198) Arbitrage funds: Low risk alternative for investors

Investors are increasingly scouting for exposures that can provide relatively stable returns. Arbitrage funds offer one such exposure. This article discusses why such funds carry alpha-like exposure and how they generate arbitrage gains.

The sharp drawdown in portfolio values since this January has seen a paradigm shift in investor behaviour. Even portfolios with equity bias now seem to prefer exposure to assets with stable returns.

Some investors, for instance, have taken exposure to arbitrage funds (arb funds) as they have generated positive returns even during market downturns. Do such funds provide optimal gains?

Risky arbitrage?

Academic arbitrage is riskless. It involves buying an asset in one market and selling it in another for a higher price without initial investment.

Financial markets do not provide such opportunities. Some risk is involved because an initial capital outlay is often required. But the strategies that arb funds engage in are the closest an investor can get to riskless arbitrage.

The concept is based on capturing the “cost of carry” in the futures price.

Take Reliance Industries. Suppose the current spot price is Rs 1,200 and the near-month futures contract trades at Rs 1,215. The portfolio manager will buy, say, 7,500 shares of Reliance and sell 100 contracts (underlying 75 shares) of near-month futures.

The trading strategy is built on the fact that futures price converges to the spot price on expiry. What if Reliance spot price is at Rs 1,350 on expiry? The portfolio will gain Rs 11.25 lakh in the spot market but lose Rs 10.12 lakh in the futures market.

The net gain on the spot-futures arbitrage will be Rs 1.125 lakh.

What if Reliance closes at Rs 1,100 in the spot market? The portfolio will lose Rs 7.5 lakh in the spot market but gain Rs 8.625 lakh in the futures market.

The net gain will be Rs 1.125 lakh. The gain is the difference between the futures and the spot price at the time the trade is initiated.

It is, however, not necessary for the portfolio manager to hold the position till expiry. If she finds that the difference has narrowed since initiating the trade, she can close the position and capture arbitrage gains.

The portfolio will, however, gain most if the position is held till expiry. The reason is that the difference between futures and spot price will then be zero and the initial difference turns into arbitrage gains.

Investment optimality

Arb funds generated between 7 and 8 per cent return in the last one year. The benchmark for such funds is typically a liquid index.

Money market funds have generated higher returns this year because of the tight liquidity in the credit market.

Such funds invest in short-term instruments such as treasury bills and commercial papers.

Liquid funds are somewhat different in that they also invest in short-term bonds.

The point is that upside is capped in money market funds as returns comprise only of interest income.

Liquid funds generate marginally higher returns but are exposed to price risk due to bond price declines.

Arb funds carry the potential to generate higher returns if there is large mispricing in assets, which is often the case in volatile markets. Besides, such funds neutralise market risk as long as the portfolio manager follows the fund’s mandate.

This gives the fund an alpha-like characteristic which fits well in the satellite portfolio within the core-satellite framework. Alpha returns refer to excess returns that the fund manager generates which has low correlation with market returns.

Investors have to consider two factors before choosing an arb fund- management expense ratio (MER) and exposure to the bond market. Most arb funds have MER between one and 1.65 per cent. This is high but not unreasonable, considering that even index funds carry an MER of one per cent.

The problem then is with the arb fund’s bond exposure. Arb funds take such exposure to earn above cash-returns when the portfolio manager does not find arbitrage opportunities.

Investors should prefer funds instead that take exposure in money market instruments. The reason is that bonds carry higher price risk that may not be necessarily compensated by the higher yield.

Besides, such exposure could bring down the stability of alpha returns, as exposure to bond market will increase correlation with market returns.

Conclusion

The continual decline in asset prices has led many investors to look for exposure that provide relatively stable returns. This article shows why arb funds could be one such exposure. At present, there are just over 10 funds exploiting the spot-futures arbitrage.

As more funds engage in such strategies, arbitrage gains may become increasingly difficult but not impossible. Till then, MERs and bond exposure will play a significant role in selecting an arb fund.

B. Venkatesh

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

197) Who murdered the financial system?

Leftists claim that the global financial crisis was caused by reckless deregulation and greed. Rightists blame half-baked financial regulations and perverse incentives. Actually, the financial sector is deeply regulated, with major roles for both the state and markets. It was not one or the other that failed but the combination.

The best metaphor for the mess comes from Jack and Suzy Welch, who recall Agatha Christie’s Murder on the Orient Express. In this novel, 12 people are suspects in a murder. And 12 turn out to be guilty. What starts as a whodunit concludes as an everybody-dun-it. In the same spirit, allow me to present the 12 murderers of the US financial system.

1) The Federal Reserve Board

Alan Greenspan, Fed Governor in 1987-2006, was once hailed as a genius for keeping the US booming, but is now called a serial bubble-maker. He presided over bubbles in housing, credit, and stock markets. He said it was difficult to identify asset bubbles in advance, so anti-bubble policies might be anti-growth. It was better to let bubbles build, and sweep up after they burst. Bernanke, like Greenspan, ignored the US housing bubble till it burst.

2) US politicians

Envisioning a home for every American, regardless of income, they provided excess implicit and explicit housing subsidies. One law forced banks to lend to subprime poor borrowers. Legislators created Fannie Mae and Freddie Mac, government-sponsored entities that bought or underwrote 80% of all US mortgages, and enjoyed exemption from normal regulations. Politicians ignored Greenspan’s warning that such a dominant role for two under-regulated giants posed a huge financial risk.

