Raghu Rajan analyses subprime crisis

I came across this speech from Raghuram Rajan where he talks about the subprime crisis. The speech is very similar to the various “Why subprime happened” research papers and speeches.

However, the speech covers a very important aspect of the crisis- Why did so many high profile, well educated investment managers take such huge exposures to the subprime mortgages?

The answer is:

Shareholders in any asset management firm are unlikely to pay the manager much for returns from beta risk – for example, if the shareholder wants exposure to large traded U.S. stocks, she can get the returns associated with that risk simply by investing in the Vanguard S&P 500 index fund, for which she pays a fraction of a percent in fees. What the shareholder will really pay for is if the manager beats the S&P 500 index regularly, that is, generates excess returns while not taking more risk.

Hence, most of these fund managers took the risk in search for higher alpha and the as risk was hidden behind faulty ratings, he managed to get higher rewards for his alpha (which wasn’t really alpha as there was high risk). I liked this para:

I buy the AAA tranche of a CDO, not because I am confused by the rating, but because I am selling a deep, out of the money put option, which will give me a steady return most of the time, but default with serious adverse consequences occasionally. By the time it defaults, I have hopefully made my money and am enjoying my own private beach in the Bahamas. A number of managers including Stan O Neill of Merrill Lynch did generate higher returns for their firms for some time, but alas we now realize it was hidden risk. Of course, his parting compensation did nothing to dissuade the rest of the flock from following his example in the future.

And his suggestion:

The broader point I am making is that we need to think about incentives of financial market participants as an important factor in the current crisis. How to improve those incentives will, no doubt, be an important issue for discussion in the years to come.

The speech was given on December 17, 2007 and Raghu Rajan has since then written a similar and popularly discussed  article for FT. 

This issue over restructuring incentive system in financial sector is being discussed widely. For instance, read Martin Wolf’s excellent article on the same.

Is subprime a pseudo or real systemic crisis?

I came across this paper from Michael Bordo et al which could be used to answer the most important question/debate going around- Is subprime crisis going to result in a recession in US economy? It says:

A true financial crisis is a banking panic or a stock market crash, where depositors and investors fear that means of payment will be unobtainable at any price.

Other events including banking panics and stock market crashes are really pseudo crisis. These include, deflations, disinflations, distress of large non-financial firms, abrupt declines in asset prices and speculative attacks on fixed exchange rate regimes.. All these events represent losses of wealth in particular sectors of economy, but none involve a scramble for high powered money , the hallmark of a real financial crisis

The paper looks at past crises and classifies them into pseudo and real crisis. Like 1987 crisis was more pseudo than real.

How about subprime? We need to wait for more data to call it a real crisis. We can’t call it pseudo either as it did lead to freezing of the payment system and Central banks had to provide huge liquidity to stabilise the system.

Addendum (19 Mar 2008):

This crisis looked like a pseudo crisis earlier but is now a real one.

More lessons from subprime crisis

I posted a while back on lessons from subprime crisis from Stephen Ceccheetti. Here is another superb analysis from Willem Buiter.

It is fairly detailed analysis and a must read. He divides his analysis into microeconomic and macroeconomic pathologies that contributed to the crisis. I also liked his way of calling solutions to the problem as ‘partial solutions’. As no one is really sure how far this crisis is going to go, it is better to be conservative and suggest what could be tentative solutions.

Highly recommended.

Assorted Links

1. WSJ Blog asks – How deep a downturn is this?

2. Fin Prof points to a primer on ETFs. 

3. Ajay Shah on the private treaties controversy.

4. TTR on importance of looking at earnings growth

5. Mythili Bhushnurmath reviews RBI’s policies.

Marty Feldstein becomes Frederick Forsyth

MR pointed to this paper from Martin Feldstein.

The paper is titled ‘Designing Institutions to Deal with Terrorism in the United States’ and is a primer on how UK and US have dealt with terrorism till now.He says how UK ‘s intelligence institutions are more apt to deal with terrorism than the US. The reason is the way the institutions were built initially.

