Normalcy restored in Wall Street!

A few months back Wall Street was on its knees, literally, out with a bowl pleading for bailouts. After a series of capital and liquidity injections, access to cheapest credit, credit expansions (by lowering collateral scope and standards), blanket deposit guarantees, and plain bailout assistance, the Wall Street landscape is now dominated with a handful behemoth financial conglomerates. The shakeouts, consolidations and mergers, bankruptcies, and bailouts of the past few months have led to an unprecedented concentration of financial power among these remaining giant "too-big-to-fail" institutions. Ironically, this and the precedents set and signals conveyed, over this period may have left the financial system even more amenable to moral hazard and systemically vulnerable to increased instability and risks.

Amidst all the talk of green shoots and glimmers of hope, the recent announcements of unexpectedly good second quarter results by Goldman Sachs, JP Morgan, Bank of America, and Citigroup stand out for its audacity.



All these institutions have taken large slices of direct (both cash and debt guarantee support) and indirect (implicit guarantees like "too-big-to-fail" support) tax-payer financed government assistance and favorable regulatory changes (like permission to investment banks to indulge in depositary activities).

It has therefore, rightfully and very obviously to anyone, been claimed that the American tax payers deserve a large chunk of the profits of these institutions. Further, all these remaining institutions stand to gain spectacularly by capitalizing on the turmoil in financial markets and their rivals’ weakness to pull in billions in trading profits.

Goldman’s profit was lifted by record quarterly revenue of $6.8 billion in its fixed-income, currency and commodities unit, where mortgage and other credit instruments are traded, and a unit where Goldman has embraced bolder risk-taking. Goldman has already returned the $10 bn it received under the TARP as equity injection, in return for preferred shares, with the dividend on them.



Goldman Sachshas been raking in money in large part because government assistance through debt guarantees, money it received from the AIG bailout and access to cheap loans from the Federal Reserve. It was paid 100 cents on the dollar for its $13 billion counterparty exposure to the insurer, and it has $28 billion in outstanding debt issued cheaply with the backing of the Federal Deposit Insurance Corporation.

As the Times writes, "Goldman’s trading revenues have been helped by the fact that several of its rivals have gone out of business following the credit crisis, a fact that has added to its market share. It has also been able to increase it fees." Its equity underwriting business also generated record net revenues, worth $736 billion in the second quarter, as it benefited among other things from a rush by other troubled banks to issue shares and raise their capital levels.

These spectacular profits have been accompanied by a return to the flawed short-term profits driven executive compensation regime, marked by the usual massive payments to executives and traders.



The fact that all these firms recevied massive amounts in bailout assistance and other aforementioned support, makes these payouts appear plain indecent. Goldman, which posted the richest quarterly profit in its 140-year history and announced that it had earmarked $11.4 billion so far this year to compensate its workers, is expected to payout on average, roughly $770,000 to its employees this year, almost the same as what they received at the height of the boom.

However, these results may actually be concealing more than what they reveal and may have been boosted by one-time windfalls, inflows of bailout monies, and most importantly the access to cheap credit to leverage for big gains. In fact, the bulk of profits of Citigroup and Bank of America come from one time asset sales - the former from a joint venture with Morgan Stanley for its Smith Barney division, and the latter from the sale of shares in the China Construction Bank. Credit losses, from credit cards to home loans, continue to mount across most of these banks, the toxic assets remain, and the fundamentals remain shaky on most parameters.

In any case, these profits and the massive payouts being made to top executives and traders is only the latest example of the now well established feature of Capitalism 2.0 - privatization of gains and socialization of losses!

Update 1
Even as Goldman is luxuriating in its tax payer sponsored profits, another bank holding company, CIT, is not so fortunate as it battles for survival - bankruptcy or bailout! But CIT's smaller size, $80 bn in liabilities as opposed Goldman's $800 bn, may make CIT "too-small-to-be bailed out". More on this here and here.

Update 2
Times reports that the generous bonuses to employees announced by the big banks for 2009 may be at the expense of shareholders. Roughly 90 cents out of every dollar that these struggling big banks earned in 2009 — and sometimes more — is going toward employee salaries, bonuses and benefits.

Citigroup paid its employees so much in 2009 — $24.9 billion — that the company more than wiped out every penny of profit, and after paying its employees and returning billions of bailout dollars, Citigroup posted a $1.6 billion annual loss.