3) Fannie Mae and Freddie Mac

They resisted regulation, and spent over $2 million lobbying legislators against any tightening of rules. As mortgagers of last resort they should have been especially prudent. But they bought stacks of toxic mortgage paper — collateralised debt obligations (CDOs) — seeking short-term profits that ultimately led to bankruptcy.

4) Financial innovators

Their ideas provided cheap, easy credit, and helped stoke the global economic boom of 2003-08. Securitisation of mortgages provided an avalanche of capital for banks and mortgage companies to lend afresh. Unfortunately the new instruments were so complex that not even bankers realised their full risks.

CDOs smuggled BBB mortgages into AAA securities, leaving investors with huge quantities of down-rated paper when the housing bubble burst. Financial innovators created credit default swaps (CDSs), which insured bonds against default. CDS issues swelled to a mind-boggling $60 trillion. When markets fell and defaults widened, those holding CDSs faced disaster.

5) Regulators

All major countries had regulators for banking, insurance and financial/ stock markets. These were asleep at the wheel. No insurance regulator sought to check the runaway growth of the CDS market, or impose normal regulatory checks like capital adequacy. No financial regulator saw or checked the inherent risks in complex derivatives. Leftists today demand more regulations, but these will not thwart the next crisis if regulators stay asleep.

6) Banks and mortgage lenders

Instead of keeping mortgages on their own books, lenders packaged these into securities and sold them. So, they no longer had incentives to thoroughly check the creditworthiness of borrowers. Lending norms were constantly eased. Ultimately, banks were giving loans to people with no verification of income, jobs or assets. Some banks offered teaser loans — low starting interest rates, which reset at much higher levels in later years — to lure unsuspecting borrowers.

7) Investment banks

Once, these institutions provided financial services such as underwriting, wealth management, and assistance with IPOs and mergers and acquisition. But more recently they began using borrowed money — with leverage of up to 30 times — to trade on their own account. Deservedly, all five top investment banks have disappeared. Lehman Brothers is bust, Bear Stearns and Merrill Lynch have been acquired by banks, and Morgan Stanley and Goldman Sachs have been converted into regular banks.

8) Rating agencies

Moody’s and Standard and Poor’s were not tough or alert enough to spot the rise in risk as leverage skyrocketed. They allowed BBB mortgages to be laundered into AAA mortgages through CDOs.

9) The Basel rules for banks

These international negotiated norms provided harmonised regulatory checks on financial excesses across countries. The first set of norms, Basel-I, was widely criticised as too rigid and blunt. So countries agreed on Basel-II, which allowed banks to use credit ratings and models based on historical record to lower the risk-ratings of many securities. This dilution of norms led to excesses everywhere. Iceland’s banks went bust holding loans/securities totalling 10 times its GDP. The dilution of risk-rating in Basel-II helped inflate the financial bubble.

10) US Consumers

Their savings used to be 6% of disposable income some time ago, but more recently has been zero or even negative. They have gone on a huge borrowing spree to spend far more than they earn. This excess is reflected in huge, unsustainable US trade deficits.

11) Asian and OPEC countries

They undervalued their currencies to stimulate exports and create large trade surpluses with the US. They accumulated trillions in forex reserves, and put these mostly into dollar securities. This depressed US interest rates, and further fuelled borrowing there.

12) Everybody

Consumers, corporations, banks, politicians, the media — indeed everybody — was happy when housing prices boomed, stock markets boomed, and credit became cheap and easily available. Bubbles in all these areas grew in full public view. They were highlighted by analysts, but nobody wanted to stop the lovely party. Everybody liked easy money and rising asset prices. This trumped prudence across countries.

So, forget the Left-versus-Right or regulations-versus-markets debate on the financial crisis. States, institutions, markets and everybody else was guilty.

These actors will for some years don sackcloth and ashes, adopt stiffer regulations, and listen to lectures on the virtues of prudence and restraint. But after seven-to-ten years of the next business upswing, I predict that we will once again have a new generation of bubbles, evading whatever new checks have been put in place. When everybody loves bubbles, they are both irresistible and inevitable.

Swaminathan Iyer
Economist

196) For a few dollars more

Is it worthwhile for developing countries to pursue policies which increase integration of their financial markets?

Financial globalisation by increasing cross-border capital flows can increase systemic risk in financial systems around the globe. That is, when markets become closely integrated, instability generated in one market rapidly spreads to other markets. The current market turmoil, seen as a consequence of financial globalisation, has revived the debate about the pros and cons of financial globalisation. The key question is: is it worthwhile for developing countries to purse policies which increase integration of their financial markets with those of the other countries. In other words, do the benefits from financial globalisation outweigh the risks?

A recent paper from Her Majesty’s Treasury* argues that financial globalisation can deliver significant benefits to countries in terms of economic growth and macroeconomic stability. Specifically, the paper claims that the main channel through which financial globalisation contributes to economic growth is by improving allocative efficiency of capital. In open financial markets, capital would tend to flow into economies where it can be put to its most productive use, thereby increasing its efficiency. Moreover, increased availability of capital lowers the cost of raising capital. This in turn encourages firms to take on more investment, thereby enhancing growth.

Furthermore, financial globalisation can enhance growth by spreading technology and managerial expertise, promoting development of secondary markets and aiding productivity growth because of increased competition. In addition, financial globalisation is likely to provide impetus to financial sector development, help promote institutions and contribute to total factor productivity growth by improving economy-wide efficiency. The paper argues that it is for these reasons a return to financial protectionism would damage global economic prospects.

