MSS funds, so as to enable the Government to mop up its borrowings without having any impact on interest rates. Rs 45,000 crore will be transferred in instalments from the 'MSS cash account' to the normal cash account of the Central Government by March 31. An equivalent amount of government securities earlier issued under the MSS would now form part of the normal market borrowing of the Centre, according to the RBI.

Reviving the securitization market

NYT has some excellent graphics on the ongoing financial crisis, the latest of which nicely captures the problem - collpase of the securitization market - and the proposed solution - Government as lender and insurer of last resort.

Banks have come to depend on selling mortgages and other loans to investors like hedge funds and insurance companies. This allows banks to make more loans and earn bigger profits.

But the market for these securities has collapsed, contributing to a freeze in lending.

To encourage new lending, under the new Financial Stability Plan (this will be part of the Term Asset-Backed Securities Loan Facility or TALF, announced in November 2008), the Treasury and the Federal Reserve would provide up to $1 trillion to private investors who acquire new securities (only AAA rated) backed by auto loans, credit card balances, student loans and small-business loans at rates ranging from roughly 1.5-3%. Depending on the type of security they are borrowing against, investors will be able to borrow 84-95% of the face value of the bonds. Investors would not be liable for any losses beyond the 5-16% equity that they retain in the investment.

An example of government financing for a $100, three-year security backed by consumer auto loans that typically earns 4-5% annually.

Because investors borrow most of the money from the government at a low rate, the effective return could be 20% or more. Even if the underlying loans default, the investor could lose only up to $8; the Treasury and Federal Reserve would bear the rest of the losses.

Friday, February 20, 2009

IIFCL is the right way ahead

The IIFCL has come out with its second tranche of tax free bonds worth Rs 2370 Cr (with a greenshoe-option) at a cuopon of 6.85% and tenor of 5 years. In order to expand the participation of individuals in the private placement, the minimum size of investment was reduced from Rs 1 Cr to Rs 10 lakh.

The IIFCL would then on-lend it to commercial banks at 7.85% to finance prioritized infrastructure projects. These banks wil be re-financed upto 60% of their loans for PPP projects. In the two stimulus packages announced so far, the GOvernment have permitted the IIFCL to mobilize Rs 40,000 Cr, Rs 10,000 Cr in 2008-09 and Rs 30,000 Cr next financial year. Besides, it is also expected to mobilize nearly Rs 9000 Cr from multi-lateral lending agencies like ADB and World Bank on soft terms. In the first round, the IIFCL had mobilised Rs. 7,369.30 Cr with a minimum lot size of Rs 1 Cr under similar terms, as against the original issue size of Rs 2500 Cr.

The IIFCL can be easily counted as one of the successful interventions of the UPA government, though it could have been activated much earlier, and taken advantage of the much more benign market conditions of the last three years. It relatively low cost of capital, when compared to the 12-13% ruling market rates for infrastructure projects, is a booster shot for the sector.

The one standout anomaly in the program is the short five year tenor. Given the large gestation periods of infrastructure projects, normally atleast 15-20 years, the five year period looks surprising and may pose considerable difficulties for projects during the financial closure. One way of looking at the problem is to use this loan to finance the construction and then mobilize fresh loans for the operational period. In one way this would help optimize the cost of debt servicing, as the construction risks, which are substantial in infrastructure projects and which command a high premium, could be off-loaded and longer term loans taken at lower cost.

In fact, this blog has been a long-standing advocate of such financing method for infrastructure projects, where the construction is financed with shorter term loans, which are then swapped for longer term loans after off-loading the construction risks. More on similar variants of infrastructure financing are available in earlier posts here and here.

"Balance sheet deflation" and the need for fiscal expansion

Martin Wolf draws attention to the analysis of the Japanese deflation of the nineties by Richard Koo of Nomura Securities who argues that a combination of falling asset prices with high indebtedness forces the private sector to stop borrowing and pay down debt, and the government then inevitably emerges as borrower and spender of last resort.

He describes this a "balance sheet deflation" (and here), where the values of assets purchased with debt plunges, driving the economy into virtual bankruptcy as borrowers start defaulting. When faced with a massive fall in asset prices, companies typically jettison the conventional goal of profit maximization ("yang") and move to minimize debt ("yin") in order to restore their credit ratings. He feels that when faced with "yin" phase of the business cycle, fiscal policy alone will be of any utility.

The situation is made even worse when interest rates are close to zero, thereby rendering conventional monetary policy irrelevant. This happened in Japan and is now happening in the US, though the learnings from Japan appear to have been misinterpreted.

The figures show that US is in a much worse macroeconomic situation that Japan, despite the much larger destruction of wealth there, and the stuttering world economy is in no position to bailout the US economy by volunteering to buy up American exports. Total outstanding consumer credit has risen from $1.7 trillion in 2000 to $2.6 trillion now, residential mortgages rose from $5.6 trillion in 2000 to $12 trillion by end of 2008, and national debt increased from $5.7 trillion to $10.8 trillion in the same period. To top it all, US has both massive public debt (internal) and current account deficit (external) problems.

