Credit squeeze from all corners. Blame whom?

In this new economic order where credit-risk from different classes of loans/debts was being sold to investors at the blink of an eye, fiascos of this nature (JULY 07 Credit/Stock Jitters) are bound to happen.

Investment bank:Bear Sterns, French bank:BNP Paribas, German bank:IKB, US Home builders:Beazer, Mortgage Companies:American Home Mortgage, Hedge Funds: Fortress.....list just gets bigger day by day. One common thread/theme connecting all these meltdowns is misunderstanding/ignorance of risk being taken.

Story starts like this:

1. Consumers tempted by low interest rates and appreciating house values got into mortgage commitments bigger than their repayment capability.


2. Builders impressed with thier margins were building hundreds of communities like crazy.


3. Mortgage banks trying to quench the insatiable appetite of the investment banks for mortgage pools, has been dishing loans to consumers with dubious financial track-records by inventing exotic loan packages like 1/2/3-ARM, ALT-A.


4. Investment banks trying to capitalize on this surprisingly huge demand from hedge-funds, university-endowments and state pension funds for high-yield instruments, were mixing up various pools of loans into CDOs in different tranches and getting these exotic bonds/instruments rated by rating agencies like Moody's and S&P and offloading them to investors across the planet.

.....and ended like this:

1. House appreciation got to a grinding halt after historic streak of 4-5 straight double-digit growth.
2. Consumers/speculators with no capacity to pay monthly mortgages were caught off-guard with this screeching halt of appreciation and faced with ARM-triggered reset of monthly mortgages called it a day and surrendered.
3. The rising defaults of this subprime and borderline home-buyers gradually started hurting the other side, the investors who bought these CDOs as their CDO-coupon payments were depending upon monthly mortgage payments of this ARM generation of consumers.
4. Market started panicking and in the absence of a reliable measurement model to do a mark-to-market, no one knows the real value of any of these pools and CDO bonds. MarkIT indexes dropped faster then investor's jaw and created a pandemonium in global markets.
5. List of casualities started to appear spanning most of the planet ranging from france to germany to australia to japan, highlighting the speed at which these instruments got shuttled around by our wallstreet wizards.

Now, the blame game starts from the other end..a) investor blaming the investment banks and rating agency b) investment bank blaming the loan originator for false representations ..etc.

As this is wrapping up, another story also touched climax.. the great LBO story of private equity groups. It again looks pretty familiar. Here it's company-flipping instead of houses.

PE groups raising multi-billion dollar funds from high net worth investors, identifying low debt/cashflow companies with low P/E multiples, scooping them up by loading the company's balance sheet with enormous liabilties by issuing bonds or taking debt which again got bundled into CLOs and tranched and sold to investors by investment banks.

All the above innovations in financial markets were genuine efforts by bankers to bring enormous liquidity into market, expand credit, calclulate and shift risk across various parties. But, the chain went broke owing to the absence of reliable pricing and valuation models.

Remember those 2 words..Pricing, valuation .. the fundamental pre-requisites for any financial instrument to flourish in a long-lasting manner. Why did they miss that???

Is credit Growth the key to US economic expansion in the 1990s?

Is credit Growth the key to US economic expansion in the 1990s than much proclaimed productivty?

Analysis:
STEP1:Take a look at the data at Federal Reserve historical data on consumer credit. The raw data shows over a 90% growth in credit during the '90s. When one adjusts these values for Department of Labor historical statistics of the Consumer Price Index, one finds that total consumer credit has grown by 70%.

STEP2:An adjustment needs to be made for growth in real per capita earnings since as real income grows so does the capacity to carry credit. When using that data to adjust the consumer credit values, in the last decade there has been a 30% increase in real individual income for the nation (non-government). Scaling the 70% personal total credit growth against the income growth yields a net 30% growth in real consumer credit carried.

STEP3:
...how much has individual credit really been growing?...Personal credit amounts are currently about $6k/person according to the aforementioned Federal Reserve data. The average household (2.6 people, $55k/year income ... historical data from the Census Bureau household income tables) carries ~ 16 k$ in credit. This is a credit/income ratio of ~ 0.3. Applying this factor to the previously determined 30% credit growth/decade (or ~ 3% growth/year) by straight multiplication, then only about 1%/year would be attributable to credit growth IF the multiplier factor were only equal to 1.

