Weekend reading links

1. This captures the big problems with Chinese exports to Europe.

In the early 1970s workers at Dongfeng, or “East Wind”, imported American trucks to inform their early attempts at making off-road vehicles destined for the People’s Liberation Army. Nearly 60 years later Stellantis, the European owner of the Jeep brand, is partnering with Dongfeng to produce a new battery-powered version of the iconic American light utility vehicle for consumers in China, the Middle East and south-east Asia... International carmakers, struggling for survival amid an expensive transition to electric vehicles, are turning to China’s technologically advanced and cost-efficient factories as manufacturing bases for their global businesses. Foreign companies already account for around two-fifths of China’s car exports to Europe, when joint ventures with local groups are included, according to the Rhodium Group, a US consultancy... Indeed, Volkswagen, BMW, Nissan, Hyundai and others are increasing exports from Chinese factories with spare capacity to markets other than Europe and the US.

2. A new approach to making clean hydrogen. 

Most of the hydrogen the world uses today — mainly for fertilizer and refining — is produced using natural gas in a process that creates lots of emissions. In recent years, the United States and other countries have invested billions of dollars trying to make “green” hydrogen with wind and solar power, but it has proved difficult and expensive. Now a growing number of companies think a better answer could lie underground. Dozens of start-ups are trying to find large reservoirs of natural hydrogen thought to exist below the surface. Others, like Vema, are trying to stimulate the processes that generate that hydrogen, without any emissions. It’s a field often referred to as “geologic hydrogen.”...

Hydrogen is the most abundant element in the universe, and it gets made naturally in the Earth’s crust when certain iron-rich minerals react with water and rust. This process, known as serpentinization, often leaves behind rocks with a mottled green color. For a long time, many geologists believed that any natural hydrogen produced this way was unlikely to accumulate in large underground deposits because the tiny molecules would slip away through cracks in rocks. Lately, that conventional wisdom has been upended... By the 2020s, scientists were publishing papers estimating that natural hydrogen deposits underground could supply the world’s needs for hundreds of years. One promising location was North America’s Midcontinent Rift, an enormous formation of iron-rich basalt that stretches 1,200 miles from Kansas to Michigan... The Energy Department has estimated that geologic hydrogen could be produced for less than $1 per kilogram. That would be cheaper than hydrogen made from fossil fuels and one-sixth the current cost of making hydrogen from wind and solar power.

It has started attracting private capital.

Companies are racing to find the fuel. One of the best-funded start-ups, Koloma, has raised $400 million from investors including Amazon and United Airlines and has drilled exploratory wells in Iowa. HyTerra, an Australian firm, is searching for hydrogen and helium in Kansas and Nebraska. Not everyone thinks the best strategy is to search for natural deposits underground. A better idea, some say, is to create them. In Quebec, a startup called Vema Hydrogen plans to spend the rest of the year injecting water into its underground test wells to see if it can speed up the process of serpentinization that creates natural hydrogen underground... Vema has already raised $15 million and is working to raise more. There are ophiolites all over the Earth, including a ridge stretching from Costa Rica to Alaska, and the company is looking at sites in Oregon and California as well. Other start-ups, including one out of M.I.T. called GeoRedox, are developing their own approaches.

3.  Semiconductor chips are one area where China lags badly.

Chinese companies will most likely make just 2 percent as many A.I. chips as foreign firms do this year, said Tim Fist, a director at the Institute for Progress, a think tank in Washington. The production gap between Chinese and foreign manufacturers is especially big for memory chips, which are essential for the large calculations done by A.I. Companies outside China will make 70 times as much memory storage capacity this year as Chinese chip makers will, Mr. Fist said...The inability to get essential tools from ASML has been a major chokehold for Chinese chip makers. Since U.S. officials led an effort to lobby the Dutch government to block shipments to China, no Chinese company has been able to buy ASML’s most advanced tools. Instead, Chinese chip makers have recruited engineers with experience using those machines at TSMC, the world’s top chip maker. And now, Chinese start-ups are trying to make their own chip manufacturing equipment... China’s A.I. companies are trying to get the computing power they need by strapping together numerous less powerful chips. Huawei has taken such an approach... The chips Huawei does produce are prone to defects and use more electricity than cutting-edge foreign ones.

