Archive for May, 2008

Credit Default Swaps- the next big crisis?

May 23, 2008

I wrote a paper on the Credit Default Swap Market. The concerns over CDS market has been raised recently by Satyajit Das. I have also seen a few comments on Eurointelligence which say:

The danger of credit default swaps

Are credit default swaps – financial instruments that insure against non-payment of interest – the next subprime? The Naked  Capitalism blog has dug up a Bloombery story, quoting a BNP Paribas analyst, as well as Eurointelligence contributor Satyajit Das, saying that there is ticking time bomb. Andrea Ciccione from BNP Paribas has done the maths, and concluded conservatively default of over $150bn. Altoghether about $1.3 trillion is at risk. Das makes the point that CDS are going to complicated the financial crisis, saying that this may well freeze up the financial system. Ciccione in particular fears counterparty risks from hedge funds, who have written many CDS. The crisis could be triggered by a rise in bankruptcies from their previously low levels, as global growth slows down. (The point is you don’t a long and deep recession to produce a scary scenario. A mere return to normal is all it takes.)

The conclusion of my paper is much the same – CDS is moving towards increasingly dangerous territory. Fed and other Central Banks by their interventions avoided what could have been a crisis in CDS. As it is simple CDS are difficult to price butthe players are increasingly moving onto more complex, low investment graded and longer tenure CDS products.

I have received some comments not agreeing to the problem but that is how it is. Unless there is a crisis we never agree to a problem at hand. Post-crisis analysis is always better than pre-crisis. When Nouriel Roubini said in 2006 that sub-prime crisis could be a big disaster, no one agreed to him. Not that I am Roubini but I believe policymakers need to look at the developments in CDS.


Bloomberg has an article summarising the developments in CDS market. It ios on very similar lines of my paper

Assorted Links

May 23, 2008

1. ICL Blog on rating agencies

2. WSJ Blog on Fed

3. NB updates list of countries using automatic tax return. It points parents are slightly less confident than their students. It pointsHP figured out default longback

4. Mankiw points his blog has has 5 million visits since first post! Great Blog. Mankiw points Vincent Reinhart comments on the Bear Stearns bailout.

5. Rodrik on recent UEFA Championship league final. Even I have a problem with final match being settled via penalties

6. Econbrowser has some fantastic comments on whether speculation is driving oil prices

Kohn offers financial lessons

May 22, 2008

This speech from Donald Kohn is interesting at the end. Though the speech is being discussed in blogosphere for other reasons (whether low interest rates led to a rise in commodity prices- advocated by Jeff Frankel and countered by Kohn in this speech).

He offers some basis finance lessons to improve management of pension funds:

most public pension funds calculate the present value of their liabilities using the projected rate of return on the portfolio of assets as the discount rate. This practice makes little sense from an economic perspective. If they shift their portfolio into even riskier assets, does the value of the liabilities backed by their taxpayers go down?

Financial economists would say no, but the conventional approach to pension accounting says yes. Unfortunately, the measure of liabilities that results from this process has a real consequence: It pushes the burden of financing today’s pension benefits onto future taxpayers, who will be called upon to fund the true cost of existing pension promises.

Overall a good read

What happened to liquidity?

May 22, 2008

This speech from Jean Paul Redouin, Deputy Governor, Banque of France  is a good one. It describes what has happened to liquidity in money markets.

He ponders that one year ago we were talking abut excess liquidity and now we are talking abot drying liquidity.

One year ago, studies focused on the issue of excess liquidity. The main questions were: why is liquidity so abundant? What disequilibrium could this cause on financial markets, particularly in pushing spreads far below their long-term average level? These questions remain at the heart of our concerns today, but the focus is now on market and asset liquidity.

The main discovery is that liquidity is not given. It can suddenly disappear, and for several months. The US ABCP market is a striking example of the sudden disruption of market mechanisms that were deemed to be robust. Another discovery is that these sudden liquidity dry-ups can affect even the core of the financial system, such as the interbank market.

He looks at liquidity from 3 angles: assets, money markets and role of banks in providing liquidity. The first and third have been debated quite a bit. I liked the one onm money markets quite a bit:

The money market today faces a real dislocation. This can be viewed from different standpoints.

First, a dislocation in maturities : over the shortest horizons (less than one week), liquidity is abundant. It’s also possible to find liquidity for horizons exceeding one or two years. But a severe liquidity dry-up is occurring between these two maturities (1 month, 3 months, 6 months), with the only entity providing liquidity at those medium-term horizons being the central bank [ECB has recently introduced a new 6-month operation]

Dislocation also appears between players: some lend only over the very short term, others concentrate on longer period.

