Archive for September, 2008

Assorted Links

September 22, 2008

1. The hectic developments continue over every weekend. Treasury has offered a plan to Congress to buy USD 700 bn of distressed assets from the various financial firms.  WSJ Blog points to the plan and economists’ reactions.

2. G-Sachs and M-Stanley have been made bank holding companies and will now be regulated by Fed. WSJ Blog discusses

3. Mankiw points to his fanmail. He points to some views on Treasury plan

4. Krugman ponders on the Treasury plan. Econbrowser as usual is very good with the analysis

5.JRV points to places where only long buy is permitted.

6. TTR on resolution trust corp

7. IDB on how growth has helped reduce caste based discrimination.

8. ACB points to how fin sector crisis in US will impact India

9. ACB points to some fine reading on fin sector. I have added a few more on the comments section.

10. Rodrik asks Where did we go wrong?

11. Econbrowser points to a paper on subprime crisis

SEC bans short-selling in 799 financial stocks

September 19, 2008

SEC has now banned short-selling in stocks of 799 financial companies. List of banned stocks is here. SEC statement says that it has taken these steps in coordination with FSA. FSA has banned 29 stocks from short-selling. List of stocks is here

SEC’s ban ends on 2 Oct 2008 but FSA’s is a longer ban till 16 Jan 2009. FSA statement says:

“While we still regard short-selling as a legitimate investment technique in normal market conditions, the current extreme circumstances have given rise to disorderly markets. As a result, we have taken this decisive action, after careful consideration, to protect the fundamental integrity and quality of markets and to guard against further instability in the financial sector.”

This is a classic case of repugnance good and short-selling being limited to only text-books. When prices rise and are seen to be away from fundamentals, all say it is very difficult to say what is the fundamental price. Hence bubbles are ignored and preference is being given to markets to correct the excesses. However, when they fall, we see such reactions.

Why not some ban on long buy when prices are rising like they are falling now? Then most financial players will cry foul, socialism etc. However, now players will say this is needed as markets are irrational etc.

I hope now the experts in India don’t say such things don’t happen in developed financial systems. Or cry foul when such decisions are taken in India……when developed economies can’t afford short-selling in times of distress, it is too much to ask emerging markets to fact the music.

Another conference on financial instability

September 19, 2008

Conferences and seminars on financial stability are becoming as common as the various failures on the financial system

The Kansas Fed conference (I discussed a few papers here; also retold a story by one of the discussants) discussed financial stability. So was the conference at Brookings (discussed one paper partially here).

There is another one coming by World Bank and IMF. All papers are available for download.

The reading material keeps piling up.

Money market mutual funds next to shut shops?

September 19, 2008

I am not sure how far this crisis will go. After analysing why biggies collapsed (Lehman, AIG), I had mentioned about Fed going broke as well.

The next in line seems to be money market mutual funds (MMMF).

Money market funds are ultra-safe investments, buying interest-bearing securities that mature within a year, and frequently within a week or month. The spectrum of investments runs from certificates of deposit to Treasury securities, from insured notes to asset-backed commercial paper, such as the Lehman notes.

Marketwatch pointed (detailed story here) Reserve Primary Fund, one MMMF “broke the buck”. This is a phrase used in money market mutual funds industry and is for a MMMF that is not able to maintain the $1 NAV on a day.

Unlike ordinary mutual funds, money funds try maintain a constant price of $1. Each day, a fund’s holdings are “marked to market,” meaning the current market value of all holdings is added up, as if they were being sold. Anything above $1 per share basically passes back to the shareholders as interest income.