4. This is one of the greatest messages from a student to a teacher, Albert Camus to his elementary school teacher Louis Germain after he won the Nobel Prize.  

5. Japanification in demographics.

And this impact of smartphones is striking.

6. Soumaya Keynes has a good read on the history of export restrictions and their impact, and why trade wars will endure. 

7. Southeast Asian economies struggle on the face of rising inflation from the War.

Their currencies have weakened.

The Philippines and Indonesia have already raised interest rates. 

8. Good FT visual story on maritime chokepoints.

This is a good illustration of the extent of damage from the Strait of Hormuz closure.

In a sign of Bab el-Mandeb strait’s strategic importance, Djibouti – whose coastline runs along the waterway – is home to military bases of several major countries, including the US, Italy, France, Japan, and the sole People’s Liberation Army base outside China. The Bab el-Mandeb strait is among several trade chokepoints that, when blocked, require vessels to travel more than 8,000 miles. These also include the Strait of Gibraltar and the Suez and Panama Canals...

The knock-on effects of a blockage can be much more significant where there is no alternative route to fall back on, as with the Strait of Hormuz, the Øresund between Denmark and Sweden, and the Turkish straits, comprising the Dardanelles and the Bosphorus, which act as the gateway between the Black Sea and Mediterranean. With the Hormuz strait, says Jasper Verschuur, co-author of a study into the risks of the world’s 24 narrow straits, “there is no alternative for 80 per cent of the trade”.

This is India's exposure to various maritime routes

9. Sajjid Chinoy writes that India's economic problem is less of a current account and more a capital account problem, arising from the sharp decline in FDI and FPI inflows. In the circumstances, he argues that demand compression can be counterproductive by slowing growth. He suggests a combination of depreciation and augmentation measures for foreign capital inflows.

The objective must be to attract a large-enough quantum of near-term capital inflows across multiple avenues — even if it involves a subsidised swap — to change exporter, importer and investor behaviour, and prevent a destabilising overshooting of the Rupee.

I am not sure how this is at all possible precisely when capital is flowing the other direction.  

10. For all talk of private participations and efficiencies, the long-distance railway networks in continental Europe is largely state-owned - Deutsche Bahn (Germany), Ferrovie dello Stato (Italy), Renfe (Spain), SNCF (France), and SBB (Switzerland). The Economist writes about how Italo, the private high-speed rail operator co-founded by Luca Cordero di Montezemolo, is trying to disrupt the German network. 

11. Securitisation and deepening of financial intermediation in Europe. 

The securitisation market in Europe remains moribund, comprising around 0.3 per cent of GDP compared with 4 per cent in the US.

12. SpaceX's IPO prospectus takes the widest liberties with US securities law. 

13. K-shape in US economy.

And now in wage decline

14. Ukraine's drones are inflicting massive damage and casualties on Russia as the country forces its way into its most favourable situation since the war began.

Some intelligence reports indicate that a staggering 1.2mn Russian soldiers have been killed or wounded since February 2022, a casualty figure no major power has suffered in a single conflict since the second world war... Backed by some €90bn in EU loans, Kyiv is pouring resources into domestic arms production in a bid to reduce dependence on western weapons and the political constraints that often accompany them. It has moved at breakneck speed to scale up the manufacture of land, sea and air drones, artillery systems, electronic warfare equipment, and even ballistic and cruise missiles.

15. The consulting industry is threatened by AI.  

Few industries are debating AI’s implications more intensely than consulting, whose core work of research, summarising data and producing neatly designed PowerPoint presentations is highly automatable. Richard Susskind, co-author of The Future of the Professions, says consultants are more vulnerable than other mainstream professions in part because the work of junior staff “can now be taken on, with mild supervision, by increasingly capable AI systems”. The sector now has two new competitors, he adds: “the AI-empowered client and disruptive start-ups. Both challenge the conventional model.”... AI also threatens one of professional services’ foundational economic models: billing by time. When a bot can review thousands of contracts in minutes and draft complex documents in seconds, the relationship between hours worked and value delivered begins to break down. Increasingly, clients are demanding pricing linked to outcomes rather than labour inputs.

16.  