Until the attacks in Britain by the radical Islamists, the MI5 had concentrated in recent decades on the activities of the Irish separatists while the MI6 dealt with foreign powers, primarily the Soviet Union and the affiliated communist organizations in other countries. The primary job of these intelligence services was and is still to understand the activities and plans of potential terrorists by infiltrating the terrorist organizations and the communities from which they come and by recruiting others to report on these groups. These forms of direct human intelligence gathering are supplemented by electronic surveillance and other forms of acquiring information. An important activity of these intelligence services is to analyze the information gathered in these ways in order to anticipate specific terrorist acts and to develop ways of reducing all terrorist activities and terrorist recruiting. Although the MI5 does not have “police powers” of arrest, it collaborates with the British police authorities (Scotland Yard) when such arrests are needed.

 So all it needed was a shift of focus of MI5 to Islamist section of the population and of MI6 to Pakistan where British terrorists are trained.

However, both FBI and CIA needed many changes to tackle terrorism. Read the paper for details.It is a nice way to bring an institutional perspective to the problem.

On reading the paper, I was taken back to the novels of the revered terrorism fiction author- Frederick Forsyth. Forsyth also explained the role of various intelligence agencies in a pretty detailed manner and most of his novels (barring the latest, The Afghan) were superb. Apart from this, Forsyth’s novels mostly had a British agent helping restore order

Update: Feldstein seems to be quite interested in the topic of terrorism and institutions related to it. Here is another piece from him

Assorted Links

1. WSJ Blog has a FAQ on recession.

2. WSJ Blog says Fed hawks falling in line with Bernanke.

3. Mankiw points to an article on what helps in recessions, Blinder’s paper on fiscal stimulus and he has a questionfor FOMC.

4. Justin Lin has become the Chief Economist at World Bank. MR has an  interesting post. Rodrik gives his view

5. Econbrowser gives more views on fiscal stimulus

6. New Economist on UK’s super rich. It points to a new paperwhich tests growth theory in OECD using Solow and Lucas theories.

7. JRV offersmore advice on restricting bonuses in Financial Sector. TTR also on the same

Review of Indian economy 2007-08

Economic Advisory Council has released its review of Indian Economy (2007-08) . Its outlook for the year (2007-08) is here.

The review is the latest report on Indian economy. Most newspapers have covered the review: ET, BS, BL, Mint

I haven’t read the report and I will post if I  find anything interesting.

Update: My disappointment with EAC continues. The report is routeine suff and there is hardly any great analysis one could look at. Like it talks about decoupling/recoupling theory indirectly, it could have done some analysis how much would the impact likely to be. I know future of subprime itself is not clear but some models could have been extrapolated.

Similarly, it says exporters who have been competitive have been able to fight the rupee appreciation. It would have been helpful to know how much rupee appreciation has impacted etc.

Then it talks about inflation and possible rise if oil prices are revised upwards but doesn’t really give any idea on how much oil price hike would impact inflation etc.

I mean there are many questions in Indian economy which needs to be answered but we cannot because of unavailaability of data and expertise on analysing data. With such good economists on the panel having access to all kinds of data, one should get more ideas.

Assorted Links

1. Bernanke gave a testimony y’day before the Committee on the Budget, U.S. House of Representatives. Here is the summary and economists’ reactions. Bernanke seems to have also shown interest in some fiscal stimulus,though hasn’t indicated what type.

However, Econbrowser has an alternative view

2. After Possner, Lacker, Bernanke, 2 more join the “rising inflation is a concern” – Fisher (of Dallas Fed) and Sandra Pianalto (of Cleveland Fed). Despite this we are mostly sure to see rate cuts in next FOMC meeting on 29-30 Jan.

3. A nice humour by WSJ Blog – Bernanke as CEO.

4. Rodrik points to an article on how Ireland achieves its growth.

5. MR pointsto this article on WhyIndia lags behind China? 

6. JRV points to the latest US Supreme court decision.

7. Ajay Shah points cut rates now.

8. TCA proposes a solution for PHDs which must be applied immediately.

9. Martin Wolf has an excellent article on restraining bankers’ pay. It is high time to do something abt the crazy salaries and severence pays. I often wonder why would someone work when he knows his non-performance pay is going to be so high.