Anything less than $1 per share has pretty much been considered the death knell for a fund company, which is why, through the years, management firms have stepped in whenever breaking the buck was a real threat.
This fund has assets worth $ 62.6 billion which included  $ 785 million of short term debt issued by Lehman.  This was just a fraction of the total assets but the fund collapsed as there were huge redemptions.
The investors knew of it exposure to Lehman and by Tuesday (16 Sep 2008), the fund size had  declined to 23.6 billion. The investors withdrew USD 40 billion on Monday and Tuesday. At 4 PM the Fund declared it will pay full USD 1 per mutual fund unit for all redemptions before 3 PM. As Lehman became worthless and investors withdrew funds at such massive scale, the NAV became 97 cents. Now it has said redemptions will be honored only after 7 days of application.
FT Aplhaville points another MMMF – Putnam Prime Money Market Fund has shut operations and is returning money to investors. The surprise is it has not broken the buck but has done so because of redemption pressures. As people demand their money back, a MMMF will have to sell the assets. Despite considered very safe, the markets are such that is safe anymore. This will result in fire sales and lower value for the assets. Fearing this, Putnam MMMF has shut operations and returning money to investors.
Read Putnam’s press release as well. 
This is pretty worrying as now MMMFs can simply fall because of redemption pressures. The quality of assets might be strong but that does not matter.  
1. Treasury announces a plan to bail out MMMFs as well. It says:
President George W. Bush approved the use of existing authorities by Secretary Henry M. Paulson, Jr. to make available as necessary the assets of the Exchange Stabilization Fund for up to $50 billion to guarantee the payment in the circumstances described below.
Maintenance of the standard $1 net asset value for money market mutual funds is important to investors. If the net asset value for a fund falls below $1, this undermines investor confidence. The program provides support to investors in funds that participate in the program and those funds will not “break the buck”.
2. Fed announces another measure to help MMMFs. Fed will:
extend non-recourse loans at the primary credit rate to U.S. depository institutions and bank holding companies to finance their purchases of high-quality asset-backed commercial paper (ABCP) from money market mutual funds. This should assist money funds that hold such paper in meeting demands for redemptions by investors and foster liquidity in the ABCP markets and broader money markets
Non-recourse loans implies Fed will give a loan against a collateral. If the borrower defaults, the lender/issuer can seize the collateral, but the lender’s recovery is limited to the collateral. If the property is insufficient to cover the outstanding loan balance (for example, if real estate prices have dropped), the lender is simply out the difference.
So, Fed will give funds against a collateral to these bank holding companies…Now MMMFs have invested in short-term paper (high quality) of these firms….. the MMFs can sell these securities back to the banking company in times of redemption…. banking firms in turn can use the Fed funds to help buy thr securites from MMMFs…..
So Fed provides funds to the various BHCs and BHCs in turn help MMMFs buyback their securities fro MMMFs…..Pretty complicated….I am not sure how Fed can fund each and every activity in financial sector….
With both Fed and Treasury intervening my initial fears about MMMFs failure has been true.

Assorted Links

September 19, 2008

1. WSJ Blog says ECB rate cut pressures grow

2. WSJ Blog reflects on Fed moves

3. CB points to a paper on history of development

4. Mankiw points  to Lehman and AIG FAQs

5. Rodrik points to a good development blog

6. FCB points to Buffet being right again. It also points to a WSJ site which has lo

7. MR on central bank independence

8. TTR says bailouts can be taken in stride. He also comments on i-bank practices

9. IDB on financial literacy. It has a good post on a financial product – pool savings and pass it to members turn by turn. This has existed in form of kitty parties amongst women for a long time now.

Lender of Last Resort logic for emerging or developed?

September 18, 2008

I have always followed Frederic Mishkin’s work religiously. His work on financial markets and monetary policy has been simple exemplary. His writing has always been very simple and lucid and this made all his papers very easy to read and understand.

Looking at the recent crisis, I just recalled a speech given by Mishkin in 2007 on lender of last resort (LOLR) function of central banks. (A large part of the speech is based on this paper presented at Kansas City Fed Symposium in 1997. The theme in 1997 – “Maintaining Financial Stability in a Global Economy” was very similar to the recent 2008 symposium –  “Maintaining Stability in a Changing Financial System” )

Mishkin says:

To be clear, by lender of last resort, I mean short-term lending on good collateral to sound institutions, when financial markets temporarily seize up. I do not mean rescuing financial market participants from the consequences of their bad decisions by lending to unsound institutions with little capital, thereby postponing the recognition of insolvency.

Despite the need for a lender of last resort, central banks in emerging-market countries, unlike those in advanced countries, often cannot undertake this role.

First, emerging-market economies often have much of their debt denominated in foreign currency.

Second, the credibility of central banks in these countries to keep inflation under control is low.

Accordingly, an injection of liquidity in the form of domestic currency can actually make the financial crisis worse by raising inflation fears and thus causing the domestic currency to depreciate. Given a debt structure characterized by liabilities denominated in foreign currency, this depreciation causes the domestic-currency value of the liabilities to rise, induces a deterioration of balance sheets, and thus causes a severe economic contraction. Moreover, a run on the domestic currency will likely be associated with a spike in nominal domestic-currency interest rates–just the opposite of what the injection of liquidity was intended to achieve .

So what should emerging markets central banks do?

Therefore, if liquidity is to be provided during a financial crisis in an emerging-market economy, it generally should be in the form of foreign, not domestic currency. But, if a domestic central bank lacks the foreign reserves to conduct emergency liquidity assistance in foreign currency to stop a financial crisis or promote a recovery when one occurs, can another institution come to the rescue? The answer is yes, and it is often best if the assistance comes not from within the country, but from without. Liquidity provided by foreign sources can help emerging-market countries cope with financial crises without many of the undesirable consequences that can result from the provision of domestic-currency.

This was 2007 and how things have changed dramatically. Infact the entire idea has been turned on its head.