Securitizing electricity revenues

The Times reports of the first ever securitization of solar electricity payments,

Standard&Poor’s has given its preliminary blessing to the first offering of this kind, rating a set of notes intended to raise $54.4 million for the fast-growing installation company SolarCity... it gave a rating of BBB+, a low investment-grade designation, to the notes. SolarCity plans to sell the bonds, which are secured by a bundle of residential and commercial power contracts, privately this month... Many of the power contracts are with individual residences and businesses, which have increasingly turned to leasing solar systems to avoid the upfront costs. Under those terms, SolarCity pays for installing and maintaining the system in return for monthly payments for the electricity generated. The deal will help finance the rapid expansion of SolarCity, which has become a leading installer of solar systems in the United States... It has signed up more than 82,000 customers so far...

Theoretically contracts backed by tariff payments by consumers should be attractive given that people will continue to use electricity and bill default rates are very low. However the lack of standardization of contracts and the lack of any performance history increases the risks associated. The prevailing market conditions have undoubtedly played a role in the issuance,

The bonds are expected to have a yield of around 4.8 percent, which, in a time of low interest rates, is a relatively high rate that compensates investors for buying such an untested security. The offering is also relatively small and will be sold only to select institutional investors.

As solar and other renewables sector expands, developers are already facing financing constraints. In the circumstances, they have to rely on such innovative approaches to mobilize the resources required to finance their investments. But such investments are not likely to be readily forthcoming in normal times. Further, there is the associated danger that the promoters, many with only a handful years of existence, may disappear leaving investors saddled with massive loans. Finally, there is the ever-present danger associated with securitization when it goes beyond its first stage into transactions that are far removed from the original contract.     

Back to square one - financial market regulation?

The bitter lessons of the sub-prime crisis appears to be slowly receding away from memory and the unhealthy practices that inflated the sub-prime bubble era are returning back with vengeance. Now that the markets are back to normal, atleast in appearances, the urge to return to the boom days is proving irresistible.

The latest evidence comes from the US Federal Reserve’s recent decision to allow major banks to increase their dividends and to buy back shares. The decision comes in the aftermath of the Fed's Comprehensive Capital Analysis and Review (CCAR), a cross-institution study of the capital plans of the 19 largest US bank holding companies.

In an excellent post, Simon Johnson has strongly contested this decision and the validity of the CCAR to reliably assess the strength of banks

"The Fed’s decision on dividends effectively lets the banks pay out shareholder equity, making the banks more highly leveraged... Bank executives and other key personnel are paid on a "return on equity" basis, so this increases their upside — that is, what they will make as long as the economy and their sector does well... Any individual bank will want to keep its equity levels low, because its executives and owners are not worried about system-wide spillover costs, such as what happens to other banks when one bank fails."

The failure risk for big banks is mitigated by the blanket insurance provided by the too-big-to-fail problem - governments cannot allow such institutions to sink for fear of a financial market meltdown. The bank executives, creditors, and even shareholders, all suffer from the moral hazard problem arising from this.

In a letter to the Financial Times, Anat R Admati and her colleague financial academics, had this to say about dividend payouts and share buybacks,

"A dollar paid out to shareholders through either dividends or share repurchases is a dollar that would not be accessible to creditors in a situation of financial distress. For this reason, and to prevent the shifting of value from debt holders to equity holders, debt covenants typically restrict dividend payments when leverage is high... taxpayers should be concerned when banks pay dividends and remain thinly capitalized, because, as we have seen, taxpayers are the ones who are likely to end up covering the banks' liabilities in a crisis... retaining earnings is generally viewed as the least costly way to raise funds and build capital, as it avoids the transactions costs associated with new equity issuance."

This debate revolves around one of the most fundamental problems in modern financial markets - who will bear the cost of addressing the systemic risks (with its massive negative externalities) that are generated by certain actions of banks, what should be that cost, and in what form should it be levied?

The sub-prime crisis has drawn attention to the dangerous consequences of excessive risk-taking and leverage, and the systemic risk created by too-interconnected to fail big financial institutions (the TBTF problem). The tax payers had to bear the burden of the massive amounts required to bailout financial institutions in the aftermath of the bursting of the mortgage bubble. It is therefore universally accepted that these financial institutions have to internalize the cost of addressing the systemic risks generated by their actions.