Indian Cricket: pre and post Sunil Gavaskar

As the Perth test unfolds,  Indian team tries another attempt to have a new opening batting partnership that of Wasim Jaffer and Virender Sehwag. And as usual, it has not worked.

Since 1987, when Sunil Gavaskar retired India has had trouble with opening batsman. Numerous combinations have been tried- 2 specialist openers,  specialist opener with a middle order batsman, specialist opener with a wicketkeeper etc. But nothing has really worked except is short phases.

The problem has been acute especially when we travel overseas where ball swings and comes at a good pace. Hence, we have poor records overseas. The situation improved lately when our middle order sustained the pressure and Sehwag performed well at top.  But then, with the calibur of India’s middle order, we should have won or atleast drawn more matches.

Now, all this is pure hypothetical stuff based on viewing cricket for a long time. So I decided to check with facts. Here is the summary (Thanks to cricinfo for providing such a useful database):

Before Gavaskar		% of played
Played	117
Won	15	12.8
Lost	49	41.9
Draw	53	45.3
During Gavaskar
Played	129
Won	25	19.4
Lost	35	27.1
Draw	68	52.7
Tie	1	0.8
After Gavaskar
Played	167
Won	52	31.1
Lost	49	29.3
Draw	66	39.5

My hypothesis is not really wrong and it shows that both number of draws and wins increased in Gavaskar’s time and since then things have detriorated quite a bit. This is actually not a bad thing at all. India did not have pace bowlers (except Kapil Dev, he bowled his heart out) and we needed batsman to save the tests. I don’t mean Gavaskar contributed entirely to the draws but in his time both the winning % and the number of draws increased.

The winning % has improved post Gavaskar but both % of draws and losses have increased. This is exactly what I mentioned above. Given the quality of our middle order, if not wins we should atleast see more draws. But that is not the case.

To win a test match you need to take 20 wickets and I would guess maximum contribution to the winning cause has been made by now Indian captain, Anil Kumble. This piece of statistic just proves my point. He has been an unsung hero for long and the day he retires the loss will be as big (if not less or more) than Gavaskar.

(I know most would be interested in comparing the home record with away record as well. Keep posted. I am working on it.)

Traffic management and financial crisis

While just walking after office for home yesterday I saw a huge traffic mess outside the historic CST railway station. This may not be new to people working in that area in Mumbai but a thought just struck me.

The place has traffic signals but because of some malfunctioning there was a problem. The outcome was everyone trying to jump signals and big confusion. As that road has fair share of traffic, one can imagine the scene.

The result was there weer traffic policemen who were trying to control the situation. However, the number of vehicles were so many that the traffic inspector was struggling to manage the situation. I believe it must have started with one traffic inspector but as situation got worse, more had to come and help the first person.

The situation is quite similar to what we see in financial markets. The traffic signals are like your various risk management techniques (VARs etc) and when things are going on well, all is ok.

However, in case of a disruption in traffic the signs are very similar to the ones in financial markets. (Note the similarity- when lights not working- someone’s risk exposures gone wrong, some vehicle having problems- some financial company having problems etc. )

And just like things become chaotic on a road in times of disruptions, similar is the scenario in financial markets.

And finally, just like when things become too chaotic, we need a traffic policeman to sort out things, similarly we need the central bankers/ policymakers to sort out problems in the financial markets.

This thought also helped me go back to a question I keep asking myself- why economists look at traffic, cars etc. to explain so many things? Answer is it just fits the entire spectrum of things in markets and economy so well.

Here is Bernanke explaining monetary policy and Jeff Frankel explaining financial globalization using very similar analogies.

Assorted Links

1. Econbrower says despite rising inflation, Fed looks more likely to cut rates

 

2. Lawrence Summers has been a big advocate for fiscal stimulus. He testified for the recent JEC hearing on the same. WSJ Blog summarizes Summers’ comments

 

3. MR points to a long article on Bernanke regime. WSJ Blog has a brief summary of the article

 

4. The latest beige book shows that only New York, Richmond and Dallas reported slower economies, compared to the previous survey period. Reason – the majority of districts had big increases in tourism, in part because the weak dollar is luring foreign visitors to the U.S.

