News not getting their due

Agreed, its election time and IPL. But there are a few big items thats not getting their fair share of attention at all.

1. Sri Lanka: Indians tend to dismiss Lankan Tamil cause as a terrorist struggle. After the bittter exit of Indian Peace Keeping Force and the subsequent assasination of Rajiv Gandhi at the hands of LTTE, there are plenty of reasons to be circumspect about poking into the fire again. But these are no ordinary times. An estimated 30 - 40 thousand tamils are trapped in an area of 10 square miles at the hands of LTTE. On the other side is an unremorseful Sri Lankan army determined to squash LTTE at any humanitarian cost. Sending foreign ministers and making public statements condemning the Sinhala majority Government is as spineless a response the government could've mustered. Where is the emergency UNSC meeting? Where are the UN observers and the threat of sanctions? Where are the peacekeeping forces to stop the military advance endangering lives of so many people? There are so many domestic issues in Tamil nadu. But I completely support the regional parties' stand that the Government has failed to stand up to the interest of minorities in the neighboring state, when it could've shown better leadership. The media apathy to the issue which is as serious as Darfur is appaling.
2. Shanno: The 10 year old girl who studied in the corporation school in Delhi after her teacher made her kneel down in the hot sun with 7 bricks on her back for over two hours. Her crime? Failure to recite alphabets. The west is bashing US over human rights abuse in Guantanamo bay over torture meted out to criminals. But in one more instance of Government apathy, Law minister suggested that a change in mindset was necessary before change in laws to deal with such situations. Its time the change in mindset comes from top. Where are the sacking of Government officials accepting responsibility? The death of a 19 year old medical student at the hands of his 4 seniors, oestensibly called ragging is another phenomenon which only catches the media and politiccians attention when someone dies. There are cries of shock and horror, promise to deliver justice and even possibly some suspensions. But things get back to normal after a few days. Is there anything to suggest things would be difficult this time around?
   

What does your blog say about you? Part II

Typealyzer.com apparently answers the question with a warning- your writing style may have nothing to do with your self perceived personality. When I last checked, this was the description typealyzer gave for my blog.

ISTP - The MechanicsThe independent and problem-solving type. They are especially attuned to the demands of the moment are masters of responding to challenges that arise spontaneously. They generally prefer to think things out for themselves and often avoid inter-personal conflicts.

The Mechanics enjoy working together with other independent and highly skilled people and often like seek fun and action both in their work and personal life. They enjoy adventure and risk such as in driving race cars or working as policemen and firefighters.

Now the same site gives this description.

ISTJ - The Duty Fulfillers. The responsible and hardworking type. They are especially attuned to the details of life and are careful about getting the facts right. Conservative by nature they are often reluctant to take any risks whatsoever.

The Duty Fulfillers are happy to be let alone and to be able to work in their own pace. They know what they have to do and how to do it.

I dont normally check out random sites which measures your love quotient, personality scores etc. But the endorsement of typealyzer was given by no less than Greg Mankiw the respected economist. But I could think of a few reasons for the change

1. I've somehow changed and become less fun and more facts.
   
2. I havent blogged enough for the site to give stable results (the difference between ISTP and ISTJ is just one letter)
3. I've quoted too many people in the recent posts and it affects the results (analyzing their personality?), especially taken together with the second hypothesis.
   

May be its just good timepass. Check it out. Let me check if this post affects the results.

My London trip

London is only my second foreign trip, the first one being a 2-day trip to Bahrain. My sister was onsite for her Genpact (an outsourcing company) project for about 6 months, and although she was totally tied up with her work there, it was her initiative to make us (my parents and me) stay with her and sight see London for 2 weeks. Bless her heart! I couldn't have afforded a London trip on my own.

There were snowstorms the week before we arrived, and frankly we weren't sure if how much we could cover. Thankfully, although it was near freezing while we were there, the sun was shining and there wasn't one cloud in the sky.

The nearest place was Kew Botanical Gardens, with an admission fee of £13 per person (about Rs. 1000. the entire period we were there, we couldn't help converting everything to Rupees in our head) It is spread over 300 acres, and was once a picnic and hunting ground of the Kings of the yore, along the banks of Thames. I found the Charlotte cottage right in the middle of the woods quite charming. We walked for 6 hours, interspersed with only slight amount of rest. In fact, we walked a lot during the trip. I was amazed how my mother at her age had the energy to come home and do household chores after all that walking.