In contrast, in a recent paper Dani Rodrik and Arvind Subramanian** argue that in the case of developing economies it is difficult to empirically establish a robust causal relationship between financial integration and economic growth. The paper goes on to argue that the presumed benefits of financial globalisation, such as, increased investment and better consumption smoothing opportunities have simply not materialised for emerging markets. It turns out that countries that have grown most rapidly have been those that rely less on foreign capital.

Rodrik and Subramanian argue that whether financial liberalisation and globalisation is beneficial or not depends on country specific factors. For example, in a country where the return on investment is low, additional foreign capital will not increase growth, but instead will drive up the value of the domestic currency. This might hinder exports and hence growth. This argument raises an interesting question. Why would there be an influx of foreign capital in the first place if return on investment is low? The paper fails to shed light on this issue.

The treasury paper also acknowledges that there are significant risks from financial globalisation. For example, increased cross-border transactions can increase systemic risk by increasing the correlation of asset prices across countries. Furthermore, it makes emerging economies vulnerable to the sudden reversal in international capital flows, which can cause exchange rate volatility and asset price bubbles. It is for this reason that both papers acknowledge that capital controls may be necessary for emerging countries at certain times.

In sum, both papers argue that the benefits from financial globalisation depend on a country meeting certain pre-requisites, although Rodrik and Subramanian appear to be more pessimistic about its potential benefits. Good institutions, appropriate regulatory and supervisory framework, responsible macroeconomic policies, financial sector development and trade integration determine the extent to which a country benefits from financial globalisation.

The current financial meltdown is bound to intensify scepticism about markets and globalisation. Neither of the papers reviewed here argue in favour of financial protectionism, but rather the message is, countries should accelerate reforms to strengthen their regulatory and supervisory systems, and should satisfy the pre-conditions for opening up of their financial markets before embarking on financial globalisation. Or else the risk-return trade off associated with financial globalisation would turn unfavourable.

Vidya Mahambare

*Embracing financial globalisation, HM Treasury, UK, May 2008
**Why did the financial globalisation disappoint? Dani Rodrik and Arvind Subramanian, Harvard, March 2008. The author is senior economist, CRISIL

195) Deregulate and perish?

Deregulation cannot be blamed since it decreased costs through increased competition and raised efficiency.

In the last few years commentators often pointed out that the persistent global economic imbalances were unsustainable. However, few would have predicted that the Western financial sector and global stock markets would be close to a meltdown by October 2008. Governments have been forced into taking action to prevent the financial system from shutting down. Therefore, taxpayers have ended up recapitalising wayward financial firms. In this context, it would be useful to review recent events with a historical perspective to better understand how some of the best-known names in banking and insurance descended into bankruptcy so abruptly.

In the 1840s several US states defaulted on loans received from European creditors and the Eleventh Amendment to the US Constitution prevented foreign creditors from obtaining repayment by petitioning US courts. Over time some of these loans were repaid since US borrowers did not want to lose their access to European credit. It was around the late 19th century that financiers such as John Piermont Morgan garnered sufficient capital to act as financial intermediaries between Europe and the US. The two World Wars devastated Europe and US-based firms were able to establish themselves as the dominant international financial houses. As capital was scarce at that time, financial firms had a stranglehold over the corporate sector.

Till about the 1970s bankers in Western countries continued to have exclusive relationships with corporate clients, and investment banks underwrote debt and equity issuance at highly profitable terms for themselves. US companies grew, along with the economic ascendancy of the US, and were able to set up triple A-rated financial subsidiaries. Consequently, in the 1980s, as underwriting margins decreased, firms such as Salomon Brothers moved away from traditional investment banking to focus on proprietary trading of stocks, bonds and later options. Salomon Brothers was perhaps the first to create mortgage-backed securities (MBS). Michael Lewis documents in Liar’s Poker that as deregulation continued in the 1980s, and savings and loans managers were allowed to sell mortgages as bonds, unscrupulous Wall Street traders made huge fortunes. Michael Milken emerged as the junk bond king and finally went to jail in 1989 for “racketeering and securities fraud”. In 1990, Drexel Burnham Lambert was driven to bankruptcy for its involvement in junk bonds.

The 1933 Glass-Steagall Act, which set up the Federal Deposit Insurance Corporation and separated commercial from investment banking since the Great Depression in the US, was repealed in 1999. This meant that deposit-taking commercial banks like Citibank could underwrite and trade instruments such as MBS and collateralised debt obligations (CDOs), and set up structured investment vehicles (SIVs). In 2000, the elite investment bank J P Morgan which was reeling from an erosion of its traditional high margin investment banking business consolidated with Chase Bank.

Hedge funds are relatively lightly-regulated on the grounds that these special investment vehicles cater only to high net worth individuals or institutions. These funds have proliferated since the late 1960s when they were first set up. They engage in complex trading strategies including algorithmic or automated trading and are usually highly-leveraged. However, it is not just hedge funds which have high leverage ratios and use automated trading, banks engage in similar practices. It is estimated that in G7 countries, at least half of all stock trades are executed per automated instructions.

It is amusing that hedge funds and asset management firms advertise themselves as having consistently beaten the market rate of return. To do this, they have to adopt higher-risk strategies. And, riskier asset portfolios face sharp corrections in value from time to time. Hedge fund managers and institutional investors profess that they can time their investment decisions optimally. This is seductive logic. However, since hedge funds take varied positions, their collective investments are a sub-set of the market and it is not credible that they can regularly outperform the average market return.

The US housing mortgage market is valued at about $14 trillion and the sub-prime component is around 10 per cent of that amount. The recent financial firm bankruptcies and credit freeze were clearly triggered by housing loan defaults. However, the root causes of the current crisis are more varied than just the repackaging and selling of “toxic” sub-prime mortgage securities by getting the rating agencies to classify them as triple A. For example, AIG was inadequately capitalised to sell high volumes of credit default swaps (CDSs) on CDOs linked to MBS. At a more fundamental level, elementary principles of risk management were abandoned by regulators. For instance, in 2004 five US investment banks, namely Goldman, Lehman, Merrill, Bear-Stearns and Morgan Stanley prevailed upon the Securities and Exchange Commission (SEC) to allow them to increase their leverage. The SEC relaxed its three-decade-old rule, which restricted debt to net capital ratios to 12:1 and allowed these five banks to increase their leverage ratios to 30 and even 40:1. If leverage is around 30:1, a reduction in the value of a bank’s assets by a little over 3 per cent will wipe out its entire equity capital.

The US has invariably been at the forefront of financial sector deregulation and innovation. At the same time, in the last ten years or so, any weakening of consumer confidence or stock market sentiment was met by increased federal spending and interest rate cuts. This was possible because some Asian and fossil fuel-exporting countries had accumulated large trade surpluses and lent back the dollars to the US through investments in US government paper. Excessively generous housing loans to non-creditworthy borrowers led to a sharp increase in demand which, in turn, resulted in a housing market bubble. MBS were repackaged such that the underlying risk was less obvious and for a time the rise in real estate prices fuelled consumer spending. Less nimble financial institutions were left holding the risk on their books and some of the firms which provided CDS cover did not have adequate risk capital.

To summarise, is it deregulation which is at the root of the financial sector’s current problems? Deregulation cannot be blamed since it decreased costs through increased competition and also raised efficiency levels. The financial meltdown was due to an abdication of regulatory responsibility, conflicts of interest leading to irresponsible behaviour on the part of rating agencies, and excessively leveraged bets taken by financial institutions combined with loose monetary policy, the last of which was made possible by global trade imbalances.

Jaimini Bhagwati

The writer is the Ambassador of India to Belgium, Luxembourg and the European Union. Views expressed are personal. Contact: j.bhagwati@gmail.com.

194) Insurance cos learning lessons hard way

For all of the last two years, capital has never been an issue for private life insurance companies. To get promoters to loosen purse strings, the management of a life insurance company had to only mention that they were growing faster than the market. Even mid-sized corporates with life insurance subsidiaries were willing to bring in a few hundred crores into the business every six months.

What drew in the capital was not the return on equity. Although it has been eight years since the industry was opened, most companies are far from break-even. The reason why capital was so freely available was the huge valuations that the market was placing on these life companies.

The valuations, in turn, were driven by 100%-plus growth recorded two years ago. Although private life insurers continued to pile up losses, these losses were explained away as notional since most of the capital continued to remain on their books in the form of provisions for solvency margins. The real surge in investments came in 2007-08 when the stock market took off, pushing up valuations of private life companies even further.

Corporates were also flush with cash and rising stocks pushed up the net asset value of various unit-linked insurance plans leading to further optimism in the business. In this one year, the private life insurance industry doubled its branch network to close to 8,000 branches and also grew their agency force 100% to 1.5 million agents. A host of new companies joined the fray, increasing the demand for managerial talent and pushing up the salary bill for the industry.

The tide began to turn earlier this year when the markets crashed in January. However, unlike the mutual fund industry, the life business held its own and saw its income rise during this period. What helped was that new Irda norms blocked exit routes for policyholders for three years. Also the new distribution capacities created earlier in 2007-08 started coming into play.

As a result, even as stocks tumbled, fresh money continued pouring into Ulips.
The outlook has, however, changed for the life insurance industry with the subprime storm gaining strength in October and bringing down with it giant institutions like AIG and Lehman Brothers. The decline in stocks has exposed the weaknesses of the life insurance industry.

For the first time, it looks likely that policyholder confidence in Ulips could get shaken. Insurance companies are already talking about a slowdown in new business in September & October. There is also the lurking fear that existing policyholders, who bought when the markets were at its peak, might be reluctant to put in renewal money, seeing how much their capital has shrunk. The negative equity returns have also brought into focus the cost structure of Ulips.

While high front-ending of costs does not matter much when stocks rise 40%, it is a different story in a bear market. Falling markets could also hit the persistency of life insurance agents, which in turn could impact policy persistency. When an agent drops out, all the money that has been invested in training the agent is lost. This pushes up the average cost of getting an agent on the street.

Companies spend anywhere between Rs 7,000 and Rs 10,000 in getting an agent trained and certified. If only one out of five agents sticks to the profession long-term, the average cost of recruiting a professional agent goes up to Rs 50,000. Similarly, when more-than-expected policies lapse, the assumptions made by insurers on new business profits go for a toss.

The other concern is that promoters may not be as willing as in the past to open their purses, particularly when the break-even date is being constantly pushed away. Unlike banking, insurance is a highly capital-intensive industry and insurance companies cannot substitute equity with tier II capital as in the case of banks.

But it is not all doom and gloom. Over the years, the life industry has built some inherent strengths that could help create strong financial institutions. With over Rs 12,000 crore invested in the industry, the life business is among the most resilient in the financial sector. Life companies have overtaken mutual funds in retail penetration because of their nationwide distribution network. Life companies also have built up immense brand value over the years because of which retail investors are willing to entrust them with their retirement savings.

