Making clients pay for losing their invesments!

We are used to having investment banks charging their clients large sums for maanging their investments. But among the many wonders of the modern financial engineering, which rose to prominence as the sub-prime mortgage bubble got inflated and subsequently burst, were instruments that ended up forcing investors to pay their fund managers for even losing their investments! Heads I win, tails I win!

Times has this nice story of how Wall Street giants like Goldman Sachs placed unusually heavy bets against mortgage securities (shorting them), even as it was packaging and peddling securities based on them, like Synthetic Collateralized Debt Obligations (CDOs), to its clients.

CDOs are made up of credit default swaps (CDS) that insure against default of mortgage bonds (as against the bonds themselves in case of normal CDOs). Sellers of CDS would receive regular payments as long as the underlying mortgage securities stayed healthy. Sellers in turn sold them off to Wall Street investment banks, who packaged them off as synthetic CDOs to their large clients. The proprietary trading desk of these firms then bet against the mortgage bonds by themselves purchasing insurance in the form of CDS and paying premiums for it. When the mortgages sour, the investors lost the right to their investments even as the swaps pay out to those who bet against them. Exercise the swaps, liquidate the short positions on these bonds by market purchases, and book handsome windfall profits! In other words, your clients pay you for losing their investments!!



Unlike conventional CDOs, where investors took losses only under extreme credit events, when the underlying mortgages defaulted or their issuers went bankrupt, the synthetic CDO holders would have to make payments to short sellers under less onerous outcomes, or 'triggers' like a ratings downgrade on a bond. This meant that anyone who bet against such CDOs could collect on the bet more easily. Regulations were progressively gamed to favor those betting against these CDOs.

At the peak of the sub-prime mortgage bubble, even as its trading and portfolio management arm was selling synthetic CDOs to unsuspecting clients, carried away by the "irrational exuberance" of the boom, the proprietary trading desks (which uses its own capital) of firms like Goldman Sachs were betting against the same underlying instruments by shorting them. When the bubble burst, the investors were left holding suckers while Goldman made windfall gains on its bets.

Goldman's version of such mortgage linked securities, whose underlying was not the mortgage bonds but the related CDS's, were called Abacus. The NYT story nicely captures how Goldman's traders were aggressively selling Abacus, trying to make its assets more attractive than they actually were, without encouraging their clients to hedge agianst these instruments going bad.

In effect, these firms were simultaneously selling securities to customers and shorting them because they believed they were going to default - "buy protection against an event that you have a hand in causing". Incidentally, worried about a housing bubble, Goldman Sachs had decided in December 2006 to change the firm’s overall stance on the mortgage market, from positive to negative, though it did not disclose that publicly. One of the sources of the Times report put such instruments in perspective,

"When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else’s house and then committing arson".

Update 1
From John Cassidy's excellent chronicle of the sub-prime crisis.

"CDS aren't really swaps at all, they should be called credit insurance contracts... In 1997, a group of math whizzes in Morgan's derivatives department took $9.7 bn in loans that it had issued to about 300 corporations, placed them in a SIV, and distributed tranches of the SPV to investors. This sounds like routine securitization, but it came with a twist. The investors - insurance companies and other banks, mainly - didn't get to own the loans, which remained on Morgan's books; they merely agreed to take on the risk of Morgan's borrowers defaulting.

In return, Morgan agreed to pay them what were effectively insurance premiums. As long as the borrowers kept making their interest and principal payments, the investors would receive a steady stream of income - some $700 m a year in total. But if some of the borrowers defaulted, the owners of the SPV stood to make up the full value of the loans. These mutual obligations were defined in legal agreements, which were called CDS.

The deal accomplished several things : it removed $9.7 bn in credit risks from Morgan's balance sheet, freeing up capital the firmm could use elsewhere; it transferred these risks to other financial institutions that had more of an appetite for them; and it created securities that could be traded, this allowing investors to get exposure to an asset class - bank loans - that they had previously been excluded from."