This means that the US economy will have to emerge out of the present crisis without any external support (Paul Krugman emphasizes this point while drawing on its role in pulling Japan out of its slump) and with the expected long period of suppressed private sector - both households and financial and non-financial businesses - consumption and investment. This leaves the ball squarely in the court of the Government, which despite its own indebtedness, is left with no choice but to engage in fiscal pump-priming in an unprecedentedly massive scale. And government spending too not in the form of tax cuts, which invariably will end up being saved or used to pay off debts.

Wolf points to the inevitable twin challenges for the US economy - reduce private sector debt and current account deficits. He opines that the former can be achieved with relatively lesser pain by forced write downs of bad assets in the financial sector and either more fiscal recapitalisation or debt-for-equity swaps and also mass bankruptcy of insolvent households and forced write downs of home mortgages. This, while increasing public debt, will usher in a slimmer and better-capitalized financial system and a healthier non-financial private-sector balance sheet in reasonable time, and will be better than a decade or more of continuous "deleveraging", with running fiscal deficits, and sustained pain. Addressing the current account deficit will be more a challenge of global economic diplomacy and co-ordinated action by the major economic powers, so as to remedy the grossly unsustainable structural imbalances in the world economy.

Wolf also spotlights on Koo's claim that contrary to the widespread misconception, Japan emerged out of the nineties thanks to the massive fiscal deficits, which prevented the economy slipping into a full fledged depression. In fact, Japan emerged out of the bad decade of nineties in the 2003-07 period, before the present crisis started taking its toll. However, like the US now, Japan too had problems in swiftly responding to the failing banks with their distressed assets and let the zombie banks continue functioning for a decade. The "public hostility to bankers rendered it impossible to inject government money on a large scale, and the power of bankers made it impossible to nationalize insolvent institutions".

Interestingly, Richard Koo finds that the Indian economy is in the yang phase, with the economy healthy, the private sector regaining its vigor, and confidence back.

Update 1
Awkward Corner sums up the balance sheet deflation debate here.

Update 2
Mostly Economics points "to an analytical framework for understanding crises in emerging markets based on examination of stock variables in the aggregate balance sheet of a country and the balance sheets of its main sectors (assets and liabilities). It focuses on the risks created by maturity, currency, and capital structure mismatches. This framework draws attention to the vulnerabilities created by debts among residents, particularly those denominated in foreign currency, and it helps to explain how problems in one sector can spill over into other sectors, eventually triggering an external balance of payments crisis."

Update 3
Paul Krugman says Koo's theory of balance sheet deflation is similar to John Hicks' "non-linear" theory of the business cycle with its emphasis on the unstable short run nature of the economy - "an economic boom causes rising investment spending, which further feeds the boom, and so on, while a slump depresses investment spending, deepening the slump, etc". Krugman says that Hicks’s big contribution was to add limits to the boom and slump: a "ceiling" set by the economy’s capacity, a "floor" set by the fact that investment can’t go negative.

Update 4 (26/12/2010)

Mark Thoma writes about the way out of such balance sheet recessions - "use the federal government’s balance sheet as a means of offsetting the deterioration in the private sector’s financial position".

US homeowner bailout plan

President Obama announced the Homeowner Affordability and Stability Plan, which is expected to help as many as nine million American homeowners restructure or refinance their mortgages and thereby avert foreclosure, shore up housing prices, stabilize neighborhoods and slow a downward economic spiral. It could ultimately cost taxpayers as much as $275 billion.

It will have three major components
1. Low cost refinancing for upto 4 to 5 million responsible homeowners (those who are current on their payments, but who are paying high interest rates and cannot refinance because they do not have enough equity in their homes) to make their mortgages more affordable by reducing their interest payments. This will remove the current restriction on Fannie Mae and Freddie Mac that prohibits them from guaranteeing refinancing on mortgages valued at more than 80% of the home's value.
2. A $75 billion Homeowner Stability Initiative to reach upto 3 to 4 million at-risk homeowners and keep them in their homes. The government will offer incentives to lenders to alter the terms of loans to make them affordable for the troubled borrowers.
3. Supporting low mortgage rates by strengthening confidence in Fannie Mae and Freddie Mac through direct purchases of their debts as part of the quantitative easing measures announced in November 2008. This will substantially increase the credit available for newer mortgages.

More analysis on the Plan is available here, here and here. A nice NYT interactive graphic sums up the Plan.

Update 1
The Obama administration announced the full details of a $75 bn homeowner bailout plan, that seeks to help 4 m people avoid foreclsoures. People with mortgages as high as $729,750 could qualify for help, and there is no ceiling on how high their income can be as long as they are in danger of losing their homes. Interest rates on loans could go as low as 2% for some and many homeowners could see their mortgage payments drop by several hundred dollars a month, and some could save more than $1,000 a month.

Update 2
FAQ on Housing bailout plan here.