 

5. WSJ Blog reviewsa paper by one of my favorite economists- Luigi Zingales. The paper says parents’ attitude effects children’s investment behavior.

 

6. Fin Prof points to an article on shareholders vs bondholders

 

7. EPSA blog covers cyclone affected areas in B’Desh

 

8. MR on congestion pricing. Also read how Indian cuisine is getting popular over the years.

 

9.  JRV onSEBI surveillance

A non-technical explanation of technical aspect of monetary policy

Mishkin in his recent speechhas explained the technicalities in monetary policy really well. The speech basically covers that financial disruptions put a strain on the entire economy. So we need better risk management systems to make better monetary policy.

In particular, the standard textbook approach to analyzing optimal monetary policy utilizes a linear-quadratic (LQ) framework, in which the equations describing the dynamic behavior of the economy are linear and the objective function specifying the goals of policy is quadratic. For example, in light of the dual mandate, monetary policy is often characterized as seeking to minimize a loss function comprising the squared value of the inflation gap (that is, actual inflation minus desired inflation) and the squared value of the output gap (that is, actual output minus potential output).

While an LQ framework may provide a reasonable approximation to how monetary policy should operate under fairly normal circumstances, this approach is less likely to be adequate for thinking about monetary policy when the risk of poor economic performance is unusually high.

Reason: black swans

Most of the quantitative studies of optimal monetary policy have also assumed that the shocks hitting the economy have a time-invariant Gaussian distribution, that is, a classical bell curve with symmetric and well-behaved tails. In reality, however, the distribution of shocks hitting the economy is more complex. In some instances, the uncertainty facing the economy is clearly skewed in one direction or another; again, this is likely when there are significant financial disruptions.

So, how should monetary policy respond to these black swan kind of events?

To achieve this result most effectively, monetary policy needs to be timely, decisive, and flexible

Read the speech for further details.

Meanwhile, I was also reading this fiscal stimulus primer(the latest buzzword is to give stimulus to the economy using fiscal policy) by Douglas W. Elmendorf and Jason Furman of Brookings Institution. They say principles are the fiscal stimulus should be timely, targeted and temporary. So first two principles are similar to the one highlighted by Mishkin. The difference is perhaps in the third point where fiscal stimulus should be temporary and monetary policy flexible and change its stance as per market conditions.

Taare Zameen Par lessons

TZP is an exceptional movie by one of the best actors in Indian cinema- Aamir Khan (AK) . He has matured considerably over the years and his “one movie at a time” strategy has worked wonders for the viewers. This time he directs the movie and does a wonderful job.

This blog is not meant to review movies but I thought this movie offers important lessons in economics. In one of the scene in the movie, AK shows his frustration at the fact that every parent in India wants his kids to become doctor/engineer etc. I don’t remember whether he mentions MBA also but we can add it to the list as well.

India has a huge population and we should see varied occupations. However, in India kids often follow a beaten path.

• At school most work extremely hard to get through limited seats available in engineering (read IIT) and medicine. The non-science students who can’t try their hand at Chartered Accountancy
• The left overs go to college (it is a substantial number) and after college most try their luck at MBA (read IIM). (Earlier the fad was to try luck at civil services, now it is MBA).
• The problem becomes extremely difficult to manage as most engineers want to do an MBA. No one seems to be interested in engineering and as a result we have cries of talent shortage in key industries (I however think talent shortage can be managed)

I don’t know whether we are able to see this or not but this trend of everyone wanting to become engineer/MBA/Doctor is going to become a bigger problem. As it is this year about 2,50,000 students gave the CAT exam this year and this number has been increasing everywhere.

The reason is simple- huge (assured?) salaries after the program. Well, I understand the reward theory but this hue and cry over high salaries is insane. We need to maintain a balance and it has clearly broken over the years.

There are elite colleges all over the world and I am yet to come across any other country where so much mention is made of salaries after getting some education. The focus should always be on quality of education and not placements.