It is widely acknowledged that adequate equity capital and reasonably high enough counter-cyclical risk weighted capital reserves are necessary to meaningfully resolve these problems. The global banking regulators recently announced the Basel 3 regulations in an effort to mitigate the systemic risks that arise in the financial markets. However, a large number of influential financial economists have argued that the capital reserves required to address such risks are much higher than what is proposed under the Basel 3.

In an excellent NYT article Gretchen Morgenson points to a few other instances of attempted regulatory dilution as the Dodd-Frank Law becomes operational. These measures are being pushed by taking the cover of getting the securitization, derivatives and the mortgage market moving again and to buoy falling home and other asset prices.

One of the biggest achievements of the new legislation was to route all derivative trades through clearing houses and exchanges. However, now bankers are calling for exempting currency swaps from Dodd-Frank citing a provision that permits the Treasury secretary to exempt foreign-exchange swaps from the regulation. Foreign exchange swap trades are in the range of about $4 trillion a day, and trading in foreign-exchange contracts generated revenue of $9 billion in 2010 in the top five US banks, more than was produced by any other type of derivative.

Critics say that the only the only reason this market did not seize up like others during the meltdown was that the Fed lent huge amounts — $5.4 trillion — to foreign central banks through so-called swap lines during the fall of 2008. However, the Treasury Secretary Tim Geithner looks inclined to providing the exemption.

There are details of interpretation of specific provisions in the Dodd Frank law that could determine whether the relevance or otherwise of the regulation. One concerns how regulators define a 'qualified residential mortgage'. Morgenson writes,

"Issuers of asset-backed securities that are made up of such loans needn’t keep any credit risk of those securities. But sellers of loan pools that don’t consist of qualified mortgages are required to retain some of the risk in them. This provision was meant to eliminate the perverse incentives of the mortgage boom, when packagers of loan pools were encouraged to fill said pools with toxic waste because they had little or no liability for the deals once they were sold.

What constitutes a qualified mortgage has become a battleground issue because of the risk-retention rules under Dodd-Frank. Qualified mortgages should be of higher quality, based upon a borrower’s income, ability to pay and other attributes to be decided by financial regulators... Among the questions to be considered is how much of a down payment should be required in a qualified loan, and whether mortgage insurance can be used to protect against the increased risks in loans that have smaller down payments.

The use of mortgage insurance during the boom effectively encouraged lax lending. Investors who bought securities containing loans with small or no down payments were lulled into believing that they would be protected from losses associated with defaults if the loans were insured. But when loans became delinquent or sank into default, many mortgage insurers rescinded the coverage, contending that losses were a result of lending fraud or misrepresentations. When they did so, the insurers returned the premiums they had received to the investors who owned the loans.Lengthy litigation between the parties is under way but has by no means concluded.

Clearly, for many mortgage securities investors, this insurance was something of a charade. So any argument that mortgage insurance can magically transform a risky loan into a qualified residential mortgage should be laughed off the stage. And yet, mortgage insurers are making those arguments vociferously in Washington."

She also points to the battle to re-open trade on covered bonds - pools of debt obligations that have been assembled by banks and sold to investors who receive the income generated by the assets, while the issuing bank retains the credit risk. The problem with this is that since the investors who bought the covered bonds would have first call on the banks' assets (over that of the FDIC), this would wind up bestowing a new form of government backing (FDIC's deposit insurance) to the major banks issuing the bonds.

And confirmation that things are indeed getting back to normal comes from the graphic below of financial sector (it accounts for less than 10% of the value added in the economy) profits, which have regained its pre-crisis share and is back to more than 30% of all domestic US profits



Felix Salmon should have the last word,

"Banks are still extracting enormous rents from the economy, and profits which should be flowing to productive industries are instead being captured by financial intermediaries. We’re back near boom-era levels of profitability now, and no one seems to worry that the flipside of higher returns is higher risk. Any dreams of seeing a smaller financial sector have now officially been dashed. And the big rebound in corporate profits since the crisis turns out to be largely a function of the one sector which we didn’t want to recover to its former size."

Financing newly created infrastructure assets

Here is the problem facing a local government agency in a major Indian city. It has constructed a massive road project with funding from a hybrid of loan from an external funding agency and a 15 year annuity-based BOT. It was proposed to re-pay the loan and make the annuity payments from a bouquet of revenue stream inflows that would come in once the road is constructed. Reputed consultants who had structured the financing arrangements, in keeping with their pro-cyclical outlook, had based their assumptions of revenue streams on the booming property prices (when the construction started). Shortly after the project achieved financial closure and construction started, the real estate market crashed leaving most, if not all the revenue stream assumptions in shambles. Now with the project completed, the repayments having come due, the already distressed local government is clueless to repay the loans. The state government is even bigger mess to bailout the project.