Lastly, the dislocation has also been a geographical one: the circulation of liquidity across borders between euro area banks came to a halt. For instance, German banks used to lend substantially to French banks, while now they hoard liquidity and French banks have to resort more to the central bank to finance their short liquidity positions. In a certain sense, borders have been reintroduced into the euro area money market!

Do read the speech for further details.

Growth Commission report released

May 22, 2008

Growth Commission has released its reporton what drives growth in economies. It is chaired by Michale Spence and has congregated some great minds together. It has top academia like Bob Solow and policymakers/ practitioners like MS Ahluwalia as Commissioners.

Plus it has brought together great economists together each contributing how their respective fields can contribute to growth. See the Working Papers, Workshop section as well.

The press release has some quotes. Michale Spence provides hope:

 “At a time when industrialized countries are experiencing a sharp slowdown in growth, many of the world’s poorest countries have found growth to be elusive. It is our belief, however, that sustained, high growth can be explained and repeated,”

 The Growth Report also kills off once and for all the misguided notion that you can lift people out of poverty in the absence of growth. Growth can spare people en masse from poverty and drudgery. And with India needing to grow at a fast pace for another 13-15 years to catch up to where China is today, and China having another 600 million people in agriculture yet to move into more productive employment in urban areas, growth will lift many more people out of poverty in the coming decades.

What a timing for this report to be released! It has come at a time when the world is facing crisis of basic necessity – food. The report has some advice for food crisis:

Actions recommended by the Report to combat food price rises (once the current emergency situation is dealt with) include an end to export bans; more effective safety nets and redistribution mechanisms to protect people vulnerable from sudden shifts in prices; and a revitalization of infrastructure investment for agriculture. The Report also urges that policies that favor bio fuels over food be reviewed and, if necessary, reversed and that reserves and inventories be accumulated to relieve temporary shortages. 

Anyways, it should be a nice read. It will provide a good review of what has worked and what hasn’t in different countries.

Assorted Links

May 22, 2008

1. TTR points techies didn’t vote in Karnataka elections. I am not sure how would that improve things

2. WSJ Blog points to Fedspeak- Kevin Warsh

3. NB points to a review of Nudges- a book on behavioral economics

4. PIB offers some selling tips

5. Frankel counters Kohn

6. Mankiw points how AEA invests its money

7. Rodrik points to his new paper on development economics. Should be a fantastic read

8. DB Blog points China is investing USD 400 bn in trade logistics infrastructure. Phew!! In India we are struggling to invest USD 500 bn in overall infrastructure.

Moody’s tries to save itself

May 21, 2008

FT has done a detailed analysis of Moody’s modelling error that gave top rating to complex financial instruments.

The article is only for subsribers but alphaville blog provides some ideas of what was going on. I found this pretty shocking:

Internal Moody’s documents seen by the FT show that some senior staff within the credit agency knew early in 2007 that products rated the previous year had received top-notch triple A ratings and that, after a computer coding error was corrected, their ratings should have been up to four notches lower.

Four notches lower? This is simply unacceptable. Even if there was a model error (which is quite common) one can’t get a lower rated product become a super rated category. And one can still understand these things happen at a fund but how can they happen at a credit rating agency. Surely, there is back-testing and other kinds of risk assessment tests which would have separated wheat from the chaff. As I had asked earlier, What were the risk managers doing?

What is also shocking is this:

On discovering the error early in 2007, Moody’s corrected the coding glitch and instituted methodology changes. One document seen by the FT says “the impact of our code issue after those improvements in the model is then reduced”. The products remained triple A until January this year when, amid general market declines, they were downgraded several notches.

So despite finding the error, the products remained AAA till the crisis happened. This from a credit rating agency is just not accepted. And on top of this we have to hear such fancy/lofty statements:

“The integrity of our ratings and rating methodologies is extremely important to us, and we take seriously the questions raised about European CPDOs. We are therefore conducting a thorough review of this matter.”

Actually none of this is new. I remember reading a lot of material in time of Enron and Worldcom meltdown. Very similar things happened then and it is sad that nothing has changed.

The blame lies with people and not models per se. I just fail to imagine that the error wasn’t known. You have a lot of people verifying the initial documents and it doesn’t require rocket science to figure out the problem that a subprime asset has got a AAA rating. If it was a standalone crisis surely more would have come out about why thesedeals were taken up. Now because the crisis has affected all, the blame is being shifted to other factors like poor markets, models (as if they were created in vacuum) etc.

Credit Rating Agencies are supposed to be really honest in their conduct as lots of market activity depends on them. And it is not good that they also follow the path of other financial intermediaries. On this you might also like to read a superb article by Roger Lowenstein very nicely titled- Triple A failure.

Assorted Links

May 21, 2008

1. WSJ Blog points to battle between headline and core prices

2. SandM Blog on BoE problems

3. Fin Prof points to advice for sound financial future

4. Ecobrowser on oil prices

Nuclear Deleveraging

May 20, 2008

I came across this article by Satyajit Das in Eurointelligence website. He has been raising a lot of concerns of developments in Financial markets- calling it naked greed, CDS scare etc.  