I think students already been rewarded by getting education from the best institutes in the country which are gaining credibility over the years. As Bernanke said in his speech – Education is the best investment.

The institutes should have stopped this practice of releasing “how high the salaries were this year” to the media long back. This reduces the pressure on people opting for a career.

The biggest gainer from these developments is the huge increase in cashflows of coaching institutes that help you prepare for these exams. So much so, that private equity has started taking keen interest in this business ! The once laidback coaching places are seeing flurry of activity. There is huge competition in these institutes and you see a lot of ads showcasing their success ratios etc. The media has also ensured the hype only increases. There are many a interviews of the selected candidates in various magazines and news channels.

There is an urgent need to develop and appreciate alternative careers. It just helps development of the society better. There have to be better incentives for someone wanting to become a painter, archaeologist, etc. Most of the students interested in such careers have to opt out because of lack of proper incentives. There have been some efforts lately as we now have fashion designers, sportspersons (read cricketers) etc.

More effort is needed.

Assorted Links

1. Econbrowser has an excellent post on the fsiscal stimulus debate going on in Us economy.  WSJ Blog looks at a CBO report on the same. Mankiw also comments on the CBO plan.

Meanwhile MR points to who has the best fiscal stimuls plan?  

2. Mankiw points to Greenspan-Krugman consensus. I loved his take on forecasting.

3. Rodrik points to an article on how financial firms are using sovereign wealth fund money.

4. WSJ Blog saysBye Bye Bagehot. It also points to Italy’s Mr. Prices.

5. TTR points to an economist article that says China’s economy is not export dependent. The article is here. I have my doubts though.

6. Ajay Shah says fix the price distortions at once. He also  asks whether India is a social secular democratic republic?

Municipal Finance in India

I had posted some days ago on Finance Ministry’s Working paper series.

RBI apart from its usual research which it publishes in its various research reports (monthly bulletins, occasional papers etc) has something called Develeopment Research Group. In this it undertakes research with a focus on policies.

It has just released a report on Municipal Finances in India. This is going to be a good primer on a subject which is not very well understood in India.  The role of municipal bodies is critical in development of the urban locations they are in charge of. The press release summarises the main findings of the report.

Assorted Links

1. WSJ Blog points that Bernanke or Kohn  would address markets once between policy meetings

 

2. Rodrik points to difference between India and China

Arvind Subramanian is a guest blogger on his blog.

  

3. Ajay Shah points to an interesting story on pension assets in Indian securities markets 

4. PSD Blog points to an interview by Mohd. Yunus

5. JRV on credit rating agencies

Is fear of floating same as fear of appreciation?

So far, it has been felt that developing countries have this fear of floating.

Emerging markets have underdeveloped financial systems and don’t have easy access to finance. Hence they borrow abroad and as a result the balance sheets are mostly dollarized. In case there is a crisis, the demand for domestic currency goes down, and it looses value. As a result,the value of liabilities increase and if currencies are allowed to float freely, the impact of crisis could be severe and hence the term “fear of floating”.

This fear came at the time of South East Asian crisis. If you note, the main fear then was depreciation of the currency.

However, what we see these days is the opposite – fear of appreciation. Most emerging markets have managed floating exchange rates and intervene in forex markets to keep their currencies undervalued. They don’t want their currencies to appreciate as it would harm their exports.

Hence we have fear to appreciate. This has been conveyed in an excellent paperby Eduardo Levy-Leyati and Federico Sturzenegger. I was actually surprised why didn’t it strike me before?

More generally, the incentives and implications to intervene in order to avoid an appreciation are radically different from those related to avoiding a depreciation: where the latter focus on short-run financial crises, the former is usually predicated on long-term economic growth. Similarly, the context conducive to one or the other differs: whereas fear of floating would tend to arise in times of financial turmoil, fear of appreciation will likely be triggered by economic bonanzas.At any rate, treating interventions in a symmetric way –in particular, attributing any intervention to fear of floating as has been previously the case in the literature– may lead to overstate the incidence of financial factors –more so in recent years when fear of appreciation appears to have prevailed.

Read the paper for further details.