So what is the way out? Here are three possible alternatives

1. The first and simplest alternative would be to re-visit the revenue streams and examine the possibility of restructuring them in light of the changed circumstances and squeeze out all possible value from them. However, the existing revenue streams alone will surely not yield adequate returns to finance the payments due.

2. The more promising and efficient alternative would involve ring fencing the asset, in this case the road, with all its linkages, into a project entity. The entity can then be registered as a special purpose vehicle (SPV) and the newly created asset (which would not have been created without the borrowing liability) transferred to the entity. This asset can then be leveraged to raise capital by issuing long term debt instruments. If the project asset happens to have some brand value (as this road incidentally has), then it may even be possible to leverage this value to optimally market its debt instruments.

3. Restructure the debt by tapping into the various infrastructure financing options which the Government of India announced recently. The recent Union Budget increased the allocation for Indian Infrastructure Finance Company Ltd (IIFCL) to raise tax-free bonds to both directly finance and re-finance infrastructure projects. The disbursements by IIFCL are expected to touch Rs 9000 Cr by the end of fiscal 2010-11 and Rs 20,000 Cr by March 2011.

The takeout financing scheme announced last year and estimated to finance Rs 25,000 Cr in infrastructure investments over the next three years is the other alternative. Under takeout financing, the short to medium-term loans granted by banks can be taken-out after a hsort duration (3-5 years) from the originating banks' books by either long-term infrastructure financing institutions or a consortium of other banks. Another financing option from the Government of India is to avail the viability gap funding(VGF) mechanism for infrastructure projects.

The local government agency has no choice but to seek between the last two broad alternatives, and adopt whichever is the cheapest. Or adopt a hybrid of both. The repayment will have to involve identifying and structuring all possible road-linked revenue streams - toll collections, impact fees (due to local development and levied on registration/property taxes), advertisement rights, commercial development of related land and so on. Incidentally, the crisis does present an opportunity for the local government agency to push through the difficult measures like tolling, impact fees etc. It will also have to be based on medium-term assumptions of normalcy returning to the property markets. The VGF can be sourced to meet a share of the deficit.

After restructuring based on these revenue streams and the VGF funding, any remaining short fall can be met with a commitment for back-loaded government budgetary support. In other words, the commercial revenue streams, internal local government agency resources (escrowing some source), and VGF will form the upfront repayment sources, and the government support will kick-in in only the later half. The advantage with this arrangement is three-fold

1. Roping in the state government will enahance the credibility of the funding model and facilitate achievement of a better financing deal at possibly cheaper rates.

2. This will avoid the cash-strapped government having to step in with any budgetary support immediately.

3. Finally, there is the strong possibility of newer revenue channels emerging and existing streams becoming more vibrant, thereby providng additional revenue sources and minimizing or even eliminating the need for any government budgetary assistance.

Lessons from Chile and Canada

Amidst the ruins of the sub-prime crisis and the Great Recession, two shining examples of good governance in administering the economy and financial markets stand out. I had blogged earlier about the role of the Reserve Bank of India (RBI) in keeping a lid on "irrational exuberance" in the credit and asset markets. Canada and Chile are two other examples worthy of emulation.

Fiscal prudence dictates that governments run counter-cyclical fiscal policy where they reduce overall debt when the economy is operating above its average growth trend and run up debts when the economy is running at below average growth so as to smooth over declines in aggregate demand. Jeffrey Frankel draws attention to Chile's achievement in effectively managing its long-term budget balance by resorting to prudent counter-cyclical fiscal measures.

At the risk of lowering its popularity, the government of Michelle Bachelet had resisted intense pressure to spend the soaring receipts from increases in copper exports and steep rises in their prices on populist expenditures. However, when the recession stuck and despite the fall in copper prices, the government drew down the assets that it had acquired during the copper boom and increased spending sharply, and thereby succeed in moderating the downturn.