Citigroup is, in effect, paying its employees $1.45 for every dollar the company took in (payout ratio) last year. Bank of America is spending 88 cents of every dollar it made in 2009 to compensate its workers. At Morgan Stanley, that figure is 94 cents. JPMorgan Chase, which has fared better than those three, paid out 63 cents of every dollar. Though Goldman is paying only 45 cents per dollar made, on average in absolute terms each of its 36,200 employees would take home a record $447,000. Until recently, the ratio for most Wall Street banks hovered around 60 cents of every dollar, in line with other labor- and talent-intensive industries like retailing and health care.

The five largest banks on Wall Street — Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase and Morgan Stanley — earned a combined $147.4 billion before paying compensation and taxes in 2009. They plowed back a combined $31.2 billion into their companies and returned a total of $2.1 billion to shareholders in the form of dividends. They paid $114.1 billion to their employees.

Update 3 (2/4/2010)
Hedge fund salaries were back to their ususal highs in 2009, with Daiv Tepper leading the pack by earning $4 bn and whose fund yielded 130% return for investors in his Appaloosa Investment Fund I, according to survey by the AR magazine. Second came George Soros's Quantum Endowment where he earned $3.3 bn and investors 29%. The earnings of the top 25 fund managers tumbled 50% in 2008.

In an indication of how richly compensated top hedge fund managers have remained despite public outrage over the pay packages at big banks and brokerage firms, the top hedge fund managers rode the 2009 stock market rally to record gains, with the highest-paid 25 earning a collective $25.3 billion, beating the old 2007 high by a wide margin. The minimum individual payout on the list was $350 million in 2009. For many of the top 25, the big personal gains in 2009 came after steep losses in 2008. Mr. Tepper's flagship fund, dropped 27% in 2008.

Big Mac Index

The latest version of Economist's Big Mac Index is out. It seeks to compare the values of currencies with respect to the dollar, by comparing the market prices (at market exchange rates) of Big Mac burgers in the respective currencies. As one of the comments in an earlier post about it pointed out, the index is more of anecdotal value than any real significance.

European farm subsidy distortions

Across the world, farm subsidies have proved to tbe hardest to tackle. The European Union's Common Agricultural Policy (CAP) has been at the forefront of any global debate to address this issue. The CAP doled out more than $71 bn in agriculture subsidy in 2008, forming more than half EU's annual budget.

NYT has a nice article that points to the nuerous distortions that bedevil CAP, including the fact that the largest recipients of the subsidy are not farmers and not even those involved with farming - "German gummy bear manufacturers, luxury cruise ship caterers and wealthy landowners ranging from Queen Elizabeth II of England ($778,812 in 2008 for her 20,000 acre Sandringham Farms in England) to Prince Albert II of Monaco (€507,972 in 2008 for his wheat farms in France)". The graphic below captures some of these anomalous subsidies.



Though the supporters point to the fact that most of the cash finds its way to farmers, these subsidies, which are not means-tested, have considerable distortionary effects on global trade in agriculture (and even value-added farm produce) trade. Massive sums are paid to farmers who have been outsourced the production of agriculture produce, and poultry and meat products by large multi-nationals like Cargill (at least €10.5 million in 2008, collecting subsidies in eight EU countries), Danone and Groupe Doux. These subsidies, often paid as the differential between the prices paid to these farmers by their buyers (both within Europe and outside) and the prevailing global market prices, enable these multi-nationals to pay less than the market price for their procurements.

They end up dumping agriculture produce at subsidy-driven lower prices in the global markets, thereby depressing world prices and undercutting poor farmers outside Europe, whose incomes are damaged. Further, over the years, these subsidies have expanded to other rural development activities, as local governments have sought to incentivize farmers away from agriculture.

Update 1
The five-decade long 55 bn euro CAP subsidy, which is typically based on land size, suffers from numerous distoritons and wastages, and 80 percent of beneficiaries receive about 20 percent of the payment. Though they are scheduled for elimination by 2013 and moves are alreadcy afoot to retain them.

Indian infrastructure - cause for cheer?

This graphic comparing the completion schedules of the major recently completed international airport terminals gives cause for cheer.