STEP4:GDP in the US has grown by about 31% in the last decade (see The Bureau of Economic Analysis' historical data on GDP ), or about 3%/year. Depending upon the multiplier factor, you can see that credit probably makes up a substantial fraction of the GDP growth just by itself.

There is at least one more important factor in the the GDP that we can adjust for in this simplified analysis: population growth in the work force. Between Jan 1, 1990 and Jan 1, 2000, the US population grew from 248 million to 275 million .... (source data Census Bureau's population statistics ) or about 10%. Assuming the workforce proportion is similar, the GDP adjustment per capita yields a growth rate of about 2%/year.

...What does this all mean?...
Conclusion 1: if the per capita GDP growth rate is ~2%/year, then credit growth--which is an absolute minimum of 1%/year and probably higher--makes up the bulk of the US economic growth in the 1990s.

...but what about productivity?...
Isn't productivity the source of the economic expansion? Productivity gains between 1990-2000 were about 25% ( Bureau of Labor Standards Productivity Statistics ) and outstripped per-capita CPI-adjusted GDP gains which were about 18%. If GDP gains had exceeded productivity gains, then the increase in credit is a consequence, all else equal. But with the percentages reversed, productivity does not appear to yield as much "gain" (to use an engineering term) on economic growth as one would hope to see.

IT WOULD BE QUITE INTERESTING TO DO A KIND OF COUNTER ANALYSIS JUST FOR THE SAKE OF DSICOVERING THE REAL CAUSE OF THIS ECONOMIC GROWTH WITNESSED BY US IN LAST DECADE.

WOULD REALLY LOVE TO SEE PRO-PRODCTIVITY-TRUMPING PERSON TO DO A COUNTER ARGUMENT BASED ON HARD DATA AND FACTS, RATHER THAN THEORETICAL PRODUCTIVITY ARGUMENT!!!!!!!!

ANY ONE UP FOR THIS CHALLENGE???????

India GDP growth? Sustainable?

Growth rate of any economy gets on to an unsustainable state when it gets constrained by short-supply of critical inputs like:

1) When investments demanded by that growth is less than savings.

2) Shortage of labor to support that growth.

3) Adequate infrastructure to handle that growth.

1)Economy Savings and Investments:The average saving rate in India was 10 per cent in the 1950s, which rose to 17.5 per cent in the 1970s and further to 23.4 per cent in the 1990s. The saving rate was 32.4 per cent in 2005-06.
Gross domestic investment rates increased from 22.9 per cent of GDP in 2001-02 to 33.8 per cent in 2005-06. Pls. note that 95% of the investments were supported by domestic savings.
One would conclude that this rate of investment (~35% of GDP) would easily support ~10% GDP growth in a non-inflationary sustainable mode. But, WAIT…

2)Labor shortages:If we look at the composition of our GDP, about 50% of this comes from services with industrial and agriculture contributing ~22% each.You clearly could see the labor shortage in specific services sectors that could scuttle the above growth estimates.

3)Infrastructure:This is the most serious impediment that could dampen the above growth estimates as under-capacity in the key infrastructural areas like Roads, Ports and Power has been knocking out the actual growth you could have versus the growth we’re limited with owing to the bottlenecks.

A serious commitment from govt. in incentivizing the infrastructure investments to attract private players to participate in enhancing these 3 infrastructural areas would definitely debottleneck theese areas and reduce the disparity that currently exists and will be more pronounced in next 2-3 yrs.

Quantification models do exist in the market place that would quantify the discount that has to be applied to growth estimates based on the mismatch/disparity between current infrastructural capacity and growth-demand.
conclusion:One would be able to (atleast in theory) come up with a reasonable non-inflationary and sustainable growth rate for our economy, with the adequate discounting applied to the estimate based on gap in the supply of critical inputs needed for that level of growth.

NOW…should this GDP come from exports-driven growth or domestic-consumption-driven one is again subject to debate

.…..CHINA is trying to get away from being an overly-export-driven GDP economy to a moderate level by bumping up the consumption rates and bring down huge (40%) savings rates.

