Archive for March 31st, 2009

Leveraging is easy, Deleveraging is a mess

March 31, 2009

Manmohan Singh and James Aitken of IMF have written a nice paperwhich explains more problems with deleveraging. ( I had warned you that expect a lot of stuff from IMF, they have been doing some great research at a greater pace recently)

The authors looks at the practice of Rehypothecation. It is like a vicious circle. Crisis lowers Rehypothecation and Rehypothecation then leads to deleveraging which then  worsens the crisis. The abstract explains the paper really well.

Rehypothecation is the practice that allows collateral posted by, say, a hedge fund to their prime broker to be used again as collateral by that prime broker for its own funding. In the United Kingdom, such use of a customer’s assets by a prime broker can be for an unlimited amount of the customer’s assets. And moreover, there are no customer protection rules (such as in the United States under the Securities Act of 1933). The paper shows evidence that, following Lehman’s bankruptcy, the extent of rehypothecation has declined substantially, in part because investment firms fear losing collateral if their prime broker becomes insolvent. While less rehypothecation reduces counterparty risk in the system, it also reduces market liquidity.

Rehypothecation had increased quite a bit before the boom. One security kept changing hands . In UK Rehypothecation was free for all but there were some restrictions and regulations in US. So as Lehman fell, the customers of Lehman UK were in complete trouble  but some solutions were available for Lehman US. Now as Lehman collapsed Rehypothecation declined as people didn’t accept security collaterals and demanded cash collaterals. This led to a vicious circle as suddenly people either didn’t have enough original good collateral or didn’t have enough cash.

Leveraging is so easy to build but once deleveraging starts (which has to happen as it is a cycle) it poses numerous problems. Another problem of asymmetry in financial markets. As a result, we keep hearing from various economists to put some cap on leverage ratio. It was completely unthinkable till this crisis . As Rodrik puts in this presentation (slide 17):

We can be certain that no future regulation will prevent similar occurrences unless leverage (i.e., borrowing) itself is directly restrained.

A good paper which explores the actual practices in financial markets and then explains the problem.

How do G7 countries respond in crisis?

March 31, 2009

In an IMF working paper Daniel Leigh and Sven Jari Stehn have analysed how G-7 economies respond in previous crisis (US, UK, Canada, Germany, France, Italy and Japan). They analyse impact and timing of both monetary and fiscal policy.

Main Findings:

It evaluates whether discretionary fiscal responses to downturns are timely and temporary, and compares the response of fiscal policy to that of monetary policy. The results suggest that while responding more weakly and less quickly than monetary policy, discretionary fiscal policy is more timely than conventional wisdom would suggest, particularly in “Anglo-Saxon” countries, but the response differs substantially across fiscal instruments.

Both fiscal and monetary policy are found to be subject to an easing bias, with more easing during downturns than tightening during upturns; and liable to easing in response to erroneously perceived downturns, many of which are subsequently revised to expansions.

Another shot in the arm for fiscal policy from IMF. The view that fiscal policy is not as bad is gathering pace. It will be a big lesson from the crisis. The other ideas are getting thrashed but fiscal policy advocacy is increasing. And this is not mainly because government spending is the last option that is why we need to build support. But it is being based on some empirical work (however, empirical models themselves are being questioned but am no authority on it).

Anyways, this paper is quite an excellent one which in a snapshot tells you how fiscal/monetary policy has responded in G-7 economies. Apart from this they also point that policies focus more on contraction and relax a bit while economies get back on track. They also suffer from overestimating the downturns and usually do much more than is needed.

Very interesting paper.

Why Larry Summers became an economist?

March 31, 2009

Assorted Links

March 31, 2009

1. MR says choose a theory.  I vote for Theory 2.

2. WSJB points to Fed Governor Duke’s speech. She syas small banks are lending

3. Peston on how Dunfermline fell

4. JRV points to some interesting papers and articles

5. Indicusblog asks which is bigger real or financial?


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