The next visit was the Natural History Museum and Victoria and Albert Museum at South Kensington (London is the city of Museums. I must've visited more museums in 2 weeks than I did the entire life) The best things in London are free. Museums are one of the few things in this world that cannot be digitized (Can you imagine a three dimensional experience of exhibits in the internet?) Victoria and Albert Museums have the best collection of Jewellery in the world. My parents and I initially searched for the Kohinoor, not realizing it is in the Tower of London.

The National Maritime Museum and the Royal observatory at Greenwich (where the famous Prime Meridian runs) is perhaps the most interesting part of my visit. The Royal observatory have the following story:

In the olden days, the sea travel was considered dangerous, because the sailors lacked navigational tools. The latitude, how far north or south of the equator one is, is relatively easy to find by the height of the Sun at midday or (in the northern hemisphere) by the height of the pole star; sailors had been finding their latitude at sea for centuries. The longitude is a measure of how far around the world one has come from home and has no naturally occurring base line like the equator (Imagine a sphere, you can always draw the equator, but can you say which one is the central meridian unless explicitly defined?). The crew of a given ship was naturally only concerned with how far round they were from their own particular home base.

In theory, two approaches are possible- either find the time accurately at sea; Knowing the time at Prime Meridian, and knowing 4 mins correspond to 1 degree helps fix the longitude. The other approach is this. If an accurate catalogue of the positions of the stars could be made, and the position of the Moon then measured accurately relative to the stars, the Moon's motion could be used as a natural clock to calculate Greenwich Time. Sailors at sea could measure the Moon's position relative to bright stars and use tables of the Moon's position, compiled at the Royal Observatory, to calculate the time at Greenwich, by which they know how far East or West they are from it. This means of finding Longitude was known as the 'Lunar Distance Method'.

Pendulum clocks which measures time accurately on Earth fares dreadfully under unstable conditions at sea. So Harrison worked on the most accurate clock at sea, while Flamsteed worked on the Mapping of the stars. Both approaches were eventually successful.

A few things an Indian would notice about London. Its public transport system is great. Not only are they well networked, but also the directions are so clear a child would find its way around. The credit crunch is visible in atleast one way- On the last day, we were shopping at Hounslow. Most of the shops were displaying 'Credit crunch prices!!!'. A couple of things were really cheap- Chocklates and Shirts. We hoarded them. People everywhere were precise and helpful with directions, not the usual take the right and go straight and ask someone there. I didnt find any signs of racism, although it could be because I'm just dumb to take note of any. Anyway, Indians are racist when it comes to Black people. Ask any African tourist who has visited India.

My mom was clad in Silk sarees and Golden ornaments and attracted attention everywhere. In Windsor castle, my mother and I had an argument over how to use the audioguide. I asked the lady at the counter to arbitrate. She smiled and said, Mother is always right. Mother is king!! (No. She did not say Queen) Oh boy! I think my mother would mimic the line if I argue with her over anything, ever.

London pictures here.

Spot the odd one out

Gandhi's glasses, like success, have many fathers. I don't know which one is more hilarious - The fight between the Government and the dashy millionaire over who would take credit for rescuing Gandhi's memorabilia for a not small sum of $1.8 million, or the owner Otis' solemn pledge that he would stop Gandhi's auction if India spends more on health care than on defense.

If Gandhi's items were acquired by legitimate means by the owner and auctioned through a legal contract, India has no right to waste precious taxpayer money going for it or use other means to coerce the owner to give up his right. The diminutive man must be turning in his grave that his memorabilia went to someone who is an antithesis of austerity.

Consider the problems India faces. The country is plunging to its worst slowdown in recent memory. It is painful to see India in international news for all the wrong reasons (latest one here) The pace of infrastructure projects implementation is debilitating, when the west is trying to manufacture growth using public spending on not too dilapidated highways and Broadband services. Justice system is in a state of decrepitude - By Delhi high court's own admission, it would take 466 years to clear its backlog, while the lawyers in southern city of Chennai strike work for issues like violence on Sri Lankan Tamils. Not even the ignominy of Mumbai attacks has galvanised the Government to come up with a concrete plan on internal security. Oh, and the Government or Vijay Mallya, rescued Gandhi's glasses in a major show of diplomatic victory. Spot the odd one out.

The Great Crash, 1929 by John Kenneth Galbraith

The past does not repeat itself, but it rhymes - Mark Twain

Crises serve a useful purpose - Regulation is a poor substitute for good memory. People after a big crisis become fearful of excesses that regulation try hard to limit. Excesses might come in different forms after a few decades, for there is nothing more predictable as human desire to make money without effort. But memory serves the same purpose as SEC, in a far more effective way.

Refreshing memory was the main intention of the author when he wrote the book in 1950s. Half a century later, as a crises of comparable proportions looms, it is worth considering the aspects of the Great crash which rhymes slightly with the current one.

When people talk about the great crash, they say it merely precipitated the already weak economy. By most standards, the real economy had slowed down. The stock market crash merely made people realize what thin ice they were on when they were speculating high stock market values.

But that's underestimating the effect of stock market crash, argues Galbraith. During that time, the top 5% of the income earners controlled more than 30% of the wealth. Any crash which wiped out the wealth of these 5% was bound to affect the real economy. But how did it crash? Like most if not all crashes, the answer is Leverage.

In 1920s, Investment trusts, similar to Mutual funds today, operated on a holding companies model taking stakes in a host of operating companies (Montgomery Ward, American Telecom etc), and issuing securities to finance the acquisition. At the height of the boom, the market values of these holding companies sold at 2 or 3 times the market values of the operating companies they were holding! That's the first stage.

How do you act on this premium (ostensibly attributed to the financial genius of the managers of the trust in picking the right stocks and achieve diversification) ? The traditional way of issuing bonds, preferred stock etc achieves leverage to some extent (Assume a 100 Rs investment in stock portfolio financed by a 50% investment. A 1% rise in value to 101 results in a 2% rise in equity (50 becoming 51)) But that's not enough when you are a financial genius. The holding companies started spawning even more holding companies and so on and so on and the final link in the chain was the operating companies. The companies also held stakes in holding companies of other institutions (the author calls it financial intercourse) creating a structure which could bring the whole system down in times of crisis.

The second cog in the speculation wheel was the amount of broker loans (loans taken by brokers in the call market to finance purchases of stocks). Unlike the period of early 2000s, the money was by no means cheap. At 12%, it would've enticed the money lender in Mumbai. But such was the nature of speculation that the brokers were willing to finance stocks at that rate, and the world was willing to finance them.

In hindsight, the speculation had to come to an end. When the investment trusts did come under selling pressure, in a bizarre display of self delusion, the trusts started using the excess cash they had built up during good times to support their own stock. By the time they had realised the futility of trying to support the stock everyone wants to dump, they had burnt through all their cash and was left with nothing to pay up their debt. When they were forced on a firesale, for the first time in history, people realised that there need not be a buyer for every seller at any price. The market went on a free fall.

There were some auxiliary reasons why the recession became as severe as it did. In the present day current crisis, at least for a time being, the American economy was sustained by a surge in exports as the crisis, combined with high oil prices weakened the dollar against all major currencies. But 1920s America wasn't that fortunate. America, at that time was a creditor economy (lender and exporter to the world). In the balance of payments equation, the current account (Exports and imports) and capital account should by design balance. In those times, most of the economies of the world ran a huge current account deficit (imported more from US that they exported) The only way they balanced it was by borrowing more from the US. Most of the loans were made to Latin American countries which had domestic instability and credit risks (nothing changed till date). As credit became tight the loans came down sharply. The only way to keep the Balance of payments in balance was that the imports from US had to come down. This deepened the crisis.

The author agrees that the Economic knowledge at that time was poor in dealing in the crisis of that magnitude, and that some of the actions deepened rather than alleviate the crisis, (the rules which forced the Government to balance federal budgets and cut back spending during crisis, the Smoot Hawley Act that smacked protectionism, the Fed inaction leading to multiple Bank failure etc) which makes the Depression of 1930s unique in some ways. But his ideas behind the crisis, the basic human desire to make money without effort, to suspend disbelief when the going is good and even actively seek justification for the new found prosperity (Noted economist Irving Fisher made the infamous assertion 'the stock market had reached a permanently high plateau') remain true of every crisis.

P.S: There is an interesting observation. President Coolidge in his state Union address in 1928 said 'No congress has ever assembled, on surveying the state of the Union, has met with a more pleasing prospect than the current one...' Historians have chastised Coolidge for his false optimism that had prevented him from seeing the looming disaster. This, says Galbraith, is grossly unfair. Historians rejoice in crucifying the false prophet of the millennium. But they never dwell on the man who wrongly predicted Armageddon.

Could what be true of Coolidge be true of Greenspan? Was it wrong to let the good times last, especially the one which had lasted for more than a decade? (Even if he didn't do what William McChesney Martin, Jr., the longest serving Fed chairman (not Greenspan like many believe!) famously quipped 'the job of the Federal Reserve is to take away the punch bowl just as the party gets going'?)

Nehru, A contemperary's Estimate

The notion of Nehru spending halcyon hours relaxing with the peasants or Nehru's affection for children are comically off the mark, claims Walter Crocker, the Australian high commissioner to India in his biography of India's first and longest serving Prime Minister, written shortly after his death. Of the dozen or so biographies written on Nehru (the man himself wrote not one but three autobiographies! An Autobiography in 1936, Glimpses of World history and Letters from a father to his daughter in 1940s), none is more critical of him (although the affection and respect for the man shines through the book), which is remarkable considering the book was vetted by the Australian Foreign ministry and a few inflammatory references were apparently removed in the best interests of India-Australian relations.

The book sometimes smacks sarcasm ('typical Indian attitudes') to being downright critical, but is nonetheless engaging. It is even funny occasionally, like the reference that senility had gotten the best of even a balanced man like Nehru.During the Jalianwala memorial day, at a time when Russians had recently sent astronauts to space, Nehru spoke glowingly of weightlessness of space and his vision of Man's conquest of nature to an audience of illiterate peasants concerned about their next square meal. It harps on his famously short temper; During an occasion of modernization of villages through self help which quickly turned into a 'typical Indian function' of speech making starting with the President's speech being telecast from the Rashtrapathi Bhavan. He went on and on; irreproachable platitude following irreproachable platitude till Nehru grew restive. After the President's speech, Nehru stood up angrily, denounced speech making, vetoed further speeches and led the crowd to a place and asked then to dig a drain.

But the book is mostly about the main issues of the day. On Kashmir, Crocker minces no words saying India went back on its promise of holding a plebiscite to decide whether Kashmir accession would be whether to India or Pakistan, just after 1947 war. This, Crocker suggests was perhaps due to suspicions that such a plebiscite may result in Pakistan's favor.

On Goa (then Portuguese colony), the author charges India of unprovoked attack on a region which had no military power worth its name, under tenuous logic of the peninsula being integral part of India (he says Spain could use the same argument against Portugal, for example). Here too, he says a plebiscite could have gone against India, mainly because of the prosperity and more efficient administration of Portuguese.

On China, however, he is more forgiving of, even sympathizing with Nehru, as he wonders why China, in spite of the support it received from India on a host of issues (India gave up the special position it inherited in Tibet from the British and acknowledged Tibet as a integral part of China; India was the first to recognize the nacent communist regime; India actively lobbied for a permanent position for China in the Security council) chose to go into war with India over a petty boundary dispute.

Walter Crocker is prescient on a host of things. Like his forecast that when dust has settled, Nehru's achievements would be scaled down (Even he would be surprised at how far it has fallen). Or his prediction that Nehru's zest for equality for the masses with such haste has made it impossible for a higher caste Kashmiri Brahmin to ever become a Prime Minister of India (Nehru destroyed the Nehrus), and that the future would be dominated by members of the lower castes who would be voting majority as against the detached-majority-upper-castes.

But he was wrong in predicting the demise of India's democracy. The author while acknowledging that India's capacity to survive says chances are in favor of tyranny and oligarchy (an suspicion voiced by even the ardent optimists of the time). India's chaotic stability has endured till date.