What is needed for the industry is to recognise the change in approach that is required post subprime crisis. Unlike mutual funds life companies have the ability to provide guaranteed return products. Guaranteed return products coupled with trusted conventional plans could help life insurers capture some of the ‘flight to safety’ that is now being witnessed in the savings markets.

Secondly, this crisis provides insurers with the opportunity to get back to basics. In the last eight years, the life business has moved away completely from protection to investment-led products. Demand for protection is expected to rise as individual liabilities rise. This provides insurers with an opportunity to build relationships with new customers.

The other issue that has to be addressed is that of professionalising the insurance agency force. Private life companies came with the promise of bringing in financial advisors who do ’need-based’ selling rather than agents who push. But this has not happened. On the contrary, fly-by-night agents have mis-sold policies with their eye on first year commissions. Quality controls can check misselling and reduce lapsations.

Finally, like in all financial services, insurers need to bring down their margins to remain competitive. The recent case of mutual funds selling systematic investment plans with life covers shows how much the boundaries have faded. From next year, there will be pension companies which will offer to manage retirement funds with wafer-thin margins. Life companies may have carved out a new market in the last eight years but they will need to bring down costs if they wish to retain their market.

193) Paul Krugman: Gordon does good

Has Gordon Brown, the British prime minister, saved the world financial system?

OK, the question is premature — we still don’t know the exact shape of the planned financial rescues in Europe or for that matter the United States, let alone whether they’ll really work. What we do know, however, is that Brown and Alistair Darling, the chancellor of the Exchequer (equivalent to our Treasury secretary), have defined the character of the worldwide rescue effort, with other wealthy nations playing catch-up.

This is an unexpected turn of events. The British government is, after all, very much a junior partner when it comes to world economic affairs. It’s true that London is one of the world’s great financial centres, but the British economy is far smaller than the US economy, and the Bank of England doesn’t have anything like the influence either of the Federal Reserve or of the European Central Bank. So you don’t expect to see Britain playing a leadership role.

But the Brown government has shown itself willing to think clearly about the financial crisis, and act quickly on its conclusions. And this combination of clarity and decisiveness hasn’t been matched by any other Western government, least of all our own. What is the nature of the crisis? The details can be insanely complex, but the basics are fairly simple. The bursting of the housing bubble has led to large losses for anyone who bought assets backed by mortgage payments; these losses have left many financial institutions with too much debt and too little capital to provide the credit the economy needs; troubled financial institutions have tried to meet their debts and increase their capital by selling assets, but this has driven asset prices down, reducing their capital even further.

What can be done to stem the crisis? Aid to homeowners, though desirable, can’t prevent large losses on bad loans, and in any case will take effect too slowly to help in the current panic. The natural thing to do, then — and the solution adopted in many previous financial crises — is to deal with the problem of inadequate financial capital by having governments provide financial institutions with more capital in return for a share of ownership. This sort of temporary part-nationalisation, which is often referred to as an “equity injection,” is the crisis solution advocated by many economists — and sources told The Times that it was also the solution privately favored by Ben Bernanke, the Federal Reserve chairman.

But when Henry Paulson, the US Treasury secretary, announced his plan for a $700 billion financial bailout, he rejected this obvious path, saying, “That’s what you do when you have failure.” Instead, he called for government purchases of toxic mortgage-backed securities, based on the theory that ... actually, it never was clear what his theory was.

Meanwhile, the British government went straight to the heart of the problem — and moved to address it with stunning speed. On Wednesday, Brown’s officials announced a plan for major equity injections into British banks, backed up by guarantees on bank debt that should get lending among banks, a crucial part of the financial mechanism, running again. And the first major commitment of funds will come on Monday — five days after the plan’s announcement.

At a special European summit meeting on Sunday, the major economies of continental Europe in effect declared themselves ready to follow Britain’s lead, injecting hundreds of billions of dollars into banks while guaranteeing their debts. And whaddya know, Paulson — after arguably wasting several precious weeks — has also reversed course, and now plans to buy equity stakes rather than bad mortgage securities (although he still seems to be moving with painful slowness).

As I said, we still don’t know whether these moves will work. But policy is, finally, being driven by a clear view of what needs to be done. Which raises the question, why did that clear view have to come from London rather than Washington? It’s hard to avoid the sense that Paulson’s initial response was distorted by ideology. Remember, he works for an administration whose philosophy of government can be summed up as “private good, public bad,” which must have made it hard to face up to the need for partial government ownership of the financial sector.

I also wonder how much the Femafication of government under President Bush contributed to Paulson’s fumble. All across the executive branch, knowledgeable professionals have been driven out; there may not have been anyone left at Treasury with the stature and background to tell Paulson that he wasn’t making sense.
Luckily for the world economy, however, Gordon Brown and his officials are making sense. And they may have shown us the way through this crisis.

Paul Krugman
(The writer is this year’s winner of the Nobel Economics Prize for his analysis of trade patterns)

192) Not Learning From History

As the world struggles in the throes of a credit crisis, it seems appropriate to recount some (un)forgettable meltdowns of the twentieth century, the economics behind them and the panic that they created. Each of these major crises had features that have parallels in the current one. Yet, history repeats itself. Could investors have drawn a lesson or two from each of these and been more prudent? Read on.

The Japanese property bubble

The fall in property prices and defaults by sub-prime borrowers flagged off the now famous credit crisis. Will this crisis tip the world into recession? Let us hark back to the Japanese property bubble in the early 1980s.