This piece says how deleveraging could lead to further problems in the financial system. This is a must read.

Assorted Links

May 20, 2008

1. Ajay Shah points to some articles on finance and some articles on Indian print media business

2. TTR says high oil prices are here to stay and points to a nice trivia on Richard Nixon

3. MR points to a very interesting article on Bernanke’s bubble lab

4. WSJ Blog has a nice post on bubbles. It also points Britain economy moves from NICE to VILE.

5. Nudges has an advicefor Internet addicts 

6. PIB compares stock markets to medicine markets

7. Rodrik on Pascal Lamy

8. DB Blog says Go Dutch

9. Econbrowser on how speculation could be driving oil prices

Does risk management minimise or add risks?

May 16, 2008

The recent Bernanke speech is another (read this Volcker speech for instance) of those ongoing illustrations of the ongoing practices in financial sector.

This Bernanke speech focuses on the risk management practices being followed in the industry. On reading the speech I have two questions to ask:

1. The Title of the post
2. Risk management is one of the most sought and highly paid job. So what were these people doing really? It is useful to debate this issues post crisis but what was going on really?


inflation targeting is being questioned

May 16, 2008

The sub-prime crisis and economic conditions (low growth and high inflation) is questioning most tenets of economics and financial systems. Like the one on inflation targeting.

What has been advocated as a successful strategy for Central banks-inflation targeting is now being questioned. I had earlier pointed BoE has instead become a growth targeting central bank. Similarly, concerns are now being felt on Australia and New Zealand Central banks who have nut cut rates but have expressed the difficulty to manage the state of affairs. Now, the academicians are joining in the debate as well.

The recent article by Joseph Stigilitz is already creating enough furors. Here he really lambasts inflation targeting central banks. I came across this article by Axel Leijonhufvud ( read his CEPR paper for details as well) which questions both – independence and inflation targeting. I am sure more are to follow arguing both sides of the story.

The Regulatory Response to the Financial Crisis

May 16, 2008

This is a good paper (with some humor) by Charles Goodhart where he writes on the subprime crisis looking in particular at the UK economy. He also has some lessons to offer:

There are, at least, seven aspects relating to financial regulation where the recent, and still current, financial turmoil has thrown up issues for discussion. These include: 1. The scale and scope of deposit insurance; 2. Bank insolvency regimes, also known as ‘prompt corrective action’; 3. Money market operations by Central Banks; 4. Commercial bank liquidity risk management; 5. Procyclicality of capital adequacy requirements (and mark-to-market), Basel II; lack of counter-cyclical instruments; 6. Boundaries of regulation, conduits, SIVs and reputational risk; 7. Crisis management:- (a) domestic, within countries, e.g. UK Tripartite Committee; (b) cross-border; how to bear the burden of cross-border defaults? This paper describes how the current crisis has exposed regulatory failings, drawing largely on recent UK experience, and suggests what remedial action might be undertaken.

Literature survey on Central Bank communication

May 16, 2008

Recently, there has been a lot of criticism of RBI (see thisIMF selected issuesfor instance). The main target areas have been managing the impossible trinity and commmunication. I have critiqued the developments on first here. Though, I did make a case for better communication I have never been sure what it means.

Like experts say RBI’s monetary policy documentis too lengthy (usually about 80-90 pages) and should be shortened like that of other central banks. Going through the document it does appear lengthy but has a lot of information for the public. It is tough reading it but tells much more about the economy (Indian) than statements given by any other Central bank.

But then other Central Banks come out with similar reports on a regular basis – economic reviews, financial stability reports, monthly reviews (which even RBI does) etc- and RBI releases them all at one go . So it is not as if other Central banks don’t have detailed documents. Infact, sometimes there is a deluge which is really difficult to manage.

My thoughts have been confirmed by this paper by Alan Blinder et al. You can also read the  short summary here.  It is a liertaure survey on Central bank communications. The abstract goes like this:

Over the last two decades, communication has become an increasingly important aspect of monetary policy. These real-world developments have spawned a huge new scholarly literature on central bank communication — mostly empirical, and almost all of it written in this decade. We survey this ever-growing literature. The evidence suggests that communication can be an important and powerful part of the central bank’s toolkit since it has the ability to move financial markets, to enhance the predictability of monetary policy decisions, and potentially to help achieve central banks’ macroeconomic objectives. However, the large variation in communication strategies across central banks suggests that a consensus has yet to emerge on what constitutes an optimal communication strategy.

So, it is important but there is no standard way of doing it. We just can’t say this particular approach is good and this bad. Every Central Bank has its own way of doing it. As long as they do their job of managing inflation it is good enough.