This classic case of successful implementation of counter-cyclical fiscal policy was underpinned by the presence of the required institutional framework and strict fiscal rules (target for the overall budget surplus at 0.5% of GDP). The government introduced a Fiscal Responsibility Bill in 2006, which gave legal force to the role of the structural budget, and created a Pension Reserve Fund and a Social and Economic Stabilization Fund, the latter a replacement for the existing Copper Stabilization Funds. As Prof Frankel writes, under the Chilean rules, the government can run a deficit larger than the target to the extent that

1. Output falls short of potential, in a recession, or
2. The price of copper is below its medium-term (10-year) equilibrium

Interestingly, there are two institutionalized panels of experts whose job it is each mid-year to make the judgments, respectively, what is the output gap and what is the medium term equilibrium price of copper. This effectively de-politicized the decision to run large fiscal deficits. The panels rightly ruled during the copper boom of 2003-08 that most of the price increase was temporary so that most of the earnings had to be saved.

Prof Frankel suggests that countries, especially commodity producers, could apply variants of the Chilean fiscal device. He writes,

"Given that many developing countries are more prone to weak institutions, a useful reinforcement of the Chilean idea would be to give legal independence to the panels. There could a requirement regarding the professional qualifications of the members and laws protecting them from being fired, as there are for governors of independent central banks. The principle of a separation of decision-making powers should be retained: the rules as interpreted by the panels determine the total amount of spending or budget deficits, while the elected political leaders determine how that total is allocated."

Mark Thoma compares such institutional interventions to a form of Taylor Rule for fiscal policy. See also Mostly Economics.

The second shining example throughout the ongoing turmoil has been Canadian financial markets. As Paul Krugman argues, Canada faced much the same domestic and external environments in the lead up to the crisis as the US - loose money policies and robust economic growth at home and a "flood of cheap goods and cheap money from Asia". Like the six "too-big-to-fail" financial firms in the US, the Canadian financial market landscape is dominated by five banking groups. But when the bubble burst, unlike the US, in Canada mortgage defaults did not soar, major financial institutions did not collapse, and there were very few bailouts.

Canada's success lay in more effective regulation which included "much stricter limits on leverage, much stricter limits on unconventional mortgages, and an independent consumer protection agency for borrowers" and its adherence to "boring banking" to keep bankers honest. Canada's independent Financial Consumer Agency had sharply restricted subprime-type lending and its bank regulators had placed well-defined limits on securitization by requiring that lenders hold on to some of their loans.

Update 1
See also this post on the parallel between the long-term unemployment in the US now and "unpleasant parallels to Canada's experience of the 1990's".

Update 2 (25/3/2010)
Simon Johnson and Peter Boone disagrees that Canada provides an example of better regulation. Canada has five mega TBTF banks who ran up higher leverage (average of 19 times levered) than the big six US TBTF banks. Their capital requirements - both Tier One capital and tangible common equity ratios - were lower than US banks and were therefore less capitalized. However, all of them enjoyed guarantees provided by the government of Canada (over half of Canadian mortgages are effectively guaranteed by the government), especially on their mortgages (just like Fannie Mae & Co, who however did relax their lending standards and slipped into trouble).

The global safe-asset imbalances and the sub-prime crisis

A large number of the explanations for the Great Recession have blamed the global imbalances - savings glut in the emerging economies and voracious appetite for debt in developed economies - and the (forced) need for their re-adjustment for creating the conditions of financial market instability that triggered off an economic recession.

However, as the crisis unfolded, instead of capital rushing away from the deficit laden US economy and dollar assets (if the aforementioned explanation were true), the capital flight was in the opposite direction. The US did not end up experiencing a deficit funding problem, as the global imbalance school would have predicted.

A more complete understanding of the crisis would have to look beyond the simple savings-deficit imbalance and explain the micro-dynamics of the capital flows. In this context, in earlier posts I had blogged about the role of demand for safe and liquid assets among emerging economy governments and investors (especially in light of their bitter experience with the currency crisis of the late nineties), which the domestic equity and debt markets could not satisfy.

Ricardo Caballero (the full paper here) attributes this phenomenon to another imbalance, one arising from an "insatiable global demand for safe debt instruments" which put great "pressure on the US financial system and its incentives". The bitter experience of the currency crisis of the late nineties and the relative lack of depth of their financial markets meant that the emerging economy markets could not meet the demand for safe assets and had to rely on external markets, of which the US markets were unquestionably superior and safer.