Update 1
It is widely acknowledged that unregulated, over-the-counter (OTC) derivatives like an option to buy a stock in the future at a fixed price set today and credit-default swaps (a form of insurance against the future default of a bond) played a critical role in the sub-prime bubble. Now Goldman's CEO Lloyd Blankfein has himself acknowledged the need to regulate them by standardizing the contracts and making them trade in exchanges.

William Cohan has a nice account of how Goldman Sachs made massive money by betting against the sub-prime mortgages, while AIG lost money betting against sub-prime mortgages falling.

Update 2 (6/11/2011)

Citigroup sold securities to investors and then turned around and shorted these same securities. The bank not only believed the securities would decline in value, but it actually spent its own money to make money off the terrible product it had sold to customers. The transaction involved a $1 billion portfolio of mortgage-related investments, many of which were handpicked for the portfolio by Citigroup without telling investors of its role or that it had made bets that the investments would fall in value. Bruce Judson has call it a classic swindle.

The SEC recently announced a $285 million dollar civil settlement with Citigroup involving both compensating the victims and penalizing the firm.

The unfortunate aspect of this settlement was the relatively light nature of the punishment given to Citigroup despite this malafide transaction being clearly established. The $95 mn fine is a relative pittance for Citigroup, whose Q3 2011 profits are estimated to be $3.8 bn. As Judson writes, "these settlements have become simply a "cost of doing business" for our increasingly monopolized financial sector and are unlikely to impact its behavior".

China and the "capacity glut"

Ben Bernanke famously attributed the global macroeconomic imbalances of the last fifteen years to a global "savings glut" whose fountainhead was China. The most damaging consequence of this "savings glut" was the sub-prime bubble in Wall Street. A less discussed, hitherto benign, result has been a massive "capacity glut" in the Chinese manufacturing machine. This "capacity glut" has been facilitated by two factors - export and build forex reserves and keep domestic consumption depressed.

Chastened by the events that precipitated the East Asian economic crisis of the late nineties, the Chinese government adopted a single-minded strategy of building up massive foreign exchange reserves by turning the country into the factory of the world and exporting the major share of production. Policies were designed to facilitate manufacturing production - tax and other fiscal concessions, cheap (often free) electricity and water, cheap and unlimited credit, limited licensing and other regulatory restrictions and so on. And all of this was driven by local party bosses, intent on generating GDP growth in their jurisdictions, regardless of how it is achieved.

And enabling this was complementary set of policies that contributed towards incentivizing savings and discouraging domestic consumption. The renminbi was tagged to dollar and aggressive exchange rate interventions to keep currency under-valued meant that imports stayed expensive. The absence of adequate health care, pensionary, and social safety nets, especially for the armies of people laid off from the old state owned units and who subsequently found work in the town and village enterprises, have meant that people have little choice but to save for the rainy day. The result was the lowest private consumption rate (35%) and one of the highest savings rate among all major economies.

The global economic recession has left the export market weak and the Chinese domestic market unwilling or unable to step in, amplifying the "capacity glut". And Mark DeWeaver has this to write about the results of the dramatic capacity explosion

"Mao’s dream of catching up with the rest of the world has been realized, albeit a bit behind schedule, not only in steel making, where annual capacity has reached 660 million tons, but in many other sectors as well. In 2008, China ranked first in steel (about half of world production), cement (also about half), aluminum (about 40%), and glass (31%)... The country topped the US in auto production in 2009, and remains second only to South Korea in shipbuilding, with 36% of global capacity...

Based on the National Development and Reform Commission (NDRC) figures, 2008 capacity utilization rates were just 76% for steel, 75% for cement, 73% for aluminum, 88% for flat glass, 40% for methanol, and 20% for poly-crystalline silicon (a key raw material for solar cells). The current project pipeline also implies less than 50% utilization for wind-power equipment manufacturers in 2010...