At that time, Japan had huge trade surpluses (excess of exports over imports) with the US. Alarmed at its unfavourable Balance of Trade position, the US, through the Plaza Accord of 1985, allowed the yen to appreciate against the dollar. In two years’ time, the yen was up by almost 50 per cent.

The country’s export-dependent economy stumbled. Capital investments slowed. To avoid a recession, Japan eased restrictions on borrowings and progressively lowered interest rates. But low inflation (due to cheap imports and the fall in international oil prices), coupled with cheap money, enabled cash-flows into the property and stock markets as well.

Over the next few years, as demand for land increased, property prices soared. In the latter part of 1989, the Nikkei too raced towards its all-time high of 38,957 points but inflation had started to rear its head.

As the New Year dawned, the stock market nose-dived. The Bank of Japan sharply increased lending rates and placed restrictions on lending to the real estate sector. Property prices plummeted. Loans given with land as collateral went bad.

Soon, slowing investment and consumption led to deflation. Following the crash, the 1990s came to be known as ‘the lost decade’ in Japan. With the Asian financial crisis further rubbing salt into the wounds, Japan’s central bank adopted an extremely easy money policy that kept interest rates at virtually zero. Even today, at half a per cent, Japan has one of the lowest lending rates in the world. Little wonder that its central bank couldn’t cut rates earlier this week, alongside several other countries, in response to the US credit crisis!

Great Depression

The current credit crisis is increasingly being compared to the Great Depression in the US in the 1930s. The 1920s witnessed a huge increase in manufacturing output in the US. But the wages didn’t keep pace. Instead, the bulk of the profits was pocketed by corporates, creating a wide gap between the rich and the blue-collared.

At the same time, capacity expansions by companies (signalling higher profits), rising dividends and speculation drew surplus into the stock market. The upward spiral helped the Dow Jones Industrial Average hit a peak of 381 in September 1929.

When volatility rose, speculation gave way to fear and the party wound up quickly. The rich stopped spending. The poor, who were earlier financing their purchases mostly on credit, cut back. As demand declined, so did production. As a result, unemployment rose. Borrowers defaulted.

Ironically, it was the onset of World War II that boosted spending and bailed out the economy .

Asian crisis

If the Great Depression was born out of the unequal fruits of industrial prosperity, the Asian currency crisis of 1997-98 exposed the harm that volatile capital flows and highly leveraged positions can cause to entire economies. The years preceding the crisis saw South-east Asian economies such as Thailand, Malaysia and Indonesia open up their economies to foreign direct investments and capital flows.

Full capital mobility was allowed, with these Asian economies aligning their exchange rates closely with the dollar.

A sharp appreciation in the dollar in 1995 caused South-east Asian currencies to appreciate against other currencies as well. This resulted in significant losses on the export front — which was a key blow to these externally dependent economies.

A widening current account deficit (financed with overseas borrowings) coupled with basic differences in the economies of the US and these countries aroused speculation as to the ‘real’ exchange rate — the fixed exchange rate regime collapsed. As a result, the currencies of countries such as Thailand, Malaysia, Indonesia, Korea and Philippines were sharply devalued.

Interest rates were steeply raised to protect the local currencies. This set off a vicious spiral of rising cost of financing for companies and a squeeze on debt servicing capabilities. Earlier, the fixed exchange rates and the free flow of foreign funds had prompted domestic banks and corporates to borrow heavily from abroad.

Once disaster struck, the high leverage choked borrowers. Banks which resorted to borrowing from abroad for lending domestically too felt the heat. The excessive inflows had also found their way into asset classes such as the stock market and real estate.

When foreign investors began to pull money out, both stock market and real estate prices slumped. In the latter half of 1997, the IMF, along with the World Bank and the Asian Development Bank, provided aid to these countries as they were in danger of defaulting on their debt repayments.

These countries also agreed to undertake structural reforms by tightening their fiscal and monetary policies.

Latin American debt crisis

A similar story had already been enacted in Latin America in the 1980s. In the context of massive inflows of foreign capital and subsequent flight, the Asian crisis was, in fact, Latin America Part II.

The substantial increase in oil prices in 1973-74 by the OPEC nations resulted in massive inflows of surplus money into the oil-exporting countries. With the availability of funds far exceeding domestic requirements, these countries parked surplus funds in international commercial banks.

This happened at a time when countries such as Chile, Uruguay and Argentina had just liberalised trade and needed money to implement economic reforms.

Besides, oil-importing countries in this area also needed money to finance their deficits. So Latin America resorted to borrowing these surplus ‘petro-dollars’ from commercial banks whose loans were short-term and carried variable rates.

As the 1970s drew to a close, oil prices spiked again, fuelling inflation and, hence, higher interest rates. Money was needed to finance both the trade imbalance and the higher interest. For this, these countries resorted to fresh borrowings, and were thus pulled into a debt trap.

A year or two later, oil prices fell, but not interest rates. In Mexico, an oil-exporting country there was a flight of capital abroad. The peso depreciated by about 80 per cent; Mexico was unable to service its debt and was on the verge of defaulting on loan repayments.

Other Latin American countries followed suit. Further lending to these countries was refused and they could not get out of the debt trap. These nations were later forced to renegotiate their debt and the IMF stepped in to co-ordinate.

Parvatha Vardhini C.

191) Rescue the Rescue

I was channel surfing on Monday, following the stock market’s nearly 800-point collapse, when a commentator on CNBC caught my attention. He was being asked to give advice to viewers as to what were the best positions to be in to ride out the market storm. Without missing a beat, he answered: “Cash and fetal.”

