Archive for January 6th, 2009

Understanding various Fed measures and difference from Bank of Japan measures

January 6, 2009

Janet Yellen, President of San Francisco Fed, in a recent speech summarises all the measures taken by Fed in response to the crisis.  She explains all the various alphabetical soup programs – TAF, PDCF, TSLF, AMLF, MMIFF etc in a nice simple manner.

Then she explains how Fed policies are similar and different from BoJ. The similarity is:

The main similarity is that the Fed, like the Bank of Japan, has increased the quantity of excess reserves in the banking system well above the minimum level required to push overnight interbank lending rates to the vicinity of zero.

The difference is:

Roughly speaking, the Fed is focused on the potential for targeted programs on the “asset side” of its balance sheet to improve credit flows in specific impaired markets, whereas the Bank of Japan was primarily focused on the potential for an expansion of the total quantity of its liabilities—the excess reserves of the banking system—to spur additional bank lending.

The creation of such a large volume of excess reserves, in the Fed’s case, results from the enormous expansion in the Fed’s discount window lending, foreign exchange swaps, and asset purchases.

And why BoJ policy did not work?

The theory underlying the Bank of Japan’s intervention was that banks might be encouraged to lend by replacing their holdings of short-term government securities with excess cash.

The problem with this idea is that, near the zero bound, short-term government securities and cash are almost perfect substitutes—both are essentially riskless assets that yield a zero or near-zero rate of return; thus, exchanging one for the other should have little effect on banks’ desire to lend.

Indeed, the Japanese experience during their quantitative easing program in the early 2000s suggests that simply expanding excess bank reserves—even by a very large amount—had little effect on bank lending or on the economy more broadly. The policy may have lowered longer-term borrowing rates, however, by symbolizing and highlighting the Bank of Japan’s commitment to fighting deflation by holding its short-term interest rate at zero for an extended time—until deflationary pressures had been convincingly dissipated.

And what lies ahead for Fed?

In contrast, the overall size of assets on the Fed’s balance sheet will be the result of decisions concerning the appropriate scale of each particular program and the extent to which the various programs and facilities are actually used by market participants. The take-up rates on these programs and facilities are likely to fluctuate over time as market conditions change.

She goes on to suggest Fed avoided deflation via its communications in 2003  (a point made here as well) and should be able to avoid it this time as well.`

Some advice for economics and financial forecasters

January 6, 2009

Bruce Bartlett, former Treasury Department economist, in a Forbes article says (HT: Paul Krugman Blog):

Unfortunately, it is in the nature of economic and financial forecasting that being right too soon is insignificantly different from just being wrong. And forecasters that are wrong when most of their community is also wrong never suffer for it. The trick is to be right just a little bit sooner than everyone else–but only a little bit.

:-) I have written quite a few posts on the forecasting business. In particular I like what Bernanke said in his speech (November 14, 2007) :

 The only economic forecast in which I have complete confidence is that the economy will not evolve along the precise path implied by our projections.  Nevertheless, as I have already noted, because policy affects spending and inflation with a lag, Committee members have no choice other than to make medium-term forecasts–provisional and subject to uncertainty though they may be.


Anyways, Bruce Bartlett article summarises the various forecasts (both right and wrong) on the housing crisis. Some people called the crisis as early as 2002 but of course got cold shoulders from Greenspan and Fed. Some people got it completely wrong as they said price rise in housing is because of economic fundamentals (rising income etc). That is why he offers the above quoted advice. Make sure you forecast just before the event breaks through. Timing is as crucial as the value of the forecast.


Barlettt also points that crisis was predicted by quite a few. This again takes me back to the previous post where I said:  I think we should just trash the idea that this crisis was unprecedented and no one could have predicted the set of events. More and more people are adding up.


Increasingly, I have started to believe that it was not  lack of crisis-sayers (yes there is a crisis) but lack of crisis-believers (people who trashed the idea). Unfortunately, it was latter which were more powerful and former didn’t get the timing right. 

War on VAR

January 6, 2009

This post from Urbanomics set me thinking about the most popular tool in risk management- Value at Risk (VAR). I had pointed to this primer on Value at Risk and had forgotten about it.

Urbanomics points to a series of articles on the subject. The discussion starts with this article from Joe Nocera on VAR. (BTW, Nocera created quite a storm with his articlepraising Dr Reddy). The article was criticised by Yves Smith of Naked  Capitalism Blog calling it misleading. James Kwak of Baseline Scenario neatly sums upNocera and Smith views:

While Smith focuses on the problem of using the wrong mathematical tools, and Nocera mentions the problem of not using enough historical data.

(In other words Smith criticises that most VAR models still assume normal distribution curves. We all know financial markets cannot be represented by normal distribution bell shaped curves anymore.)

Kwak adds another weakness – the scenario changes over a period of time. Stock/Asset prices are influenced by numerous investors and one is always unsure how much weight should you give to future. So, we may get VAR value using the past values but can never be sure how much the future will change. This puts entire VAR calculation into a fix.