While it is impossible to compress the life of a man in about a couple of hundred pages, much less a complicated man like Nehru (There were two men in Dr.Jeckyll and Mr.Hyde; there were more like twenty in Nehru), the author presents a riveting account a man who is done great injustice by a one-sided portrayal by his hagiographers

Why men are smarter than women

Lawrence Summers is considered one of the smartest economists of the world today. But his provocative but politically incorrect talk (In an age where political correctness borders on the ridiculous when it comes to gender, race etc.) at the NBER cost his Presidency at Harvard University and possibly a chance to become the current Treasury secretary. (I couldn't locate the original transcript of the talk anywhere. The NBER link is gone now)

Summers in his talk said innate differences in ability could explain why women are underrepresented in higher engineering and PhD programs. But what he was mentioning was not about the absolute differences in IQ, but their variances.

"If one is talking about physicists at a top twenty-five research university, one is not talking about people who are two standard deviations above the mean...But it's talking about people who are three and a half, four standard deviations above the mean in the one in 5,000, one in 10,000 class. Even small differences in the standard deviation will translate into very large differences in the available pool substantially out"

Studies have indicated that Men have higher variances in intelligence than women. This could mean at tail of the spectrum (dumb and the smart) men would outnumber women and at the extreme ends the difference would be stark.

What about average IQ? While some studies have said the average difference is miniscule, the recent ones does say that the difference could be significant. Santoshi Kanazawa, the evolutionary psychologist at LSE offers this explanation at his blog. Since taller people are smarter, and men are on average taller than women (this no one would deny), it could be the case that men are smarter than women, not because they are men, but because they are tall. He goes on to state that controlling for height, women are slightly but significantly more intelligent than men.

So why are tall people more intelligent? Heck, We could go on like this.

Are you one-handed?

VoXEU.org, as the name suggested is a EU assisted portal set up by the Centre for Economic Policy Research (www.CEPR.org) in conjunction with a consortium of national sites. Vox aims to promote research-based policy analysis and commentary by leading scholars. But the website forces the authors to limit the commentary to maximum 1500 words a piece, making it accessible to a commoner.

There are perhaps a hundred explanations for the crisis in its aftermath (and before the crisis too, but who listens when the going is fine?) but a couple of ideas are worth highlighting.

Why did the Fed pursue a loose monetary policy for a long time?
It is said rightly that Fed kept a low interest rate regime for too long, contributing to asset bubbles. But why did it do that? Axel Leijonhufvud, Professor of Economics at UCLA, attributes the failure to inflation targeting, which is long heralded as the central bank's main job. In spite of the loose monetary policy, inflation stayed low for almost 5 years, because the developing economies kept their home currencies from appreciating and flooded the US markets with cheap imports.

Axel goes on to argue that while the imports kept the core inflation down, the Fed didnt recognise the asset price inflation it helped create(Alan Greenspan called it Asset froth instead of bubble, the typical George Orwell-coined-doublespeak).

In Age of Turbulence (the book was released when its author Alan Greenspan still had a reputation) Greenspan says how disturbed he was seeing the long rates (10 year GSec rates, the market's inflationary expectation) go down when the Fed started to tighten Monetary policy in June 2004 (He thought the fall was because of a global disinflation phenomenon, owing to rising productivity which put a lid on wages. He says and I quote, '..One recent evidence is the extraordinary number of labor contracts with 5-6 years maturities. We never had labor contracts of more than 3 years duration in the past 30-40 years').

To see how liquidity creates asset bubbles, we should recognise that financial market works differently from a Bread market, in that the demand and supply doesnt balance by price discovery, but the effects of high prices and high leverage are reinforcing. A typical investment bank had a capital of 1$ and borrowed $24 to buy assets worth $25. (the leverage of 24 might look eye-popping, but Lehman Brothers operated at a peak leverage of 32 in the First Quarter 2008). Assuming the assets earned 0.5% more than liabilities, the Return on equity was 12.5%. Since everyone chases the return, the spread of 0.5% narrows significantly, characterized by low risk premiums.

The only was to maintain RoE was to either hoard up more leverage, or chase riskier asset classes. Either actions have a reinforcing effect on prices. This is different from Bread market where the demand cools when prices rise.

Leverage works both ways- a drop in about 20% value in a portfolio where 20% of the assets are in MBS can wipe out capital (Case shiller home price index was down 23% from 2006 levels).