In fact, the demand for safe assets went beyond what was available even in Wall Street and other developed economy markets. The capital flight to safety and liquidity of US assets, and the resultant abundance of liquidity, therefore set in motion perverse incentives to re-package, securitize and sell riskier assets and payment streams as AAA-rated securities (with help from the rating agencies) by creating complex instruments that sought to hide the various risks. The largest re-allocation of funds (from the emerging to developed economies) matched the downgrade in perception of the safety of the newly created triple-A securitization based assets. He writes,

"The surge of safe-asset demand was a key factor behind the rise in leverage and macroeconomic risk concentration in financial institutions in the US as well as the UK, Germany, and a few other developed economies. These institutions sought the profits generated from bridging the gap between this rise in demand and the expansion of its natural supply... the safe-asset shortage was also a central force behind the creation of highly complex financial instruments and linkages, which ultimately exposed the economy to panics triggered by Knightian uncertainty.

This is not to say that the often emphasized regulatory and corporate governance weaknesses, misguided home-ownership policies, and unscrupulous lenders played no role in creating the conditions for the surge in real estate prices and its eventual crash. Instead, these were mainly important in determining the minimum resistance path for the safe-assets imbalance to release its energy, rather than being the structural sources of the dramatic recent macroeconomic boom-bust cycle."

And about how the various credit market mechanims worked to both trigger off and then amplify fear and panic to spread through the markets, he writes

"The triggering event was the crash in the real estate 'bubble' and the rise in subprime mortgage defaults that followed it... The global financial system went into cardiac arrest mode and was on the verge of imploding more than once. This seems hard to attribute to a relatively small shock that was well within the range of possible scenarios.

The real damage came from the unexpected and sudden freezing of the entire securitization industry. Almost instantaneously, confidence vanished and the complexity which made possible the 'multiplication of bread' during the boom, turned into a source of counter-party risk, both real and imaginary. Eventually, even senior and super-senior tranches were no longer perceived as invulnerable.

Making matters worse, banks had to bring back into their balance sheets more of this new risk from the now struggling ‘Structure Investment Vehicles’ and conduits. Knightian uncertainty took over, and pervasive flights to quality plagued the financial system. Fear fed into more fear, causing reluctance to engage in financial transactions, even among the prime financial institutions.

Along the way the underlying structural deficit of safe assets worsened as the newly found source of triple-A assets from the securitization industry dried up and the spike in perceived uncertainty further increased demand for these assets. Safe interest rates plummeted to record low levels.... Widespread panic ensued and were it not for the massive and concerted intervention taken by governments around the world, the financial system would have imploded."

He feels that addressing these issues would require governments to "explicitly bear a greater share of the systemic risk". This would in turn need the savings surplus countries to re-balance their portfolios toward riskier assets, apart from increasing the depth and breadth of their financial markets. The governments of the developed economies would have to either itself supply much of the triple-A assets or let the private sector take the lead role in supplying them with government support only during extreme systemic events.

Caballero argues that the most efficient approach would be a balance between government and private sector option, which would more effectively manage the systemic risk created through the private sector supplied triple-A rated securities. He writes,

"It is possible to preserve the good aspects of this process while finding a mechanism to relocate the systemic risk component generated by this asset-creation activity away from the banks and into private investors (for small and medium size shocks) and the government (for tail events). This transfer can be done on an ex ante basis and for a fair fee, which can incorporate any concerns with the size, complexity, and systemic exposure of specific financial institutions. There are many options to do so, all of which amount to some form of partially mandated governmental insurance provision to the financial sector against a systemic event."

End of securitization - return to traditional banking?

Evidence indicates that credit expansion by banks is declining and securitization is plunging. James Kwak feels that the securitization market will not get back to the levels seen before the crisis.





The debt-securitization market, which enabled banks to package corporate loans, home mortgages, student loans, auto loans, credit card loans, and other debts into all types of complex securities and resell them to investors, and thereby freeing the banks to lend more, has been the source of roughly 60 percent of all credit in the United States. Now, all private debt securitization has virtually dried up, though the Fed has used its $1.25 trillion credit line and spent about $905 billion buying government-guaranteed mortgages (of fanne and Ginnie Mae's and Freddie Mac) in an effort to keep mortgage rates low. The Fed is also trying to get investors to use the credit provided at attractive terms under the Term Asset-Backed Securities Loan Facility (TALF) to buy the securities.