…..US, on the other hand is fighting to bump-up it’s domestic savings (It only manged to save 13% of it’s national income last year versus 50% with china). And that’s just looking at national averages that include saving by consumers, businesses, and governments. The contrast is even starker at the household level — a personal saving rate in China of about 30% of household income, compared with a U.S. rate that dipped into negative territory last year (–0.4% of after-tax household income).

We’re luckily in the middle grounds with a reasonably good balance of domestic savings and export-driven share. It has to be mainatained that way to avoid risk of negative
GDP growths in case of sudden drop in exports owing to emerging protectionism in various countries or overly-consumeristic public driving down the savings to US-levels.

Transformation in Retail markets. Good or Bad?

Disintermediation (removing layers and layers of middlemen) of goods travelling from producer(farm owners) to consumer(you and me) is one of the primary goals of retail revolution. Direct FDI in retail in the next 5 yrs would eventually lead this economy to dsintermediated and effective chain mostly composed of producer, optional-trader and retail/wholesale groups.

PROS:
It serves many purposes to the stakeholders:1) Keeps the CPI (consumer price index) and the inflation in constant check as consumer will have to spend less to get more as a result of world-class logistics/supplychains of these retail groups compete to get consumers into thier stores, there by giving the consumer a quality product at competitive price (which our indian consumers were never previleged with in the past).

2) Will for sure benefit the producer/farmer as these retailers attempt to cut all the layers and go direct to producers for procurement in several ways (a)contract farming where farmers are ensured of risk-free returns for your harvest, (b)smart traders making use of commodity futures to hook up the aggregated produce to retail-procurers at very good rates that will eliminate layers ….benefits farmers and retail/wholesale procurers.

3) Will encourage farmers to start cultivation using up-to-date farming techniques for high-yields at low capital/operating costs as there is a clear danger of getting marginalized in this new world if his farm isn’t delivering the product at the same price as others.

4) will lessen/status-quo the subsidization burden on federal/state coffers as improved productivity in the chain would more than compensate for the costs of WTO-forced integration of indian economy to global market where a farmer in Idaho could dump his well-subsidized and high-yield produce to countries like india and china.

5) Gradually helps to Scrap all these inefficient and corrupt state/federal agri. mktg agencies that barley accomplished thier stated objectives.

6) Encourages cooperative movement amongst farming community to collectively share the burden of improvisation techniques to compete well on global level.

CONS:
As with any change in staus-quo, there ought to be some cons with this change.
1) Economy of Scale wold tilt in favour of agrarian-economies where large-tracts of land would be harvested by effective-farming techniques and hooked to world-class consumer delivery supply-chains.(TRANSLATION: Big corporate (or) entrepreneur managed contract-farming done with an up-to-date farming techniques and harvests sold to efficient retail–supply chains like Reliance, Mittal-Walmarts. Innovative/Creative small/medium farms is always an exception anywhere). This would certainly happen to our farming in the next 5-10 yrs. Eventually this is inevitable for any capitalistic economy integrated into world through WTO.
What would happen to small and midsize farming community who had been prcatising farming using traditional low-yield techniques on small tracts and relying on thier harvest for decades?
This is where our federal policies and 5/10 yr plans should kick-in to plan and support a smooth transition of this community to other sectors where jobs/business opportunities being created would be serving this huge-block of farming community. How skillfull is our federal stewards in doing this is going to dictate the level of civil-unrest that has to be managed by our country in the next 1-2 decades.

2) There would be a significant downsizing of the number of mom-and-pop retail stores currently serving consumers. Assuming that the jobs created with these big-retailers and thier upstream logistic lifecycle (walmart itself employs 1.2 million in USA at it’s 3400 stores that’s visited by 100 million consumers) is a bigger figure when compared to the job-loss at these unorganized retail sector, the only concern that govt. has to interpret correctly is the often complained (not fully substantiated) sub-standard quality of life that’s common place with these walmart-kind of employers (The average full-time hourly wage for a Wal-Mart employee is $9.98, which is just above the minimum wage).

Any thoughts??

Banking Dilemma!