It is central banks of developed economies that have to provide liquidity (or do the lender of last resort) in foreign currency mainly in US dollar. The emerging markets so far have been doing quite fine. Moreover, central banks of developed economies have expanded their accepted collateral basket to securities issued by US Treasury (Bills,  bonds etc) .

The recent press releases from various central banks is just another extension of this LOLR function started in 2007.

The FOMC has authorized increases in the existing swap lines with the ECB and the Swiss National Bank. These larger facilities will now support the provision of U.S. dollar liquidity in amounts of up to $110 billion by the ECB, an increase of $55 billion, and up to $27 billion by the Swiss National Bank, an increase of $15 billion. 

In addition, new swap facilities have been authorized with the Bank of Japan, the Bank of England, and the Bank of Canada. These facilities will support the provision of U.S. dollar liquidity in amounts of up to $60 billion by the Bank of Japan, $40 billion by the Bank of England, and $10 billion by the Bank of Canada.  

All of these reciprocal currency arrangements have been authorized through January 30, 2009. 

Mishkin a leading votary of financial globalisation just missed how integrated the markets have become.  A stress in one country has an impact on the other as well. LOLR in foreign currency is also applicable to countries which are more financially integrated as others.

Prof. Mishkin should perhaps try and rework his thoughts/papers in line with this new reality.

Federal Reserve is broke now

September 18, 2008

With all the bailouts, one was always wondering what happens to Fed. How does it get the cash etc to bail out so many firms? Moreover, with Fed now accepting almost everything as collateral one was always going to question Fed’s balance sheet.   

Now it seems Fed has also run out of cash. FT Alphaville points (hat tip Eurointelligence) that US Treasury has taken out a special liquidity scheme to help Fed. The statement from US Treasury says:

The Federal Reserve has announced a series of lending and liquidity initiatives during the past several quarters intended to address heightened liquidity pressures in the financial market, including enhancing its liquidity facilities this week.  To manage the balance sheet impact of these efforts, the Federal Reserve has taken a number of actions, including redeeming and selling securities from the System Open Market Account portfolio.

The Treasury Department announced today the initiation of a temporary Supplementary Financing Program at the request of the Federal Reserve.  The program will consist of a series of Treasury bills, apart from Treasury’s current borrowing program, which will provide cash for use in the Federal Reserve initiatives.

I was thinking how will this help? On one hand Fed is providing liquidity and on the other Fed is draining that liquidity via the T-Bill auctions.

I also read New York Fed statement which says the same thing:

Today, the Treasury Department announced the initiation of a temporary Supplementary Financing Program. The program will consist of a series of Treasury bill auctions, separate from Treasury’s current borrowing program, with the proceeds from these auctions to be maintained in an account at the Federal Reserve Bank of New York. Funds in this account serve to drain reserves from the banking system, and will therefore offset the reserve impact of recent Federal Reserve lending and liquidity initiatives.

This is pretty scary. I dont know what is going to happen ahead. There is news that Morgan Stanley (only 2 i-banks remain – Goldman Sachs and Morgan) also might be taken over by Wachovia or Citic (a Chinese Bank).

Funny times really. I r’ber reading when Chinese started oenoing up their financial sector in 2006, Morgan Stanley was one of the leading firms to help Chinese firms become more market oriented. Not in their wildest dreams would MS have imagined that they would need help from China.

Assorted Links

September 18, 2008

1. WSJ Blog asks whether we can get some reforms going in US fin regulation

2. TTR on AIG.

3. MR points central bank independence lost. WSJ Blog points central banks on soccer field

4. Krugman points liquidity trap situation in US

5. IDB on double standards in development sector

Understanding AIG’s financial problems

September 17, 2008

I think Prof. Rogoff was slightly quick to say US government is letting wall street firms fail and calling it a good sign.

Fed is providing upto USD 85 billion of liquidity support (capital) and US government will now own 79.9% of AIG’s equity.

The AIG facility has a 24-month term. Interest will accrue on the outstanding balance at a rate of three-month Libor plus 850 basis points. AIG will be permitted to draw up to $85 billion under the facility. 

The interests of taxpayers are protected by key terms of the loan. The loan is collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries.  These assets include the stock of substantially all of the regulated subsidiaries.  The loan is expected to be repaid from the proceeds of the sale of the firm’s assets. The U.S. government will receive a 79.9 percent equity interest in AIG and has the right to veto the payment of dividends to common and preferred shareholders.

Loan is expected to be repaid after from sale of assets?? I think that is too much of optimism. Even in AIG’s press release similar optimism is shown.

Fed had to again reach out to an exigent clause to bail out AIG. After Lehman’s analysis (bankruptcy and source of problems), it is time to take a peek at AIG’s financial mess.

I just took a look at AIG’s Q2 2008 financial statement. Its business is divided into 4 segments (see this for details):

  • General Insurance
  • Financial Services
  • Life Insurance & retirement services
  • Asset Management

The income/loss in each division in Q2 2008 is as follows (in billions):

  • General Insurance :  $ 0.8
  • Financial Services : $ (-5.9)
  • Life Insurance & retirement services: $ (-2.4)
  • Asset Management : $ (-0.3)
  • Total: $ (-5.4)

So total losses are USD 5.4 billion in Q2 2008 and losses are a staggering 13.2 billion in the 6 months ended June 2008.

The main troubles are in 2 divisions: financial services and Life Insurance & retirement services and they continue to bleed. Fin services losses also includes $ 5.6 billion of unrelaised market valuation loss on CDS portfolio:

Capital Markets reported a $6.24 billion operating loss in the second quarter of 2008, due to $5.56 billion of unrealized market valuation losses related to AIGFP’s super senior credit default swap portfolio and a $518 million credit valuation loss. In addition AIGFP experienced low transaction volumes due to challenging market conditions.

I am not one bit surprised over this CDS. Eurointelligence points:

AIG was a huge Credit Default Swap writer, and that insurance required collateral to be posted, depending upon such factors as credit rating and credit spreads;

The recent crisis has posted numerous concerns over CDS market. I had posted number of times about the problems in these markets.

What I don’t understand is huge losses in the Life Insurance & retirement services. I was seeing Nouriel Roubini’s commnets on CNBC in the morning and he was critical of the investments done by AIG. He said this money should have been invested in safer securities as it is for retirement and life insurance. But it was invested in all kinds of exotic (he called it toxic) financial instrumnets. I could not get much clarity from AIG’s press release and would have to look more into details


IRDA has issued a statement saying AIG’s insurance venture with Tata is safe

Big Picture points more links


RBI measures post Lehman bankruptcy

September 17, 2008

RBI has taken certain measures post Lehman bankruptcy. 

Lehman Brothers has 2 outfits in India –

  • Lehman Brothers Capital Pvt. Ltd. (NBFC)
  • Lehman Brothers Fixed Income Securities Pvt. Ltd. (a primary dealer)

RBI has asked Lehman Brothers Capital Pvt. Ltd. to take permission from RBI before taking any direct/indirect liability from any institution in India or making any forex remittance. It has asked Lehman Brothers Fixed Income Securities Pvt. Ltd not to undertake any transactions in G-sec market.

As I posted a while back, Barclays has only brought North American operations. The other worldwide businesses are still in Lehman. So, till Lehman finds a buyer for its worldwide businesses as well, we might expect these measures in other economies as well.

Barclays buys Lehman’s broker-dealer unit

September 17, 2008

I had indicated that Barclays is in talks with Lehman to buy its broker-dealer business. The deal has been executed and press release from Lehman tells about the deal. The features are:

  • Barclays Agrees to Acquire Lehman Brothers’ North American Investment Banking, and Fixed Income and Equities Sales, Trading and Research Operations, Including Approximately 10,000 Employees
  • Discussions to Acquire Lehman Brothers’ Select Operations Outside of North America
  • Barclays Agrees to Purchase Lehman Brothers’ Headquarters Office Building and  Two Other Facilities
  • Barclays Enters into Support Agreement with Lehman Brothers to provide;
    – $500 Million DIP-Financing to Lehman Brothers Holdings Inc.
    – A Substantial Interim Credit Facility to Lehman Brothers Inc.

So, both capital markets division and i-banking division have been bought. Basically, Barclays capital, the i-banking arm has brought the lehman assets.  

 The total amount of deal has not been disclosed. So, Lehman Holding company has three remaining businesses:

  • I-managment division (worldwide)
  • Capital markets (worldwide minus North America)
  • i-banking operations (worldwide minus North America)

I loved the statements from the officials of both Barclays and Lehman:

Robert E. Diamond, Jr., Barclays President, said, “This is a once in a lifetime opportunity for Barclays. We will now have the best team and most productive culture across the world’s major financial markets, backed by the resources of an integrated universal bank. We welcome the opportunity to add Lehman’s people and capabilities to the Barclays team.”

“This is a wonderful outcome for a great number of our employees that will preserve and strengthen our terrific franchise,” said Richard S. Fuld, Jr., Chairman and Chief Executive Officer of Lehman Brothers.

I am sure Barclays must have got it a fraction of a price but it is too early celebrate. It will still have to assume Lehman’s division losses and financial markets are still extremely panicky.  About Fuld, less said the better.

Assorted Links

September 17, 2008

If there is one prediction which has been true and perhaps better than the expected it is events in this week. Before this week started it was said that it would be an eventful week. It has truly surpassed the prediction

1. FOMC maintains rates. WSJ Blog comments that there were no dissents this time. It points NY Fed chief Geithner skips the meeting to stay in New York. WSJ Blog says inflation is still a worry for Fed.