The Delhi International Airport Limited (DIAL), led by GMR Group, are expected to complete the brand new Terminal 3, at a cost of nearly Rs 10,000 Cr within the schedules time, before the start of the 2010 Commonwealth Games in Delhi. The Terminal 3 is being touted as the third largest terminal in the world (after Dubai International Airport's Terminal 3 and Beijing Capital International Airport's Terminal 3). The recently inaugurated Terminal 1D that caters to all domestic flights is an impressive achievement.

I have two possible explanations behind the success of the DIAL

1. As the Businessline article points out, construction started a little late in December 2006, only after the site was handed over to the developer. This helped plan for the entire construction period, and ensure that "once the construction started, no hold-ups occurred because some contract or the other had not been entered into, or when entered into, was under-specified". Typically, as the example of the recently opened Bandra-Worli Sea link illustrates, site clearance and litigation associated with it is a critical delaying factor.

2. More importantly, the recent experience and learnings from the Hyderabad International Airport Ltd (HIAL) (constructed by a GMR led consortium) must have been of enormous help. The contractor had the luxury of relocating the entire material and manpower supply chain from its Hyderabad experience. The project managers, designers, engineers, sub-contractors (with their moulds and castings, and ancillaries), suppliers, and operational service providers could plan out their schedules and time-lines more effectively.

The success of GMR underlines the crucial importance of gaining expertise in construction and management of massive infrastructure projects. It is not easy to plan for and mobilize materials and man-power on such a massive scale as required for these projects. Indian private companies sorely lack this experience and this partially explains why we have been so badly behind China in the construction of mega infrastructure (and even any type of construction works) projects.

As I had blogged earlier, to a large extent, hitherto our private sector infrastructure construction majors have bidded for massive power generation, ports, airports, metro-rail and other projects without the requisite capabilities - both professional expertise and the resource supply-chain - to execute these porjects. In the main, these local private bidders offered the major share of the finances for the project and rode on the back of the project management capability offered by their foreign consortium partners (who were anxious to get a share of the Indian growth story). However, there are clear limitations to what a foreign consortium partner, however large, can deliver.

It needs to be borne in mind that even the Chinese contractors took sometime to find their feet. But with some runs on board, they took off. Only when that happened did the capital-investment in infrastructure driven Chinese growth really take-off. So maybe, with a few more successes like the airports and the Bandra-Worli sea link, there is hope ahead at the end of the long tunnel of Indian infrastructure sector!

Nudging on achieving targets

A simple experiment in nudging at work place. The other day, during the monthly review of the performance of our engineers, we decided to get them to commit themselves to a voluntary loss (percentage distribution losses are the primary performance indicators in any distribution utility) reduction target for 2009-10. The engineers gave their voluntary targets in the form of a written commitment.

This commitment letter is now being framed for display in their respective offices, strategically positioned exactly facing their seats. It is hoped that the looming salience of the framed loss reduction commitment will keep "nudging" the engineers to meeting their targets!

Cost-benefit analysis in policy making

Cost-benefit analysis (CBA) is one of the oldest methods of evaluating a project or a proposal or a policy. Standard economic theories claim that economic efficiency, measured by the difference between benefits and costs, should be the touchstone for making policy choices.

In recent years there has been an interesting debate about its utility in evaluating social and welfare policies and environmental regulations. Opponents point to the difficulty in identifying, quantifying and monetizing the marginal costs and benefits associated with these policies. They argue that such policies suffer from numerous externalities, both positive and negative, that are outside the framework of quantifiable parameters. Further, CBA is silent about issues like fairness and processes and distribution of costs and benefits. Regulatory policies with aggregate benefits exceeding aggregate costs will also have winners and losers.

Prof Robert Stavins points to an old article which examines whether there is role for benefit-cost analysis in environmental, health, and safety regulation. They gave eight principles on the appropriate use of CBA

1. CBA can be useful for comparing the favorable and unfavorable effects of policies, because it can help decision makers better understand the implications of decisions by identifying and, where appropriate, quantifying the favorable and unfavorable consequences of a proposed policy change. But, in some cases, there is too much uncertainty to use benefit-cost analysis to conclude that the benefits of a decision will exceed or fall short of its costs.

2. Decision makers should not be precluded from considering the economic costs and benefits of different policies in the development of regulations. Removing statutory prohibitions on the balancing of benefits and costs can help promote more efficient and effective regulation.