If simply leading the world in output is the goal, the Chairman’s vision has been resoundingly vindicated. But if product quality, environmental protection, and economic efficiency are important as well, this state of affairs is little short of nightmarish."

And to compound the problem, the conventional solution of addressing this excess capacity by shutting down production has become a political hot potato given the strong support these firms and investments have from the local party bosses and the large numbers of people they employ. The result is that even these aforementioned capacity utilization rates understates the true magnitude of the problem.

Nudge, not legislate, voter turnout!

The Gujarat government have recently passed a legislation making voting in local government elections compulsory. If the voter fails to vote for the reasons other than prescribed in the rules, he may be declared a "defaulter voter" and would face consequences for which rules will be framed and approved in due course.

Mandatory voting is sure to raise opposition among liberals who reject it as being against the fundamental values of democracy itself. Further, on the implementation side, there are far too many imponderables that can come in the way of enforcement of any rules that seek to punish "defaulter voters". Further, apart from increasing awareness, there may be other effective means of mobilizing voter turnout, especially in low turnout urban areas, like "nudging" people to vote.

In this context, research into randomized experiments to increase voter turnout conducted during the 2006 US mid-term elections and 2005 German federal elections by Daniel G. Goldstein, Kosuke Imai, Anja S. Göritz, and Peter M. Gollwitzer carry great relevance. They conducted two experiments - a mere measurement treatment (asking people if they intend to vote, thus causing them to reflect on their intentions) and an implementation intentions treatment (asking people how they intend to cast their vote, thus making them plan) - and examined the outcomes for both one-shot goals (e.g., voting on Election Day) and open-ended goals (e.g., voting early or by post) with deadlines in either days or months in the future.

They found that "mere measurement increased voter turnout for open-ended goals and for proximal one-shot goals but not for distant one-shot goals. Implementation intentions increased voter turnout for both open-ended and one-shot goals in the near and long term." Therefore, when elections are just around the corner, or when open-ended early-voting options exist, the mere measurement treatment can nudge people to vote in larger numbers.

The Nudges blog points to voter mobilization techniques involving randomly sending letters, airing radio and print advertisements, phoning homes, or sending canvassers door-to-door making personal pitches, all of which seek to "nudge" voters into actually casting their votes. It was found that mobilization techniques involving direct contact (as opposed to the impersonal channels of phones, e-mails and advertisements), like sending volunteers to remind voters about the vote next day, is effective in significantly increasing voter turnout. In fact, research by Betsy Sinclair et al based on experiments conducted in 2006 Californian elections, have found that voter turnout increases more (by more than 9 percentage points) if you send a neighbor instead of a stranger to someone’s house.

Instead of taking the extreme step of making voting legally compulsory, governments interested in addressing the voter turnout issue may be better off "nudging" than "legislating" voters to cast their votes. During the last elections in India some of these were tried out, though they were of the impersonal mass outreach variant. In fact, such techniques are more likely to be effective in local government elections. Residential Welfare Associations (RWAs) and other local volunteers may be mobilized to remind voters about their voting responsibility, say two days before the voting, so as to avoid infringing with the restrictions on campaigning that come into effect 48 hours before close of polling.

Techniques that use the "mere measurement treatment" would also avoid controversies over covert campaigning (using this nudge experiment to campaign) and can be tried out in urban areas, which have the lowest voter turnout and where subversion of these campaigns are least likely. Further, people in these areas are more likely to respond to these signals given the higher level of "peer pressure effect" within communities. So maybe, it is time that NGOs and public interest organization take a leaf out of the aforementioned studies and recruit community volunteers to "nudge" people into voting, and thereby prevent the need to have such compulsory voting legislations.