2. There is another bailout  of AIG. WSJ Blog says Fed invokes another exigent clause.

3. Meanwhile there are also suggestions to set up a new govt. entity to deal with fallouts in financial crisis. WSJ Blog points

4. Mankiw points to a Rogoff article on bailouts

5. Rodrik on capital flows conundrums

6. PSD blog on creative destruction and emerging markets

7. As Bankruptcy gains steam, it is time to see how much creditors can get. DB points to a study

8. TTR says higher capital for i-banks is not a bad idea

Understanding why Lehman/ Bear Stearns collapsed

September 16, 2008

I have written a fairly long post explaining the various nuances of Lehman Bankruptcy. Though I have explained why Lehman became bankrupt, I still wanted to know the details- the financials of the company etc.

I came across this excellent excellent paper from Stephen Morris and Hyun Song Shin. I had earlier pointed to another superb paper from Shin where he (along with Tobas Adrian) had pointed that we can no more ignore market brokers from the financial regulation imposed only on banks. Infact market brokers are as sensitive to monetary policy actions as commercial banks.

In the new paper, Shin discusses the need to have  a systemic approach to regulation. I will discuss the regulation aspects in another post. In this I want to focus on what went wrong with Bear Stearns and Lehman. (see page 14 onwards). The results are based on November 30 , 2007.

First Bear Stearns:

One notable feature of Bear Stearns is the large proportion of funding that comes from payables – fully 22% of total balance sheet size. …. the bulk of the payables are deposits of hedge fund customers, and reflect the large prime brokerage business at Bear Stearns. Because hedge fund customer deposits are payable on demand, they are vulnerable to a classic run that reflects coordination failure among the hedge fund customers. Such a coordination failure may reinforce whatever increase in repo haircuts that already prevail in the markets. During the run on Bear Stearns in March 2008, the defection of its hedge fund clients was one of the contributory factors in the funding shortage that eventually led to Bear Stearns approaching Federal Reserve support.

How about Lehman?


One notable item is the “payables” category, which is 12% of total balance sheet size. Payables include the cash deposits of Lehman’s customers, especially its hedge fund clientele. It is for this reason that “payables” are much larger than “receivables” on the asset side of the balance sheet (only 6%). Hedge fund customers’ deposits are subject to withdrawal on demand, and hence may be an important source of funding instability.

See the similarity. Both had short-term liabilitites to honor and if not nonored could lead to bankruptcy.  With Bear this was an important factor and same conditions should apply to Lehman as well. As we all know now Lehman could neither find anyone to inject capital nor sell its assets. Though Lehman had other issues as well like high leverage ratio (30.7 compared to commercial banks average of 10 to 12) , low cash holdings etc. Still this makes sense as there is numerous press coverage saying Lehman could not find anyone to lend to help honor its commitments.



Understanding Lehman Brothers bankruptcy

September 16, 2008

We are living in highly eventful times and there is just so much happening. The biggest problem is to follow and read up on so many happening events. The reading material just keeps piling up.

I had posted on last Thursday that Lehman is next firm on the firing line after Fannie Freddie mess. All were expecting Fed/Treasury to do something over the weekend but Fed/Treasury declined to help Lehman. The reasons are unknown but most say the desires help was way too  much. Moreover AIG also joined the firing line making it more difficult to Fed/Treasury  to intervene.

The result is Lehman filed for Bankruptcy. It said in a press release that it intends to file for Chapter 11 Bankruptcy. In a separate press release later in the day it said it has filed for one. It says:


None of the brokerdealer subsidiaries or other subsidiaries of LBHI was included in the Chapter 11 filing and all of the U.S. registered broker-dealers will continue to operate.  LBHI is exploring the sale of its broker-dealer operations and, as previously announced, is in advanced discussions with a number of potential purchasers to sell its Investment  Management Division (“IMD”). LBHI intends to pursue those discussions as well as a number of other strategic alternatives.

The press release also says that its international subsidiaries in Europe are also facing trouble as support from parent company stops.

I am puzzled though.

Lehman has three business segments – Capital Markets, I-Banking and Investment Management. Out of the three it is Capital Markets which has been bleeding profusely and losses have doubled from USD 2. 4 billion in Q2 20008 to USD 4.2 billion in Q3 2008. Infact the other two have made profits in Q3 2008- Ibanking USD 0.6 billion ( USD 0.9 billion in Q2 2008) and I-management – USD 0.6 billion (USD 0.9 billion in Q2 2008).

But the press release on bankruptcy says it Broker dealer and I-managment will continue to operate. Broker -Dealer is nothing but capital markets segment. I just saw Lehman’s factbook and it said its capital markets division is divided into four markets – equity, fixed income, prime services and mortgage capital. As far as I understand this is nothing but the functions of Broker-Dealer. The division which is bleeding the most and has got into trouble continues to run its operations. Why should this be?