3. BCA should be required for all major regulatory decisions. The scale of a benefit-cost analysis should depend on both the stakes involved and the likelihood that the resulting information will affect the ultimate decision.

4. Although agencies should be required to conduct CBA for major decisions, and to explain why they have selected actions for which reliable evidence indicates that expected benefits are significantly less than expected costs, those agencies should not be bound by strict benefit-cost tests. Factors other than aggregate economic benefits and costs may be important.

5. Benefits and costs of proposed policies should be quantified wherever possible. But not all impacts can be quantified, let alone monetized. Therefore, care should be taken to assure that quantitative factors do not dominate important qualitative factors in decision making. If an agency wishes to introduce a "margin of safety" into a decision, it should do so explicitly.

6. The more external review that regulatory analyses receive, the better they are likely to be. Retrospective assessments of selected regulatory impact analyses should be carried out periodically.

7. A consistent set of economic assumptions should be used in calculating benefits and costs. Key variables include the social discount rate, the value of reducing risks of premature death and accidents, and the values associated with other improvements in health.

8. While CBA focuses primarily on the overall relationship between benefits and costs, a good analysis will also identify important distributional consequences for important subgroups of the population.

The authors write, "Although formal benefit-cost analysis should not be viewed as either necessary or sufficient for designing sensible public policy, it can provide an exceptionally useful framework for consistently organizing disparate information, and in this way, it can greatly improve the process and, hence, the outcome of policy analysis. If properly done, benefit-cost analysis can be of great help to agencies participating in the development of environmental, health, and safety regulations, and it can likewise be useful in evaluating agency decision-making and in shaping statutes."

Case for stimulus

There has been an intense debate about the utility of fiscal stimulus in boosting aggregate demand during such deep economic recessions.

Supporters like Paul Krugman have based their arguement on the claim that private sector demand (both consumption and investment) has fallen so sharply that only the government can replace it. He points to research by Jan Hatzius of Goldman Sachs who finds the private sector financial balance (defined as the difference between private saving and private investment, or equivalently between private income and private spending) has risen from -3.6% of GDP in the 2006Q3 to +5.6% in 2009Q1. This 8.2% of GDP adjustment is already by far the biggest in postwar history and is in fact bigger than the increase seen in the early 1930s. He represents this in terms of the graphic below.



The graph shows the private sector surplus and the public sector deficit, both as functions of GDP. He writes,

"The private sector line is upward-sloping because higher GDP means higher income and more savings, the public-sector line is downward-sloping because higher GDP means higher revenues. In equilibrium the private surplus equals the government deficit (not strictly true for any one country if you add in international capital flows, but think of this as a picture for the world economy).

What we’ve had is a sharp increase in the desired private surplus at any given level of GDP, due to a combination of higher personal saving and reduced investment demand. This is shown as an upward shift in the private-surplus curve. In the 1930s the public sector was very small. As a result, GDP basically had to shrink enough to keep the private-sector surplus equal to zero; hence the fall in GDP labeled 'Great Depression'. This time around, the fall in GDP didn’t have to be as large, because falling GDP led to rising deficits, which absorbed some of the rise in the private surplus. Hence the smaller fall in GDP labeled 'Great Recession'."

Update 1
Brad De Long feels that either the Fed has to act to stimulate the market for liquidity (money market) or the Treasury has to act to stimulate the market for savings (bond market). In other words, to create jobs, the government has to do something to change the balance of supply and demand in either the market for liquidity or the market for savings.

However, opponents argue that any Treasury intervention in the savings market to boost demand would increase the national debt and also drive up interest rates, and thereby force businesses to cut back on investments. And any more Fed action to reduce unemployment and boost spending and income is opposed on the grounds that the market is so awash with liquidity that spending is not constrained by liquidity shortage, and that further liquidity injections would fuel inflationary pressures in the future without boosting employment and spending in the present. But as De Long writes,

"Both of these arguments are comprehensible; each might well be true. But they cannot both be true at the same time. Either the economy is so awash in liquidity that the Federal Reserve cannot do much to boost spending—in which case additional spending by the government won’t generate any substantial rise in interest rates. Or additional government spending will crowd out investment as businesses scramble for liquidity and interest rates rise—in which case the economy is not awash in liquidity, and quantitative easing by the Federal Reserve could do a lot right now to boost spending and employment."