Update 1 (3/11/2010)

Excellent summary of the nudge techniques being adopted by political parties in the US to get people to turnout for voting. A study by Yale professors Alan Gerber and Donald Green during the 1998 elections split 30,000 New Haven voters into four groups - some received an oversize postcard encouraging them to vote, others the same message via a phone call or in-person visit, and the control group received no contact whatsoever. The in-person canvass yielded turnout 9.8 percent higher than for voters who were not contacted. Each piece of mail led to a turnout increase of only 0.6 percent. Telephone calls, Gerber and Green concluded, had no effect at all.

Capitalist public administration

Sauvik Chakraverti has a provocative op-ed in the Mint which claims that India’s bureaucracy is wasteful and cumbersome and advocates a "truly capitalist public administration" ("government comprised of magistrates, policemen, judges, jailors and hangmen—nothing more"). While not holding a brief for Indian bureaucracy and even being sympathetic to the accusation, the solution advocated is at best ignorant and at worst dangerous.

Apart from the highly simplified, to the extent of being obtuse, ideological position articulated, there is a shocking level of (wilful) ignorance about the application of abstract concepts like "new public management" to our context. Take the example of the "capitalist administration" of garbage collection, steered by "just one civic official" and "rowed" by the market, to replace the "department with many rungs, recruits thousands of sweepers, buys hundreds of trucks", with its "very big jharoo tender".

"We in India, too, face a spiralling government deficit. In all our cities and towns, huge bureaucracies have been set up which contribute nothing towards improving our lives or our urban environs. These must be sacked and the system of government service delivery drastically reformed. Further, if we save money by contracting out garbage collection, we will have more left over for building roads. In my book, roads and garbage collection must be top priority for all urban local governments — and both must be provided non-bureaucratically."

The underlying assumptions in this arguement include

1. Urban bureaucracies are grossly inefficient and contribute little or nothing towards improving our lives
2. Huge amounts are being squandered by urban local bodies (and their bureaucracies) that is adding to the government deficit
3. Contracting out garbage collection is more efficient and effective than done by government
4. There are private contractors with adequate capacity to step into the shoes of the "department" and collect garbage.
5. That private contractors can do garbage collection cheaper than the "department"
6. That there are piles of money to be saved, which can be used to build roads

The reality is that most of our cities are run on shoe-string budgets, relying predominantly on property taxes and user charges (both lightly levied). India stands alone among major countries where urban local bodies do not get a meaningful share (in some states it is nothing) of the direct and indirect taxes collected by state and central governments. Urban local bodies, except in the metros (and here too small in proportion), receive hardly anything from the "government", to contribute to the "government deficit". And talking about deficits, if only our debt-averse local bodies could actually get themselves to borrow more (and of course the debt market to have the depth to supply the credit)!

About private contractors, one only needs to look at the litter of failed experiments, across cities, with civic services contracting (garbage collection, street-lighting, water and sewerage treatment facilities etc) to realize the shallowness of the "market". The perception that private contractors can do the same service, with better quality, cheaper than government is one of the most enduring fictions in the privatization folklore. For some practical evidence of such "market" interventions, see this, this, this and this.

Apart from all the aforementioned substantive problems, these canards do considerable dis-service to the final objective - efficient and cost-effective delivery of quality public services. Here are just two examples.

One, the perception that urban local bodies (or government "departments") are wasting massive financial resources, which can be saved to finance other activities, is oft-used by many (fiscally constrained) state governments to deny cash-strapped urban local bodies even the the meager resources committed under the Finance Commission recommendations. The slogan is - cut down expenditures and save money to increase revenues! People just don't seem to realize that delivering quality civic services costs handsome money, which has to come from both much higher user charges and share of taxes.

Second, the arguement that we can dramatically transform civic services in our cities by pulling out the "department" and bringing in private contractors is also fraught with dangerous implications. Given the serious problem of supply-side constraints associated with private contracting of works and services, it is only inevitable that there are failures and bad experiences (more failure than sccesses, atleast in the initial years) with outsourcing and privatization, which ends up discrediting the process itself. We need to look no further than the controversial water privatization in Cochamamba, Bolivia (or water supply O&M by Delhi Jal Board and electricity distribution franchising in Orissa) that put privatization on the backfoot and ended up becoming a rallying symbol for opposition.