Again, to recall Lehman Brothers Holding Inc (LBHI) has filed for bankruptcy. This takes up back to the concepts of Holding Company:

A holding company is a company that owns part, all, or a majority of other companies’ outstanding stock. It usually refers to a company which does not produce goods or services itself, rather its only purpose is owning shares of other companies. Holding companies allow the reduction of risk for the owners and can allow the ownership and control of a number of different companies. In the U.S., 80% or more of voting stock must be owned before tax consolidation benefits such as tax-free dividends can be claimed.

As I understand it, LBHI owns all these seperate subsidiaries under the three segments – capital markets/broker-dealer, i-banking and i-management. It provides capital to run all these seperate segments and these three businesses are its assets. As overall position of these segments deteriorated, there were losses.  

LBHI had to either sell its assets or get more capital. It could not got any buyers for its assets (I-management business is on the block, Barclays is interested in broker-dealer business) nor was able to infuse new capital ( Korea Development Bank declined). Treasury/Fed declined  to help. There was only one way out- bankruptcy filing.

This brings me back to the original problem. Even if it is a holding company, how will it manage by keeping the broker-dealer business running. The way the financial markets are it is only going to be more losses for the same. It could have allowed i-banking and i-management to function but put broker-dealer in a freeze.

Another problem is if it manages to sell off both dealer-broker and i-management business, what remains in the holding company? Only I-banking? How will they service the What happens to the foreign operations? Would they file for bankruptcy as well in their respective countries? As I see the recent financial results closely, I realise out of the total expecetd revenue loss of 2.9 billion, Europe and Middle East had losses of USD 0.9 billion and US conributed about 2.0 USD to the loss. so, surely concerns are going to be felt in Europe divisions as the bankruptcy press release also says.

Interesting times surely.

Addendum: 1. The one organisation which muct be having the last laugh at this concept of holding companies.

Assorted Links

September 16, 2008

1. The talk of the town is Lehman Brothers bankruptcy, AIG ask for help and impact on fin markets. WSJ Blog points whether govt no-support for Lehman tight? It also says whether and how Fed can save AIG

2. Krugman says worse might still not be over

3. WSJ Blog has a fantastic post saying as jobs in finance fall, those in engineering will rise.

4. IDB has some good assorted links

5. In these times of distress CB points to some good economics humor

6. MR on Glass Steagall Act. I am sure we are going to have many discussions on this topic after this crisis eases somewhat.

7. Macroblog says automatic enrollment can help increase pension savings.

8. Mankiw welcomes developments in fin markets

Will China further worsen the economic situation?

September 15, 2008

China’s inflation has eased to 4.9%  in August 2008, the slowest pace since June 2007.  This was after a series of rate hikes were done to control inflation. This news came on 10 Sep 2008 and  I immediately thought what if China eases its rates now?

Easing of rates in China would be a lot different than those in other advanced economies. Most developed economies are facing severe distress in financial markets and this is expected to hit their real economies as well. The real economy has stood up well so far but it can’t hold on if financial markets continue to deteriorate.

In China’s case if it lowers interest rates, it will again lead to a higher demand for food commodities and oil. This will lead to higher global prices and once again we have a global inflation problem.

Just to recall, inflation has been a global phenomenon for a while now, but Central Banks were not willing to act (read my paper here) The developed economies’ central bankers were blaming the recent rise in inflation on developing economies and expected latter to raise rates (IMF also joined in playing the same game).

They said as developing economies have grown, their consumption levels have increased leading to rise in prices  of food and oil prices. So, the onus was on developing economies to hike interest rates and bring the prices down. As these prices are global in nature, it will lower inflation in developed economies as well. In other words, the developed economies’ Central Banks can continue to manage their financial markets and growth and let inflation be managed by developing economies.

As I thought through this, now China has lowered its interest rates (see Reuters release as well):

China’s central bank said Monday it would cut the one-year benchmark lending rate by 0.27 percentage point from Tuesday and cut the reserve requirement ratio for smaller financial institutions from Sept. 25 to boost economic growth.

China’s benchmark deposit interest rate will remain unchanged, the PBOC said in a statement posted on its Web site.

It is actually pretty confusing. China has three policy rates –  1 year Lending rate, 1 year deposit rate and the reserve ratio (which is like the Cash reserve Ratio of the Banks).

So lending rate has been reduced for all the banks from 7.47% to 7.20% . The Reserve requirement has been reduced for all banks except  five biggest banks and the Postal Savings Bank by 1 percentage point. The 1 year deposit rate is unchanged at 4.14%. Further:

The PBOC said the aim of the easing was to maintain fast and stable economic growth.

It might appear from the statement that China’s growth rate is slipping. Lets see the data.

The recent data shows China’s industrial output grew by 12.8% in August which is lower than July – 13.7% and lower than August 2007 – 17.5%. The GDP is expected to increase by 9% in 2008 compared to 11.9% in 2007. The recent figures are surely lower than previous figures but still are much higher given global conditions. 