It has another surprise finding.The normal belief is that undervalued currency should help exports to grow and hence aide growth. In  other words, the growth is export driven. The authors find that exports hardly contribute to the growth and the main channel of growth is that depreciated currency leads to higher savings which are channelised into investments and finally growth.

This study is worth replicating in the Indian context and see the results.

Why is after sales service so poor?

This is one area where Indian companies need to improve drastically. I don’t have the numbers, papers etc to show how  bad they are. It is just based on my experience.

We often have a limited view of our purchasing decisions- How many choices does a consumer have? What is the price of the various products? Whether this is worth buying etc etc.

Why don’t we evaluate the product/service also on the basis of the “after sales service”? The answer is a consumer does not understand the importance of this at the time purchase. At the time of purchase he is most interested in the answers to the questions asked above.

Most companies do suggest that their after sales services are good etc. but it is all a false. They know the only important thing that matters is to push consumers into buying a product and anything else you do is wastage of money. Hence, the standards are extremely poor and one often feels cheated and dejected.

Taking a cue from Western companies most have set up call centres to take not of the complaints and do nothing about it. In the name of corporate governance and other management euphemisms they show their concern for the consumer. But you know all is false.

Some of the practices are so atrocious that one does not know what to do and only realises the same after the purchase of the product. For instance, say you buy a CDMA phone from the store of one of the reputed companies. The moment you let the store staff know you are here to purchase you are greeted really warmly. So you are all happy and after checking the features etc you buy one.

Now if it turns defective and you go to the same store again, you are told that they can’t help. Their logic is that stores simply provide the cellphones and are not responsible for the defects. They ask you to go one of the service centres of the mobile phone maker. If you appeal and say why should you go, well all you get is a ” I don’t care” attitude. So, you end up going to the service centre and you are actually told that you are lucky as the service centre is just nearby !!

There are many such examples. There are hordes of websites where you see consumers showing their dissent against the products and services. With so many products and services, you should expect better service standards, but what you get is the opposite.

Now, all this got me thinking. Why don’t companies improve their standards? Why is more concentration on just sales part of the business. Well the reason is well-known, lack of vibrant consumer courts. They know that not many people approach the consumer courts in India, hence they can continue to ignore the poor service standards. The people don’t approach consumer courts because of corruption related issues. Efforts are being made to increase consumer awareness but it will take sometime.

I was told that US companies lay more emphasis on the “after sales” as that is where most problems are. They may sell a product for 100 USD but if it is defective and the company is sued, they might end up paying many times of 100 USD.

But in India, they can afford to relax as there are bound to be no such problems. If few people even file cases, the cost of improving their services is higher than the compensation given to those few. As a result, the services hardly improve. 

Assorted Links

1. WSJ Blog points Government should spend $ 100 billion to revive US economy 

2. TTR points to World Bank’s latest report on world economy. It talks of soft landing

3. Tyler Cowen on what 4 things economists have learnt in the last year.

4. Rodrik points to new meaures for globalization.

5. Fin Prof is back after a long break and he points that prediction markets aren’t perfect.

6. PSD Blog points to YouTube for ideas

7. Econbrowser on how low will Ben go.  Another excellent articleon how subprime crisis originated.

After Possner and Lacker, Bernanke raises inflation concerns

It is surely going to be interesting times for Fed policymakers in 2008. After Possner and Lacker, Bernanke also revisits rising inflation possibilities in his latest speech:

Even as the outlook for real activity has weakened, there have been some important developments on the inflation front. Most notably, the same increase in oil prices that may be a negative influence on growth is also lifting overall consumer prices and probably putting some upward pressure on core inflation measures as well. Last year, food prices also increased exceptionally rapidly by recent standards, further boosting overall consumer price inflation. Thus far, inflation expectations appear to have remained reasonably well anchored, and pressures on resource utilization have diminished a bit. However, any tendency of inflation expectations to become unmoored or for the Fed’s inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and reduce the central bank’s policy flexibility to counter shortfalls in growth in the future. Accordingly, in the months ahead we will be closely monitoring the inflation situation, particularly as regards inflation expectations.

Keep posted.