And finally, Sauvik's priorities, garbage collection and roads, are at odds with the priorities of just about any civic specialist (not just officials and public representatives) which are water and sewerage, along with solid waste treatment. Incidentally, roads, though very important, come much later, so much so that the Government of India refuses to sanction road works under the JNNURM.

None of this is to decry private participation in urban civic services (regular readers of this blog will appreciate its position on the debate!). Nor is it a defense of the department. This is only a note of caution against embracing attractive ideological shibboleths ("city managers using NPM")that grossly simplify the complex challenge of delivering public services in extremely challenging environments with scarce resources. We need "practical public administration" and not "capitalist public administration".

Are MFIs and moneylenders complements?

Marginal Revolution draws attention to a WSJ article that appears to indicate an increase in traditional money lenders even in areas with heavy concentration of microfinance activity.

The RBI has reported that the number of registered traditional moneylenders increased 56% to 19,627 from 12,601 between 1995 and 2006. Another survey has estimated that the traditional moneylenders' share of total rural Indian household debt grew to 29.6% from 17.5% since the nineties when microfinance movement took-off.

Interestingly, WSJ sees moneylenders and microloans as complementing each other, in so far as SHG members may be drawing on moneylenders to help them keep their repayment deadlines and avoid the very powerful peer embarassment. The argue that since moneylenders may actually be helping SHG members repay their microloans in time, atleast some of the MFIs may have been bankrolled by moneylenders themselves. In this paradigm, moneylenders and MFI are some form of complementary services! Econ 101 defines two goods or services as complementary when they are bought and used together, the demand for one mirrors that for the other and vice-versa.

Speculating about the growth of moneylenders, as evidenced in the aforementioned figures, there are a few silver-linings -

1. It is possible that the proliferation of MFIs has forced moneylenders out into the open and made them register their activities. In other words, the growth of MFIs has generated a positive externality - competitive pressure on moneylenders to become more efficient (and thereby access formal sources of funding mechanisms) and transparent. Further, to the extent that older moneylenders are now getting themselves registered, the true numbers of newly enterant moneylenders may be exaggerated.

2. Even assuming that the numbers of moneylenders have been increasing, it may only underline the severe credit stress faced in rural India. One indication of this is the fact that official figures show the rate of banking credit and deposit growth as being much higher in villages than cities. A recent article in Businessline estimated the appetite for microfinance at about Rs 1.30-lakh crore a year, whereas microfinance disbursements were about Rs 28,000 crore in 2008-09.

In other words, thanks to the increasing penetration of economic growth into villages, the rural credit demand may be rising at a rate faster than what both the banks and MFIs are able to meet. And moneylenders may be only stepping in to fill in the vacuum. So we should be having more aggressive outreach of microfinance. It is also one of the most important arguements in favor of banking access and strategies like Total FInancial Inclusion (TFI).

Copenhagen agreement

It was naive to expect that a high-profile climate change summit at Copenhagen would have resulted in any quantifiable and binding emission reduction targets for two simple reasons. The costs of reduction are substantial, salient, and immediate, whereas the benefits (while substantial) are intangible, diffuse and long-term. Behavioural psychologists have a classic application of prospect theory - small and intangible benefits Vs moderate and tangible costs. More fundamentally, for the political masters, the costs are suicidal (or atleast result in losing votes) while benefits are not going to win votes.

After nearly two weeks of acrimonious discussions, the representatives of nearly 200 member nations finally cobbled up a non-binding Copenhagen Accord on climate change. The Accord, which does not contain specific emission reduction targets, sets the goal of limiting the global temperature rise to 2 degrees Celsius above pre-industrial levels by 2050.



