Archive for January 22nd, 2008

Raghu Rajan analyses subprime crisis

January 22, 2008

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?

January 22, 2008

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

January 22, 2008

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

January 22, 2008

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.


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