The solutions suggested aren't path breaking- more capital and more reserves to constrain leverage, but that's not my point. What do you do when you read two interpretations for the same phenomenon and both looks fine at that moment? Am I suffering something similar to Harry Truman's one-handed-economist syndrome?

What is your most hated phrase?

The oxford list of most hated expressions must be dated. Here are the few economics jargons (although becoming layman expressions nowadays) I find annoying.

My top 10.

1. Too big to fail (Best left unsaid)
   
2. ____ gets worse before they get better (Fill in the blanks)
3. Pump priming
4. Stimulus (Even a half percent cut in excise duty of an esoteric product is being bandied as one)
   
5. Animal spirits
6. Greed and Fear
7. Bailout
8. Bottoming out
9. Panic out there
10. Monetary policy is losing traction

Am I missing out (so many outs!) on some obvious candidates?

University of Chicago on Credit crisis II

As I said, the crisis can be broken into four parts, origins, Liquidity crisis, incentives and the policy responses. The first two were covered here.

Incentives

Creating liquidity in the otherwise illiquid subprime mortgage market, an otherwise noble goal, created perverse incentives for the lenders. Amit Seru, Professor at the University of Chicago did a research on the both the number of loans originated and the default rate around the FICO score of 620. FICO measures the credit worthiness of individual borrowers and a score of 620 and above is considered eligible for guarentee by Fannie/Freddie. An analysis of the origination of loans around 615-619 and about 620-624 showed a sharp spike in loan origination at around 620.

Since the lenders were eager to get the borrowers at that threshold, this jump could probably be explained. But what is more interesting is that the probability of default against the FICO scores. Normally it should have a negative slope- higher the score, lower the probability. What the results showed was that there was a jump in default at a score of 620, implying the lender did not do the due diligence because he knows that for scores above the threshold, the loans can be securitized and sold off. It could also mean that the borrowers know the threshold themselves and cheat their way to get just above 620 to qualify for a loan.

Assuming the second reason, while plausible but hard to detect, is not a major factor, it is safe to conclude that ceteris paribas (loan contract terms especially remaining the same), the incentives play an important part in due diligence.

Fiscal response to the crisis

Anil Kashyap, the delightfully articulate economist (Have you read this?) is an expert on Japan. He makes a convincing case for things to avoid in a response to the crisis which has an eerie similarity to the present one (Or for that matter, most crisis have the same cause- falling house prices- When would people learn that anything that rises can fall?) Japan is famous for its lost decade because the government failed to recapitalize the Banking system for a long time. The Government initiailly tried to deny the problem. They tried to hide the bad assets by creative accounting rules - Banks were allowed to chose which ones to carry at market values and which ones at book values!! In November 1997, when multiple large institutions failed (sounds like deja vu) the government got involved in half hearted recapitalization (The amount desired by the strongest bank was given to all banks as part of recapitalization)

These attempts shows valuable lessons for the current crisis. The strong banks are likely to ask the government to buzz off when offered capital, fearing Equity dilution of the existing shareholders. But it is advisable to recapitalize strong banks (or even encourage private funding). Its critical to stop dividend payments by the newly recapitalized banks, which are frankly money laundering of tax payer money. Better still, stop dividend payments done by all banks, strong and weak for 3 years, in order to nullify signalling effects associated with dividends.

The site is new but its well worth the read.

Podcast, my new fad

Since I spend almost 3 hours a day commuting to work in the congested Mumbai roads, and speed read both my newspapers in half the time, I guess there must be something better than listening to the same songs in my ipod everyday.

I never realised all the news agencies/magazines/Business schools distribute surprisingly good analysis on variety of topics for free. Podcasts from Chicago Booth and Economist are very good. Bloomberg has some good pieces too.

I don't know how long this would last.

How do you forecast GSec rates?

Why do i care? Because my boss asked me for a simple model which predicts 10 year yields. Why do you care? Since you are reading my blog, may be you have some interest in the random thoughts running through my brain. So bear with me.