The Accord does not firmly commit the industrialized nations or the developing nations to firm targets for midterm or long-term greenhouse gas emissions reductions, and only codifies the commitments of individual nations to act on their own to tackle global warming. It provides a system for international monitoring and reporting progress toward those national pollution-reduction goals,and also calls for hundreds of billions of dollars to flow from wealthy nations to those countries most vulnerable to a changing climate.

One thing though is of great relevance. Given the weight pulled by the big emerging economies led by China, India and Brazil, the Copenhagen summit may be a bellwether of the future of multi-lateral negotiations in other areas (trade, capital flows and financial market regulation, arms trade, nuclear proliferation, labor flows etc). This also means India should be willing to assume the greater responsibility of not just blocking (or appearing to) unfavorable multi-lateral agreements on moralistic grounds, but pro-actively craft out negotiating positions (say, draft agreement alternatives) that protect our interests while keeping in mind the larger objective of such agreements.

"Paradox of toil"

One of the most interesting policy debates during the current recession has been over the most effective fiscal policy options to combat the situation. Broadly, the divide has been over which of the two types of policy alternatives - tax cuts and direct spending measures - is superior.

Supporters of tax cuts claim that tax cuts increases the disposable incomes in the hands of individuals and firms and thereby incentivizes them to consume and invest, and is therefore the least distortionary of options. They also point to the relative ease of implementing tax cuts against the well knwn lags in direct spending measures.

However, the supporters of tax cuts may have overlooked the fact that while tax cuts may be an effective (even the better) policy during a normal recession, it may not be an appropriate remedy for the present times. The current recession is exacerbated by the zero-bound induced liquidity trap, which sets in motion a set of rational expectations that are likely to end up perversely affecting indirect measures like tax cuts. In view of the fact that recessions which come along with a zero-bound in interest rates are very rare (the only major such recession being the one faced by Japan at the turn of the century), all available literature examine only the regular economic contractions.

Paul Krugman points attention to a paper by Gauti Eggertsson that examines the types of fiscal policies that are effective at zero interest rates and finds that direct spending policies score over tax cuts. Eggertsson's model finds that when the economy is facing the zero-bound (liquidity trap), tax cuts, on both capital and labor incomes, are contractionary and deflationary spiral takes hold.

Standard New Keynesian models have long argued that when an economy is faced with liquidity trap, tax cuts on capital income unleashes rational expectations that encourages people to save the additional income instead of investing it - paradox of thrift. In Eggertsson's model, cutting taxes on labor income expands labor supply, and puts downward pressure on wages. The resultant deflationary expectations increases the real interest rates and lowers both output and employment. A "paradox of toil" is the result!

Fundamentally, at zero-bound, the economy faces insufficient demand and therefore only fiscal policies that directly stimulate aggregate demand can succeed. Such policies include a temporary increase in government spending and tax cuts aimed directly at stimulating aggregate demand rather than aggregate supply (such as an investment tax credit or a cut in sales taxes). Greg Mankiw recently advocated investment tax credits to incetivize businesses to invest.

The contractionary effect of tax cuts is understandable given the fact that they have no direct effect on consumption spending and investment. The labor and capital income tax cuts increases the supply of disposable incomes in the hands of individuals and businesses respectively, incomes which they can either save, use to pay off debts, or spend/invest. In the prevailing conditions - deflationary and recessionary - both consumers and businesses are more likely to either save or pay off debts, than spend or invest.

Eggertsson's verdict on the debate is fairly conclusive,

"Policy makers today should view with some skepticism empirical evidence on the effect of tax cuts or government spending based on post-WWII US data. The number of these studies is high, and they are frequently cited in the current debate. The model presented here, which has by now become a workhorse model in macroeconomics, predicts that the effect of tax cuts and government spending is fundamentally different at zero nominal interest rates than under normal circumstances."

See also Casey Mulligan's take on the "paradox of toil", one that again ignores the specific circumstances.