Moreover, the recent inflation and industrial output figures are just for August and we are yet to see a declining trend. It could just be a blip. But as the rates have been lowered, we might just expect the growth to pick up again and higher food and oil prices in future.

This will surely test the developed economies and their central bankers. They are banking on developing economies (esp large ones like India, China etc) to increase their interest rates. However, their expectations might just turn pretty sour. They would just hope that China’s Central Bank does not lower the rate further.

Some might say that China’s economy might not really expand as it is an export driven economy. With developed economies down, China will not find any takers for its exports. Agreed but this just turns the entire problem on its head. 

This just implies, the developed economies central banks’ would hope that their economy does not pick up soon.  Because if it does, so would China’s exports followed by rise in incomes and then in prices of food and oil. This would lead to higher inflation again putting Central Banks in a dilemma.

Pretty troublesome times for sure.


As I write this, the yields in the Indian G-sec market eases further. Participants joke saying it is because of the rate cut in China. 🙂

One set of alphabet soups lead to another

September 15, 2008

As the subprime crisis started to unfold , one got a list of fancy finance terms- ABS, CDO, ABX, NINJA Loans, No Doc loans etc. (see some explanation here). This was aptly called alphabet soup.

With the crisis, Fed has started another set of alphabet soup. These are the various new facilities launched to calm financial markets- TAF, TSLF, PDCF etc. Here is a brief summary:

  • TAF provides additional liquidity via auctions. The basic idea was firms were not willing to borrow at the discount window because of the stigma problem. Discount window provided a signal that this firms was in trouble. Moreover, in discount window the rate was known but amount was not.  In TAF it was opposite, Fed decided the amount and the rate of borrowing was determined via auction. TAF is open to depository institutions. Against the liquidity, the firms have to park collateralised securities with the Fed. Fed keeps revising the accepted securities
  • TSLF is another facility which helps exchange other securities for Treasury (Govt securities) and is available to the Primary Dealers. Basically two things happened which led to TSLF. One, it was seen Primary Dealers were as important as commercial banks and needed funding. PDs are organisations like Merrill, Lehman etc (see the entire list here. Two, the confidence wrt to other securities declined and markets only wanted government securities. So via this facility a PD could exchange other securities and get treasuries on its books.
  • PDCF is another facility available to PDs where they get overnight loans in exchange for a collateral. Unlike TSLF, this is an overnight loan

In sum TAF and PDCF provide liquidity and TSLF helps exchange collateral. Still confused? Nothing to worry most are.  Need to read it again and again.

In its recent move Fed has expanded the acceptable collateral in both PDCF and TSLF facilities.

The collateral eligible to be pledged at the Primary Dealer Credit Facility (PDCF) has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks. Previously, PDCF collateral had been limited to investment-grade debt securities.

The collateral for the Term Securities Lending Facility (TSLF) also has been expanded; eligible collateral for Schedule 2 auctions will now include all investment-grade debt securities. Previously, only Treasury securities, agency securities, and AAA-rated mortgage-backed and asset-backed securities could be pledged.

So Fed is accepting almost anything these firms have on their balance sheets. Newswire report that Fed is accepting equities as well but I Don;t see that in the statement. RGE Monitor has a superb post on the subject

Though, I am still confused.  As Fed revises these facilities, I always need to go back and revise what each facility means. May be Fed should also appoint a Chief Communications Officer like UBS to help understand this alphabet soup.

Assorted Links

September 15, 2008

1. US financial markets are expected to explode this week after Merrill Sale and Lehman expected to file bankruptcy. WSJ Blog points to official statements.

2. WSJ Blog points what to expect in the upcoming FOMC meeting

3. Krugman on Lehman, TSLF Put

4. Mankiw says rent control is the best way to destroy a city

5. PSD Blog says there is a need to develop some guidelines for randomised evaluations.

6. MR points to some links on the financial mess.  MR on financial regulation

7. Ajay Shah pointsto an article on problems with IIP data.

8. TTR on Lehman Brothers

9. IDB points out health insurance initiative. It also reflects on Singus crisis

10. ACB on financial sector hypocrisy

Market based financial system vs bank based financial regulation

September 12, 2008

I was reading papers presented at Kansas City Fed Symposium 2008.  Three papers presented in this Symposium are epics (above 100 pages), and the other three are around 40-50 pages. Obviously, I picked the latter.

I read this paper by Anil Kashyap, Jeremy Stein and Raghu Rajan and other one by Adrias Tobin and Hyun Song Shin . Rajan et al suggest a new measure to help banks manage risks better. They say there are two things which stand out w.r.t banks in this crisis:

1) Banks continue to have substantial amount of mortgage backed securities (MBS) on their balance sheets despite having the option to securitise

2) banks financed these assets with short -term market borrowing.