I did what everyone does. Google. The paper written by my Economics prof Rudra (say Rudro, he is very particular about the pronunciation) takes into all sorts of macroeconomic parameters, takes the data from a particular time period, generates the important factors that affect 10 year yields, creates a linear equation with a lag, makes an out of sample prediction for a period of 8 months (8 data points), calcualtes the RMPSE (root mean predictive squared error and compares that with RMPSE with a model generated with a trend line and says what the improvement is.

Cool. Next I asked our economist team here if they have done any econometric forecasting like that (I havent taken any econometric courses to replicate the method). Not only have they not done anything like that, but the guy says the forecasting of long term yields is rubbish, as the rates are entirely based on expectations and not based on history. In any case, the volatilty is unprecedented.

It is a universally acknoledged fact that NOW is always somewhat unprecedented. But as long as you take the right factors, you should still be closer to the truth. After all, expectations do not come from the heavens, but based on the data available. I would use my limited knowledge. All I want is a simple model.

I took exactly the same data (BSE100, REER, M3, WPI, Oil prices, IIP etc.) I dont have the tools to account for multicollinearity (two X factors are correlated) but I can still filter the factors based on t-statistics till all the factors in the regression equation have low p-values. Also, forecasting requires that I take all the inputs with a lag.

After 2 iterations, I filter down to just 3 factors - REER(t-1), IIP (t-1) and GSec (t-1). Based on the out of sample forecasts the actual and forecasted came close (forecast period Mar to Oct 08).

To be fair, the last month was unprecedented. The yield fell practically over 200 bps (from 7% in November end to low of 4.86% in December end) and then rose 120 bps last week. The fall of 200 bps was expected; The additional government borrowing of Rs. 5000 crores which pushed the yield up 120 bps was unexpected. Any model however correct (I asked the economist to check and if possible refine it) has to be supplemented with Qualitative data. Inspite of this, and the recent discredited models of credit rating agencies and Taleb's wide popularity, I think a model gives the relationship between variables elegantly in a way no amount of theory could.

University of Chicago on Credit crisis

Initiative on Global markets have a surprisingly good 4 part lecture on Credit crisis each dwelling on one aspect of credit crisis - the origins, the liquidity crisis, incentives and the policy responses- lessons from Japan. While the conclusions reached are fairly conventional wisdom, the rigor of the research is something of note.

Mortgage crisis
Amir Sufi divides the areas into Prime and Subprime Zip codes (those areas where more than 60% of the loans originated by subprime borrowers are Subprime zip code areas while those with more than 60% prime are prime zip code areas. The growth in loans in subprime zip codes are about three times the growth in Prime areas between 2002 and 2005. There is a precedent in this even between 1999 and 2001, so he chose to see if there is any difference between then and now.

The factors why the loan growth exploded can be a) income growth in subprime is greater than prime areas; b) House price expectations were relatively higher in subprime and c) securitization was higher in subprime, with the associated incentives (as suggested by conventional wisdom)

If a) was indeed true, there seems to be a fair case for the growth in subprime loans. In fact between 1999 and 2001, that was indeed the case. Between 2002 and 2005, the growth in income was about 4% for subprime while for prime borrowers was 8%. Even then, if there is a possibility that the subprime borrowers crossed a threshold to qualify for a homeloan so the home loans exploded (its a similar case with demand for cars in India- a once an income threshold is crossed, the market explodes) So Amir takes only the zip codes where there is a negative growth in nominal income and sees the relation between loan origination growth between subprime and prime growth. Even there, the loan growth is starkly higher.

So the second explantion for the loan growth, higher house price appreciation for subprime borrowers does have some evidence. But it may be the case that the price appreciation happened precisely because of loan origination growth. It is difficult to disentangle the effects between the two variables when causality is the case. Which makes it all the more curious that rating agencies put the house prices on the RHS of the equation for giving the ratings for securitized debt.

There is also strong evidence for the third relationship but it is taken up in the third part. The moot point is micro trends are important for predicting a crisis- how did loan origination grow faster in a segment which has seen slower or even negative growth in income compared to prime borrowers, as was seen as early as 2004? The other conclusion is its important to not treat house prices as exogenous.

Liquidity crisis
Doug Diamond says Banks, investment banks and hedge funds are by nature, highly levered institutions. It is impossible for investors to check the quality of assets of a bank as compared to say, a car company. Which is why both Equity and long term debt is in short supply for a bank and they rely on deposits or wholesale funding.

The more difficult it is to judge the quality of assets, the more levered the institution. That is why Bear Sterns or Lehman have leverage of about 30-35 while even Goldman Sachs had to be satisfied with a modest 20 times leverage. And the funding for the investment banks is almost entirely overnight, because they cannot monitor what the banks do with their money even less than a commercial bank. The investment banks can rapidly alter the risk profiles on a daily basis since they have a trading portfolio as compared to a loan portfolio of a commerical bank whose risk profile is sticky. In this scenario, the only bargaining chip the investors have is that they can stop rolling over short term money. It keeps the investment banks in check, but it also increases the risk of run, which is costly for both the borrower and the lender. If it is costly, why does the investor do it? In times of uncertainity, the investor knows if he doesnt pull out, someone else will and they would get the 100 cents on dollar while he potentially loses some because he was patient.

This is what happened with Northern Rock, a fundamentally solvent bank with no exposure to US subprime but got its funding mostly from ABCP market. With that market crashing because investors stopping to rollover funds for anyone with any exposure to Mortgage assets (Northern Rock assets were mostly in UK prime segment). The fear of solvency was enough to start a run on the bank which became a self fulfilling prophecy.

When the bank fears a run because the capital has become low, it can either raise capital or dump assets to bring down the leverage. Banks usually opt for the second because the first may take time or prove difficult. But there was no market for these assets because of two reasons. First, if the investors think if they dont buy assets today worth $5 today they can get it even cheaper tomorrow (perhaps $2) they would stop buying it. Two, if other instituions think if they buy these assets cheap, they have to mark their similar investments down which results in their capital levels getting low, they wouldn't buy it. This is what TARP 1 wanted to correct; Paulson thought if the government becomes the buyer of dodgy investments of the last resort, the lower bound can be made $5 or even the hold to maturity value of the asset, so that the actual payout by the government may not happen at all, and the instituions may appear solvent. But the more direct approach is to direct equity into the troubled banks so that they need not firesale the assets at all. TARP 1 went into rough weather.

The lecture discusses the effect of short term debt remains the same for every crisis, right from Bank runs of 1930s to current one. The solution proposed then was to insure all short term debt for 90 days, conduct audits for all banks, differentiate good banks from bad, inject equity into good banks, merge the average ones, and let the bank banks go through resturcturing through the FDIC route. Now that the liquidity crisis have largely eased as the Fed is lending to everyone, we may not know how that would've worked.

The other two aspects we can see later.

Firefox is better than chrome

I had stopped using firefox when google released the beta version of chrome. But now I realize its still some way to go in terms of speed and performance.Some pages take eons to load and sometimes it just gets hung. That every window is a seperate process is only quantum of solace. What say?

What does your blog say about you?

Typealyzer.com apparently answers the question with a warning- your writing style may have nothing to do with your self perceived personality.

I thought I would do better than a mechanic. Heck, even Paul Krugman and my friend are mechanics.

Satyameva Jayate (Truth shall triumph)

If you see one cockroach scurrying in the light, there are probably a dozen in the shade. When Satyam (Sanskrit word means truth) board accepted a proposal to buy the family firm (Maytas, no prize for guessing the similarity) of promoters for a whopping $1.6 billion, there was so much hue and cry with people wondering why the board members (including the independent directors) bowed to one man who had barely 5% stake in the company. As it turns out, they were indeed acting in the best interests of the company. An overpaid asset is worth more than a fictitious one. So much for shareholder activism.

It might seem like a double whammy that just when the apocalypse predictions about the world are coming true, there is a big wave of frauds hitting the markets. But as Warren Buffett once said, "You only find out who is swimming naked when the tide goes out". If luck can run out for Bernie Madoff after running a con operation for decades, what hope does Raju (Satyam chairman) have? In fact, there are reports that SEC was indeed warned about scandal as early as November 2005, full two years before the revelation (?!) Who knows if Krishna Palepu, the esteemed Harvard professor, independent director at Satyam and a leading authority on Corporate governance knew this all along? Or for that matter, how did PwC audit a non-existent cash and Bank balances?

Eventually, Satyameva Jayate. But be wary when you switch on the light just yet.