Actually, I am increasingly getting sceptic of academics who talk about standardising things. It reminds you of Washington Consensus times when there was an emphasis on standardisation of fiscal and monetary frameworks on lines of the western world which failed for obvious reasons. This is not to say we shouldn’t change but there should be a case for it as well. the more I read,  increasingly I agree with Dani Rodrik that second best institutions are as good.

Assorted Links

May 16, 2008

1. WSJ Blog points to Mishkin speech an emerging hot topic- asset bubbles. It also points to Stern’s comments

2. Ajay Shah points to tale of 2 countries- Botswana and Zimbabwe

3. MR points to Pixar touch

4. Take the Nudge poll

5. Mankiw humor 

6. Rodrik defends Larry Summers

7. Fin Rounds points to a new website on investment banking

Does financial education lead to better money management?

May 15, 2008

It is usually assumed that financial literacy will lead to better management of personal finances. I came across this Richmond Fed short note on efficacy of financial education which is quite interesting.

First, it says there is little doubt about the role of financial education/literacy but its effect on fiancial outcomes  is unclear.

Second, It points to two papers which reviews the developments and says not all such awareness programs are effective.

The two biggest problems are: 1) a lack of control groups, and
2) a dearth of longitudinal data (which follow people over time to track their learning and behavior). Additionally, there are questions about how to best measure growth in financial literacy among individuals. Do you simply look at their debt and savings after the fact? Their ability to live within their means? Their general level of satisfaction about their financial situations?

Third, it points to ongoing research at Fed which tries to understand the causation better.

A study now under way at the Federal Reserve Board of Governors aims to overcome the largest problems with financial education research. The Board researchers are following the financial behaviors of two sets of young people, one of which has experienced a two-day financial education program, and another that didn’t. Both groups share basically the same demographic makeup, live in the same place, work for the same employer, and perform substantively similar jobs. They are all young soldiers at Ft. Bliss, an Army base in El Paso, Texas.

Hmm, this is going to be a really interesting study as it is based on the MIT-PAL’s randomization techniques.

So finally, after that usual policy approach of just implementing a plan/program without understanding its effectiveness is being questioned.  I am seeing more and more radomised evaluation programs understanding what works and what doesn’t work in financial education. These techniques of MIT-PAL need to be implemented at a wider scale and scope.

Assorted Links

May 15, 2008

1. WSJ Blog points to Volcker testimony

2. Nudges points to using defaults to save energy in electric appliances

3. PIB has a fantastic post- Is running to the subway irrational or not?

4. Mankiw points to Joe Stigilitz take on inflation targeting

5. Rodrik points to comments by former IMF chief on financial markets- nice turnaround huh?

6. Fin Prof points to a paper saying it is tough for property funds beating real estate markets

A short literature survey on behavioral finance

May 14, 2008

I came across this short and comprehensive literature survey on behavioral finance by Martin Sewell.

However,  what i fiound more interesting is  Professor Sewell’s profile. He is a professor in Computer Science at University College London! His website is here and has written quite a few literature surveys on various aspects of financial markets like Efficient Market Hypothesis, Fund Management, Market Microstructure etc. 

Worth a look!!

BoE says MPC is facing most difficult challenge

May 14, 2008

Bank of England released its inflation report for May 2008. It is a good report to understand the developments in the UK economy.

I just read the opening remarks which are not really comfortable:

As I described to you in February, the challenge facing the MPC is to balance two conflicting risks to the outlook for inflation in the medium term. On the downside, a sharper than expected slowing in activity would pull inflation below the target. On the upside, inflation, after a significant period above target, could have a greater tendency to persist. In the Committee’s judgement, the balance of these risks around the central projection is to the upside.

The Monetary Policy Committee is facing its most difficult challenge yet. For the time being, at least, the ‘nice’ decade is behind us. The credit cycle has turned. Commodity prices are rising. We are travelling along a bumpy road as the economy rebalances. Monetary policy cannot, and should not try to, prevent that adjustment. The Monetary Policy Committee must focus on bringing inflation back to the 2% target in the medium term. As our remit states, “the real stability upon which economic prosperity is founded requires that inflation remain low and stable for a long period of time.” Inflation will return to the target and growth will eventually recover to a sustainable rate. But we will need to be patient.


Assorted Links

May 14, 2008

1. IC Law Blog points to a paper on Hedge Fund regulation in India

2. MR points to a new website on prediction markets

3. WSJ  Blog points to Fedspeak – Bernanke, Dale Stern, Yellen

4. WSJ Blog pointsto a fantastic Richard Thaler interview 

5. Nudges offers tips to buy a house

6. PSD Blog summarises findings of a Small Business Financing Conference at World Bank

7. Hamilton of econbrowser doesn’t agree with Bernanke

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