Now as house prices fell, so did value and risks of MBS. As Banks sold these assets it led to fire sales depressing prices further. And as assetpositionworsened banks found it difficult to raise capital/get short term borrowing etc….This led to problems for all.

Rajan et alsay theobvious solutions is to raise capitalstandards but this has problems and doesn’t address main causes for all the problem. The main problem is banks don’t like equity capital as it is expensive.  Moreover, investors prefer to give debt as they worry that any bad decisions by managers could lead to wipe out of equitycapital.

So by asking banks to have more equity capital might be difficult to implement at the first place. But this way that capital lies inefficiently on the balance sheet which no one likes and if they again use it as they used it, we are still open to the earlier problem. Another point is that Banks were thought to be well capitalised as the crisis struck. So what is the way out?

Their main idea is that there should be a insurance market. The investors buy an insurance policy against a bank and monies are invested in a lockbox(invested in treasuries). If there is a problem with the bank the money goes to the bank and if not the money along with the interest goes back to the insurer.  JRV compares the concept to a catastrophe bond. Read the paper for more details.

A good idea but we already have credit derivative markets which also work on the same idea. Only thing is that monies are not invested in a lockbox and instead we have a market where swap rates are readily available and traded. Moreover, with a highly interconnected marketwhat is needed is a solution that applies to other financial firms as well. For instance in this crisis we have seen problems with Bear Stearns (an I-bank) and Freddie/Fannie (Housing mortgage companies). So we need to look at the problem in a holistic manner.

In the other paper Shin et al show the importance of looking at other market intermediaries (they call them broker dealers).  

In a market-based financial system, banking and capital market developments are inseparable. We document evidence that balance sheets of market-based financialintermediariesprovide a window on the transmission of monetary policy through capital market conditions. Short-term interest rates are determinants of the cost of leverage and are found to be important in influencing the size of financial intermediary ba lance sheets. However, except for periods of crises, higher balance-sheet growth tends to be followed by lower interest rates, and slower balance-sheet growth isfollowed by higher interest rates. This suggests that consideration might be given to a monetary policy that anticipates the potentialdisorderlyunwinding of leverage. In this sense, monetary policy and financial stability policies are closely linked.

This is pretty much what we see in the ongoing crisis. The effect is on the entire financial system. The authors show how important market intermediaries have become and their supply of credit to markets has increased post securitization. Though broker dealer assets are still 1/3rd of bank former have grown at a much faster pace. The authors show how monetary policy has a big impact on these intermediariesandposes problems for financial stability because of leverage linkages.  Read the paper for details.

This brings me to the title of the post. I realise financial system has increasingly become marketbasedbut regulation is still centred on banks.   I mean regulation to increase capital, Rajan et al’s solution etc. For other market firms we ususally have regulation like disclosures, annualreportingetc. Not as stringent prudential supervision and regulation as we see in the case of Banks. (For a primer on Bank Based vs Market Based system see this)

We saw in LTCMcasethat a non-regulated firm could pose significant challenges to the entire financial system. That time also Fed had to intervene. This time Fed had to intervene and privide support to Fannie/Freddie and Bear Stearns, both outside Fed ambit.

It is not just markets but activities of financialfirmsthat are getting integrated as well. What is needed is a rethink on financial regulation and make it more market based (focus will still be on banks). THis is exactly what Robert Solow said as well:

Could we redesign the mechanism to achieve most of the benefits of a broader supply of mortgage capital while sharply limiting the scope for predation and instability? This question calls for serious thought….Still, it is worth noting–….that when the Federal Reserve recently proposed some fairly anodyne improvements in the regulation of mortgage lending, the industry instantly opposed them as incipient socialism, and claimed implausibly that even the smallest regulatory safeguards would dry up the supply of loan.


Mostly Economics ranked as a friendly blog

September 12, 2008

Mostly Economics Blog has been fairly steady in the blog rankings. It was ranked as the second best South Asian Economics Blog in 2008 by and ranks 150-160 as per 26econ ranking of worldwide economics blogs.

In a new blog ranking by Econolog (Hat tip – Econbrowser) Mostly Economics has been ranked as one of the friendliest blogs. This ranking is more analytical and apart from ranking usual top economics blogs gives rankings based on several categories like readability, most active etc .

So Mostly Economics ranks in the Friendly Blogs category. Definition of friendly:

Friendliest lists the blogs which link out to other blogs most frequently.

Not exactly what one would be expecting. I thought friendliest meant things like easy to read, navigate, etc. 🙂 But still, it makes it to some ranking.

It is nice to see Mostly Economics being ranked with likes of Marginal Revolution (a superb blog) which gets No 1 Blog overall and is also mentioned in the Friendly List.

Also see econ26 comparing the 2 rankings.

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