I’m in both — because I know an unprecedented moment when I see one. I’ve been frightened for my country only a few times in my life: In 1962, when, even as a boy of 9, I followed the tension of the Cuban missile crisis; in 1963, with the assassination of J.F.K.; on Sept. 11, 2001; and on Monday, when the House Republicans brought down the bipartisan rescue package.
But this moment is the scariest of all for me because the previous three were all driven by real or potential attacks on the U.S. system by outsiders. This time, we are doing it to ourselves. This time, it’s our own failure to regulate our own financial system and to legislate the proper remedy that is doing us in.
I’ve always believed that America’s government was a unique political system — one designed by geniuses so that it could be run by idiots. I was wrong. No system can be smart enough to survive this level of incompetence and recklessness by the people charged to run it.
This is dangerous. We have House members, many of whom I suspect can’t balance their own checkbooks, rejecting a complex rescue package because some voters, whom I fear also don’t understand, swamped them with phone calls. I appreciate the popular anger against Wall Street, but you can’t deal with this crisis this way.
This is a credit crisis. It’s all about confidence. What you can’t see is how bank A will no longer lend to good company B or mortgage company C. Because no one is sure the other guy’s assets and collateral are worth anything, which is why the government needs to come in and put a floor under them. Otherwise, the system will be choked of credit, like a body being choked of oxygen and turning blue.
Well, you say, “I don’t own any stocks — let those greedy monsters on Wall Street suffer.” You may not own any stocks, but your pension fund owned some Lehman Brothers commercial paper and your regional bank held subprime mortgage bonds, which is why you were able refinance your house two years ago. And your local airport was insured by A.I.G., and your local municipality sold municipal bonds on Wall Street to finance your street’s new sewer system, and your local car company depended on the credit markets to finance your auto loan — and now that the credit market has dried up, Wachovia bank went bust and your neighbor lost her secretarial job there.
We’re all connected. As others have pointed out, you can’t save Main Street and punish Wall Street anymore than you can be in a rowboat with someone you hate and think that the leak in the bottom of the boat at his end is not going to sink you, too. The world really is flat. We’re all connected. “Decoupling” is pure fantasy.
I totally understand the resentment against Wall Street titans bringing home $60 million bonuses. But when the credit system is imperiled, as it is now, you have to focus on saving the system, even if it means bailing out people who don’t deserve it. Otherwise, you’re saying: I’m going to hold my breath until that Wall Street fat cat turns blue. But he’s not going to turn blue; you are, or we all are. We have to get this right.
My rabbi told this story at Rosh Hashana services on Tuesday: A frail 80-year-old mother is celebrating her birthday and her three sons each give her a present. Harry gives her a new house. Harvey gives her a new car and driver. And Bernie gives her a huge parrot that can recite the entire Torah. A week later, she calls her three sons together and says: “Harry, thanks for the nice house, but I only live in one room. Harvey, thanks for the nice car, but I can’t stand the driver. Bernie, thanks for giving your mother something she could really enjoy. That chicken was delicious.”
Message to Congress: Don’t get cute. Don’t give us something we don’t need. Don’t give us something designed to solve your political problems. Yes, Hank Paulson and Ben Bernanke need to accept strict oversights and the taxpayer must be guaranteed a share in the upside profits from all rescued banks. But other than that, give them the capital and the flexibility to put out this fire.
I always said to myself: Our government is so broken that it can only work in response to a huge crisis. But now we’ve had a huge crisis, and the system still doesn’t seem to work. Our leaders, Republicans and Democrats, have gotten so out of practice of working together that even in the face of this system-threatening meltdown they could not agree on a rescue package, as if they lived on Mars and were just visiting us for the week, with no stake in the outcome.
The story cannot end here. If it does, assume the fetal position.

THOMAS L. FRIEDMAN

New York Times News Service

190) Greenspan: Revered to reviled?

Warned about the after effects of a house price collapse, Mr Greenspan’s response was that asset bubbles were not the business of central banks.

He was hailed as the greatest central banker of all time (This writer thought so too). But former US Fed Chairman Mr Alan Greenspan’s reputation is heading towards tatters.

Never in history or hereafter will a central banker have as sharp or quick a fall.

The problem was the phenomenon of an asset price boom — specifically the boom in house prices.

This took place in the environment of sharp falls in US interest rates engineered by the Greenspan Fed, following the collapse of the dot com bubble and 9/11. From 5.5 per cent, as we entered 2000, the Fed cut to 1 per cent and kept it there for as long as three years.

In the meanwhile and as a result, housing prospered as did the stock market. Economic growth was tepid compared to the Clinton years (and might have been far worse but for the housing investment stimulant). Early warning

Sane advice was not in short supply. Mr Greenspan was warned — not once but several times, not by an odd economist, but many — about the after effects of a house price collapse.

His response was that asset bubbles were not the business of central banks and they should not influence monetary policy.

The most he would concede was that central banks might have a lot of cleaning up to do if asset prices crashed — in essence, no action on the way up but rate cuts and adequate liquidity provisioning on the way down.

Mr Greenspan did not see a housing collapse in his tenure but did successfully tackle the 1987 stock market fall, the Mexican and Asian crises and hedge fund LTCM’s implosion with his recommended medicine.