However, as Paul Krugman argues, the end of securitization and the return to the traditional model of banks making and holding loans should be welcomed and finds no reason to consider securitization to be superior to conventional banking. He feels that instead of reviving the securitization market, the Fed should be trying to get banks to start lending out of all those excess reserves they currently hold.

Next bubble - securitizing life insurance policies?

Even as the sub-prime mortgage bubble with its exotic CDS, CDOs, and SIVs fades away, Wall Street appears ready with the next big investment opportunity - buying, bundling, packaging, securitizing, and selling life insurance policies - or "stranger-owned life insurance"! The $26 trillion life insurance market in the US provides ample opportunities for the development of a market in these derivative securities.



The Wall Street banks could "securitize" the hundreds or thousands of policies it purchases (directly or through a SIV "life" settlement company) from individuals (who volunteer to sell their policies in return for cash) by packaging them together into bonds, and then resell those bonds to investors, like big pension funds, who will receive the payouts when people with the insurance die. The earlier the policyholder dies, the bigger the return (the periodic premium payout is minimal) — though if people live longer than expected, investors could get poor returns or even lose money. As NYT reports, either way, Wall Street and rating agencies would profit by pocketing sizable fees for creating the bonds, reselling them, rating issues, and then trading them.

However, in the event of a bubble blowing up in these securities, settlement companies could end up over-paying for insurance policies and become saddled with derivative securities whose underlying is worth less than the cost incurred in purchasing them. Advances in health care could increase the life expectancies of a category of patients, thereby forcing the investors in these securities to take huge losses (as they are denied the payout when the patient outlives the policy). And insurance companies could end up with payouts that would cripple them.

This could also end up unsettling the insurance industry itself. That is because policyholders often let their life insurance lapse before they die, for a variety of reasons — their children grow up and no longer need the financial protection, or the premiums become too expensive - and the insurer does not have to make a payout. Now, if a policy is sold and packaged into a security, policies will stay in force and cause more payouts over time. Insurance companies will be forced into increasing their already high premiums or regulating the industry more stringently.

A life insurer is betting that the insured person stays alive as long as possible, preferably outlive the policy. The insured person has hedged against the eventuality of his untimely death by purchasing life insurance. By buying out an individual's life insurance policy, the "life" settlement company ends up betting that the individual dies at the earliest. In the final analysis, instead of providing a hedge against death, life insurance (or atleast the part of it getting sold) becomes yet another instrument for financial speculation.

Like all previous such investment bubbles, this too presents ample avenues for conflicts of interests and incentive distortions. The one big difference would be that unlike all previous bubbles, these market distortions are likely to cause human fatalities. Consider this extreme scenario. Assume an individual has both life and health insurance coverage. Desperate for cash, he sells off his life insurance, which is purchased by a Wall Street investment bank, which also has some form of exposure (say, share holding interest) in a health insurance provider.

Given the windfall that comes with a premature death of the individual, it is clearly in the interest of the investment bank and its health insurance provider partner to be negligent on the provision of health insurance to the individual. Another example is the possible emergence of life settlement brokers who will coerce or incentivize the ill and elderly to take out life insurance policies with the sole purpose of selling them back to them.

Securitizing talent

I had blogged earlier about Brazilian corporate groups Traffic and Grupo Sonda who have been identifying and buying contracts to promising upcoming footballers. These players are then trained, loaned to local clubs and then, if found very good, sold on transfer to big clubs for massive transfer fees.

In a similar vein, Freakonomics draws attention to a recent play, Monetizing Emma, which paints a future where Wall Street traders invest in smart schoolkids in return for a substantial share of their future earnings. The play depicts a boutique investment bank, Thackeray Walsh, which in 2013 is issuing bonds backed by an A-list pool of adolescents pledging a share of their future earnings in return for money now.

In the same context, the post also points to a proposal to link up teacher's pay to their students’ future earnings, turning the students into "investments" - "What if teachers were paid based on the future income their students make. For example, student A grows up to make 100k a year. We look at the records and find the 20 teachers that taught student A and compensate them based on that. Compensation could be based on number of months spent with student."