Archive for December 15th, 2008

Housing Market continues to increase prices

December 15, 2008

I don’t understand this hue and cry which real estate companies have been making. They show as if skies are falling for them, but refuse to make any changes in their practices and prices. If any company (or a set of companies) is (are) in trouble and are not able to sell their products, the obvious choice is to incentivise prospective customers. However, such things don’t apply to real estate industry. They drove irrational exuberance and want to continue to live by it (see this article on DLF and Unitech practices by Mint and a primer on economics of home buying in mumbai).

I happened to visit the recent property exhibition at Navi Mumbai by Builders Association of Navi Mumbai and was visibly disappointed. The builders continue to increase prices of properties compared to previous exhibition in 2007. Some seemed to have learnt lessons but are passing off cheap discounts as say 10% off, stamp-duty off etc. This is trivial stuff as the real thing- property prices continue to be high. And despite the government notice to sell property on basis of carpet area, one still has to pay 30%-40% as the super built-up area ( see the explanation here

Now, it is demand and supply basics. They could pass-off these higher prices pre-crisis but if they want to sell off now, they have to lower prices. Why? because there is weak demand.

First, home loans are coming at a higher interest rate. Though banks have lowered rates for houses less than 20 lakhs, there are hardly any houses available for that amount in Mumbai (and I would guess the same for other metros)

Second, people don’t have the kind of incomes they had. Most of  this home buying was driven by people in growth sectors- IT, Finance etc and these sectors don;t have the kind of growth.

Three, people can see now the bubble has been burst with real estate companies losing so much value on stock indices. Financial markets are lead indicators of further trouble to come.

Fourth, the easy money phase is over with foreign money and domestic money drying up. Liquidity may be much better now, but people are wary going forward.

And despite all the trouble no decline in prices.  I have been seeing news channels, reading papers etc on housing markets  and all say the same- hardly any change in prices. I was hearing a radio station where someone from the real estate industry himself said the industry has been thriving on excessive profits for past 4-5 years and that phase seems to be over. However, nothing is being seen in change in prices.

I agree this industry employs large number of people and needs support. But you support an industry which is willing to change as per economics of the situation. All this help from RBI and Government is not going to lead to demand as prices are still too high. And once you include practices (there is just too much information asymmetry between a builder and a buyer, see this), you know the buyer is being taken for a ride.

This is actually a great time to reform the industry and its practices. But there seems to be no effort on this front. What one gets instead is bailouts and cries from the industry.

A nice article on hedge funds

December 15, 2008

Donald MacKenzie has written a nice article on hedge fund industry- practices, strategies and problems. Read the Volkswagon case-study:

Situations in which many hedge funds have similar or identical positions are called ‘consensus trades’ or ‘crowded trades’. Every so often these cause sudden, huge movements in prices that have little or no basis in economic fundamentals such as the prospects for the firm, sector or country at issue.

In the last week of October, for example, Volkswagen briefly became the world’s most valuable company by market capitalisation, but not because investors were suddenly struck by how attractive its cars were or by optimism about the prospects of the motor industry. Rather, a consensus trade had gone disastrously wrong. Volkswagen’s ordinary shares had started 2008 half as expensive again as its preference shares, and the difference had soared during the year.

The holders of preference shares can’t take part in shareholder votes, and they receive a fixed rate of interest rather than the fluctuating dividends offered by ordinary shares, but both kinds of share are stakes in the same firm, and it seemed reasonable to conclude that the growing difference between their prices was an anomaly that would correct itself. So a large number of hedge funds – some say as many as a hundred – bought Volkswagen’s preference shares and short sold its ordinary shares. These matched long and short positions meant that the funds were insulated from overall fluctuations in the company’s fortunes: it ‘was meant to be a low-risk trade’, as one London fund manager told the Financial Times.

Unfortunately, Porsche, which already owns 42.6 per cent of Volkswagen’s ordinary shares, had quietly been increasing its stake by buying call options (a call option is a contract that gives you the right to buy an asset at a fixed price). If it turns all those options into Volkswagen shares, Porsche will own 74.1 per cent of them; the government of Lower Saxony owns a further 20.2 per cent that it’s very unlikely to sell. That would leave only 5.7 per cent of Volkswagen’s ordinary shares available to be traded on the market. However, hedge funds and other traders had between them short sold shares equivalent to 12.9 per cent of the total, and in consequence were obliged to buy and return them. They understandably panicked, and the resultant frantic efforts to buy Volkswagen shares caused the price to quadruple.

Literature Survey on managing capital flows

December 15, 2008

Masahiro Kawai and Shinji Takagi of ADB Institute have produced a gem of a paperon capital flows and its management. Though it is a literature survey and is bound to have references, this one is very rich and all in just 15 pages. There is not much to say as far asn analysis goes, so would just paste the abstract for interested readers: 

How to manage capital inflows remains an important policy issue for many emerging market economies. This paper presents a brief survey of the literature on managing capital inflows, with a focus on developing and emerging market economies. The paper, after discussing the economic characteristics of capital inflows, provides an overview of the evolution of thinking on capital account liberalization, the use of capital controls as an instrument of managing capital inflows, and the effectiveness and limitations of conventional macroeconomic and structural instruments. Although the literature is still evolving, it provides little practical guidance on capital account liberalization. For those countries facing a surge in capital inflows, consensus seems to be that, aside from learning to live with an appreciating (and fluctuating) currency, and strengthening the financial system, there is no effective and sustainable policy measure either to reduce the size of inflows or to prevent the adverse consequence of such inflows. Additional work is especially needed to develop tools to identify and quantify the various risks of capital inflows.

Get ready for increased reports on financial frauds now

December 15, 2008

I have been waiting for this type of news to come. With crisis this deep and huge financial flows pre-crisis, financial frauds is something natural to expect. The events of financial fraud have begun to roll now.

Portfolio points 3 cases of frauds have been reported:

First, we witnessed the New York lawyer Marc Dreier being arrested after impersonating another lawyerin what has to be one of the most bizarre and fascinatingfraud cases in recent history. Charged with swindling hedge funds out of hundreds of millions of dollars, Dreier was denied bail on Thursday after prosecutors called him “an enormous risk of flight.”

Then we had Chicago. Oh, Chicago, your corrupt politicians never cease to captivate the country! Governor Rod Blagojevich was chargedwith brazenly soliciting bribes in his quest to fill the Senate seat vacated by President-elect Barack Obama.

And now, we have Bernie Madoff. The president of Bernard L. Madoff Investment Securities, the 70-year-old Wall Street trader was arrested by the F.B.I. and charged with securities fraud late Thursday. The fraud allegedly totaled over $20 billion.

Here is the Dreir story from NYT which is slightly more complex with issuance of fake promissory notes. What was SEC doing?

Madoff was a classic case of ponzy scheme which is reporetd to have swindled about USD 50 billion from investors. For details see NYT , WSJ, Marketwatch. I liked this from

Mr. Madoff, 70 years old, allegedly told employees he had a couple of hundred million dollars left and wanted to distribute it before turning himself in to authorities, this person said.You read that right. When the boss comes in and says “Take your bonus now before the Feds get it instead,” you know something is amiss. 

What amazes me is that both Madoff and Dreir managed to swindle not just ignorant public (which is expected to be financially literate) but suave hedge fund investors (Madoff in particular) and managers (Dreir in particular).  In Madoff’s case:

Most Ponzischemes collapse relatively quickly, but there is fragmentary evidence that Mr. Madoff’s scheme may have lasted for years or even decades. A Boston whistle-blower has claimed that he tried to alert the S.E.C. to the scheme as early as 1999, and the weekly newspaper Barron’s raised questions about Mr. Madoff’s returns and strategy in 2001, although it did not accuse him of wrongdoing.

Investors may have been duped because Mr. Madoff  sent detailed brokerage statements to investors whose money he managed, sometimes reporting hundreds of individual stock trades per month. Investors who asked for their money back could have it returned within days. And while typical Ponzi schemes promise very high returns, Mr. Madoff’s promised returns were relatively realistic — about 10 percent a year — though they were unrealistically steady.

This reminds of the classic paper by Dean Foster and Peyton Young who show how difficult it is to differentiate between a genuine fund manager and a con one. They also show how easily a con fund manager can show him to be a genuine one. The paper looks at more sophisticated strategies that con managers can use, Madoff shows it is a lot easier.  

Assorted Links

December 15, 2008

1. Krugman analyses the need for European coordination

2. WSJ Blog points ECB trying to start bank lending

3. Mankiw points to a cartoon on financial engineering

4. CTB points trade is falling

5. Econbrowser pointsto a new paper from John Taylor who criticises Fed for the crisis

6. ASB on financial fraud. MR has some points as well

7. JRV on financial limitations

8. ACB points to 2 Krugman secrets


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