In fact, he was busy fighting a different war — one against deflation, strange as it sounds today. In this, he was on the same wavelength as the present Fed Chairman, Mr Ben Bernanke, who too missed the significance of asset bubbles. By the time Mr Greenspan decided to start raising interest rates, it was too late to check the boom, which, sooner or later, was bound to end in tears.Regulation laxity

More than failure to recognise the risk of asset bubbles, Mr Greenspan must be faulted for the laxity in bank regulation, which enabled the financial system to create millions of (now) worthless mortgages and Collateral Debt Obligations backed by these weak assets.

The crowning glory was the rush to insure them with Credit Default Swaps, which were written for trillions of dollars by institutions like the late unlamented AIG on the strength of dubious credit ratings awarded by conniving rating agencies.

It will remain a tragedy that the first rate mind of Mr Alan Greenspan did not see all this coming.

S. Balakrishnan

189) Global financial crisis: A slippery slope

We are going through the most serious global financial crisis since the Great Depression. It is centred in the United States, but its implications are worldwide.The nationalisation of Bradford & Bingley in the UK and financial support for Fortis in Europe highlight the dangers of contagion.

Only concerted action by governments and monetary authorities, particularly those of the US, can prevent a global disaster. The crisis is as much real as it is based on the fear in the minds of participants in the financial system. That is why the $700 billion Troubled Asset Recovery Plan proposed by US treasury secretary Paulson and rejected by US House of Representatives is so important. The US government must commit large amounts of taxpayer funds and show firm determination to solve the problem.

There were four main factors behind this crisis. One, the US had long and continuous economic expansion with low inflation over the last 15 years, making financial markets and regulators complacent. They forgot that there is a “business cycle”. Only 18 months ago, regulators, particularly the US Federal Reserve, were focused on dealing with the so-called ‘liquidity glut’. In the process, they missed noticing the emerging risk due to asset price inflation, particularly in real estate.

Two, during these good times financial institutions (FIs), particularly investment banks, grew very large. They took big risks and made huge profits. In recent years, FIs contributed nearly 40%, as against the normal 10%, of total US corporate profits. They paid huge salaries to recruit the best and the brightest from top business schools, who, in turn, helped create and sell complex financial products, credit derivatives and other securities whose risks were not understood by either investors or the top managements of investment banks.

Three: The good times encouraged banks to take higher risks. Highly leveraged transactions with “life covenants” became the norm. Investment banks themselves, became highly leveraged: 32:1 for Lehman Brothers before it failed, as against 8:1 for a conservative bank. Investment banks did not have sufficient capital to support the risks on their balance sheets.

Four, there was major failure of leadership at most FIs. Dealmakers took charge and risk managers were completely sidelined. Credit was mispriced so much that there was only small difference in the yield between junk bonds and US treasuries.

The very first inkling of the crisis came in February 2007 when Bobby Mehta, chief executive of HSBC, North America and another executive of HSBC, USA were sacked for catastrophic forays into high-risk US mortgage securities. These two bankers had received $40 million in bonuses the previous two years. The bank was forced to issue the first profit warning in its 142 years history but the timely action to recognise and deal with this problem has served HSBC well. Few market participants picked up the implications of this market signal.

Since early 2008, treasury secretary Henry Paulson and Federal Reserve chairman Ben Bernanke have been spearheading the fight against the financial crisis. Their challenge is to prevent systemic failure and recession, without creating a moral hazard, which would encourage people to act irresponsibly in the future.


They orchestrated Bear Stearns’ merger with JP Morgan to stabilise the markets in March. Last month, they took over Fannie Mae and Freddie Mac, virtually government enterprises believed to have “the full faith and credit of the US government” behind them. They let Lehman Brothers file for bankruptcy as it did not represent a systemic risk. By this action, they also gave a salutary warning to shareholders and creditors of FIs that the US government would not always bail them out.

Merrill Lynch’s merger with Bank of America, nudged on by the regulators, was a smart move. It addressed a problem before it became serious. AIG had to be rescued. Its normal insurance business continues to be sound, but it has assembled a huge portfolio of structured securities and credit default swaps that posed a risk to the entire financial system. Washington Mutual’s takeover by JP Morgan, and Wachovia’s acquisition by Citigroup underline the current fragility of US banking system.

Depending upon how effective the US government and other monetary authorities are in dealing with the current crisis, it would take at least a year, possibly more, for the credit markets to get back to normal. In the medium term, we will see US lawmakers impose fresh, perhaps, too many, regulations, on the financial system. The structure of the financial industry will undergo a major change. After the Great Depression, the Glass-Steagall Act separated commercial banks and securities firms. Ironically, the current financial crisis has led to combination of the two.

There will be other changes. Insurers will have to stick to their basic business and not take on huge risks on unrelated ventures. There is likely to be more regulations on hedge funds and other unregulated financial entities. Capital requirements for most FIs will be further enhanced. There would be an overhaul of executive compensation, and strengthening of risk management. Most derivatives such as Credit Default Swaps would become exchange-traded to eliminate counter party risk. Rating agencies will completely revise their approach to rating of mortgage and other complex securities.

This crisis will have some impact on India as well — we are not decoupled from the global financial systems. We have already seen the Indian stock market move in tandem with global markets. Capital flows into India will, the in short term, slow down. The rupee will depreciate.

On the other hand, our domestic financial system is robust and well capitalised. The Reserve Bank has already initiated sound measures to control inflation and excesses in the property sector.

There is an additional concern and an opportunity. Indian corporates who made large acquisitions overseas in recent years, with significant leverage, will be challenged. At the same time, asset prices are very depressed, particularly in the US and Europe, presenting Indian companies with interesting acquisition opportunities.

(The author is former India CEO of Bank of America)