 Further Kwak points:

There was one part of Nocera’s article that I liked a lot:

At the height of the bubble, there was so much money to be made that any firm that pulled back because it was nervous about risk would forsake huge short-term gains and lose out to less cautious rivals. The fact that VaR didn’t measure the possibility of an extreme event was a blessing to the executives. It made black swans [unlikely events] all the easier to ignore. All the incentives — profits, compensation, glory, even job security — went in the direction of taking on more and more risk, even if you half suspected it would end badly. After all, it would end badly for everyone else too. As the former Citigroup chief executive Charles Prince famously put it, “As long as the music is playing, you’ve got to get up and dance.” Or, as John Maynard Keynes once wrote, a “sound banker” is one who, “when he is ruined, is ruined in a conventional and orthodox way.”

This, I think, is an accurate picture of what was going on. If you were a senior executive at an investment bank, even if you knew you were in a bubble that was going to collapse, it was still in your interests to play along, for at least two reasons: the enormity of the short-term compensation to be made outweighed the relatively paltry financial risk of being fired in a bust (given severance packages, and the fact that in a downturn all CEO compensation would plummet); and bucking the trend incurs resume risk in a way that playing along doesn’t.

If you were an individual trader, the incentives might have been the opposite: shorting the market was an opportunity to make a name for yourself and open your own hedge fund, while buying more mortgage-backed securities would just keep you in the same bonus tier as everyone else. But it’s the CEOs who called the shots, and their personal risk aversion was what mattered. Or, in the brilliant words of John Dizard (cited in the naked capitalism article):

A once-in-10-years-comet-wiping-out-the-dinosaurs disaster is a problem for the investor, not the manager-mammal who collects his compensation annually, in cash, thank you. He has what they call a “résumé put”, not a term you will find in offering memoranda, and nine years of bonuses.

After Greenspan/Bernnake put, we had emerging market call option and now resume put. All this makes me recall an excellent paper from Dean Foster and Peyton Youngwho show how difficult it is to seperate a con fund manager from a real one. One should also read Ragu Rajan’s analysis.

Now, coming back to risk management. I have always wondered why so many people who call themselves as risk managers/engineers/specialists fail to see these events so regularly? This department also attracts the highly talented people for the challenges and incentives it offers. They all come from top B-Schools/ Finance Schools and know the limitations of VAR . Infact you talk to any one from risk management of a finance firm and they would tell you they use many more tools apart from VAR.  The job is one of high prestige and they should be more than happy to call the shots, as signalling risks leads to more prestige for them.

I can at present think of two reasons. One, in good times you don’t want a risk manager saying not to lend/borrow etc. Infact, if you hear the risk manager there is a huge chance, you do not grow as much. So, as a result risk management takes a backseat and you let the sales guy call the shots. The risk managers also don’t mind as common they get higher incentives too.

Second reason is herding/peer grouping. Well, there could be some finance firms that let risk management call the shots even in good times. However, when they see others growing so fat, they simply cannot stand back and do nothing. Infact, numerous articles now a days show how the various financial firms became aggressive on sub-prime assets after seeing other firm do well on the same. This is a case we saw in India as well with banks going crazy on their loan portfolio. One got atleast 10 calls from different banks offering home loan, auto loan etc. You could see this being aped across banks. Now a days getting a call in a week is a rarity (infact, those who have taken loans might be getting a few to pay up!).

So, where does all this take us. I think it all boils down to how greedy one gets. All these models like VAR etc are just tools and let us face it no tool is perfect. The tools depend on numerous assumptions and are fairly complicated for anyone to understand. So, one assumption is violated and the whole thing crashes (for instance in subprime CDOs an assumption was we can never have a nationwide housing market crash). So, we can have more fancier models and tools (which am sure will come after the crisis) but we can never be sure of the risks involved. 

However, this does not imply risk managers are not at fault. They oversell their models and tools showcasing them to be gods of financial markets who can predict it all. They should be more sober and realise that predicting risks in financial markets is much more complex than their models.

I can’t think of a better example than LTCM. It had the best brains and all who is who in their team. They must surely be aware of the risks but the greed was too much to overcome. Reading LTCM books by Roger Lowenstein and Nick Dunbar one gets awed by two things- one the team (of course) and two the greed.

The best bet is for the financial market as a whole is to be less greedy which is obviously a  very difficult thing to do. After all, we all rever Gordon Gekko and remember his golden words -‘Greed is Good’.

Assorted Links

January 6, 2009

1. MR points that about 40% of Obama plan would be on tax cuts. Krugman doesn’t like it and says public investment is the best way out.

2. Krugman also counters Buiter and suggest a large fiscal push is the answer to the crisis

3. WSJ Blog points to a new economics term- Mondustrial Policy (Monetary Policy + Industrial Policy)

4. WSJ blog points to this new Rogoff paper . Well, if you thought bad news is over, read this.

5. Mulligan still believes this crisis is over-exaggerated

6. Mankiw points money multiplier is decreasing and is below 1 now. Bernanke would not like this at all.

7. Here is a new year message from John Bogle

8. BS points to an article from Liar Poker writer  Michael Lewis

9. CTB does a reality check on the deposit insurance

10. Urbanomics has an excellent post on VAR . It also is sceptical of best practice monetary policy (so is mostly economics)


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