With decent deposit growth rates (24%) and access to cheap funds (100-150 points over 6-month LIBOR) from international markets, banks are eager to find borrowers. Not succesful at that, banks are parking all that money in different non-direct-lending channels like SLR bonds, revers repo.

Natural question here is why wouldn’t banks find borrowers with corporate investments at peak rates?. ECB route has become a golden-transit for private-sector using which they (just like banks) can access cheap capital from intenration markets. Highly-rated corporate-debt can be placed with little effort overseas with decent LIBOR+150 rates. There’s no point for these corporates to chase domestic banks for funds given the cheaper alternative (ECB).

Another blow to banks is an effort by RBI to squeeze money-supply (20% growth in money supply which is above the nominal GDP-growth of 13% that naturally explains the inflationary pressures with too much money chasing fewer goods) by gradually increasing CRR (7%). This excessive money supply is resulting from record FII inflows ($8.4 billion) and forex reserves standing at $225 billion.

What would be your strategy, if you were a corporate treasurer at one of these banks?

Oil Subsidies. How Long?

This is a great multi-faceted issue to analyze and understand how inter-twined the underlying goals are, and how creative the solutions could be to fit our indian context::

1) CLASSIFICATION:
A good question raised recently is “Do those 1 Million and odd Tax Paying (or) 2Million and odd businessmen really need public-tax-funded petrol-subsidies?. My question is, how do you implement tiered-pricing charging differently for various demographic-consumers based on thier annual income?. A public funded study to identify the consumption patterns would be a good first step. It tells you what % of total petrol is being consumed by what demographics. It also would give us clues on the weightage that should be given to petrol as a commondity in CPI basket.

Certain commodities like Kerosene, Cooking-Gas has to be subsidized during these transitionary stages of the economy. But, if these subsidies get to a point where govt/budget-planning is compromising primary education or health-care allocations to balance, It is TOTAL waste of money..given the GDP contribution a good education/healthcare economy is going to make versus a broken one.

2) CONSUMPTION: From the economy’s perspective, the lower the imports.. the better the balance-of-payments/trade-surplus would be. But, with Petrol/Diesel becoming a necessity for house-hold owing to majority of the working class relying on personal transport and indirect-material-transportation-cost associated with diesel trucks…it’s a commodity that will be in CPI basket with decent weight and would have to be monitored.

POSSIBLE SOLUTION: Govt can create a model where states and/or cities investing/setting an efficient public transportation would be strongly incentivized as studies have clearly shown that countries carrying good public transportation had lower per capita fuel consumption. Once you provide this, the weight of fuel in CPI basket can come down and non-essential-splurge of fuel could be taxed through congestion(time/permiter) taxes you see in countries like singapore and UK.In essence, provide an alternative to typical-households before you tax the consumption (or) eliminate subsidies on that commodity.

3) CPI/WPI/PPI: Good amount of totally valid discussion is in different blogs on the accuracy, applicability, transparency, usage of these different inflation metrics in indian context. CPI, despite the fact that this is still not reflective of typical household consumables and not transparent..is a resonable metric to look at, as the criteria is better than WPI.

QUESTION: Now, should govt. be manipulating the market (Oil bonds, etc.) each time a commodity in CPI basket shows price distortion (or) handle the CPI at the macro-economic level by leaving the control-knobs to RBI??
MY ANSWER:A) If distortion is artificial (price gouging, etc.) >> step in and correct the situation. [Examples: Wheat, Cement]B) If distortion is global and supply-driven and is inevitable >> make policy changes to cut down the demand and incentivize alternative commodities and/or also delegate it to macro-economic-policy-drivers like RBI.[Examples: Petrol, Cement]

The federal govt. can make these kind of guidelines as part of National-Commmodity-policy, just like security policy and evolve this under independent body with out any politicking and mud-slinging by opposition during these market distortions forcing the ruling-party to haphazardly invent short-term price-smoothing tricks (Oil Bonds!) that create more damage in the long term.

Any takers? Montek? Manmohan? Chidambaram? RBI Team?

PS: My comments to different blogs in IndianEconomy.org:

INDIA: Wheat Imports and Derivatives:

INDIA: Oil Bonds:

INDIA: Productivity Miracle:

INDIA: Protect the chain:

INDIA: Helping indian farmers: