Let 'em Die - Why bailout GM?

The rationale behind the $700bn bailout for US Financial Institutions goes something like this: Buying distressed securities at a marked down price on favourable terms. Warren Buffett for example made a deal with Goldman Sachs in very favourable terms - not something which retail investors can make. The idea is, if the US treasury buys distressed securities at current market prices and with the low cost of borrowing that the US Govt can enjoy, and the staying power it has, its going to make money in the long run. The key thing is to buy at market. That these assets will be worth more over time is the main reason why this bailout plan does not punish the tax payers.

This is exactly the problem with a similar idea for GM. Firstly; it is unadulterated nonsense that GM's ills are a ripple effect of the collapsing US economy. Detroit has been declining for a long time now. It is true that tough economic conditions have affected sales, but it has just accelerated GM on the road to bankruptcy which it is already in. In the case of Detroit, the chance that tax payers’ money is squandered away is high. GM made the electric car first in 1996, but ultimately withdrew it. It has always been poorly managed and having this extremely short sighted view of the market. Secondly, it is also not true that the failure of the American auto firms would mean the collapse of the American auto industry. Toyota makes its cars in the US. Nissan, Honda and others have their plants all around. Lastly, there is nothing that makes buying into the big three a sound investment. To quote Ben Graham: "An investment operation is one which upon thorough analysis promises safety of principal and a satisfactory return." If we are to believe that the government is only investing the tax payer money and not squandering it away GM or other companies must satisfy criteria like having good management, sustainable earning power etc.

If it’s not a bail out but only a loan, which I assume is going to be something like that which was made to Chrysler, where do we have somebody like a Lee Iacocca? Iacocca before joining Chrysler had several successes, most notable of them being the Mustang. Are there managers with such a track record today? Look at what Carlos Ghosn has done to Nissan. Ghosn is an icon in Japan. Does the US have an answer? Where are the managers who can face reality and make better cars? Detroit has very consistently demonstrated a lack of leadership. Their answer to the superior Toyota Production System initially was that it had something to do with Japanese culture. Then they lobbied for protectionism. Japan proved them wrong by implementing the TPS right in the US. They even taught GM in the NUMMI plant.

Auto majors have not demonstrated a consistent earning power either. AIG for instance was a sound company before the financial tsunami struck, but Detroit sucked even before the meltdown. The meltdown has in fact helped GM and others hide their stupidity. GM is losing about forty dollars a share which is priced at about three dollars. GM has a minus 110% five year average return on equity. That's underperforming the industry by a 122%. Honda has a return on Equity of 13.7%. Ford has a -22.24% five year average ROE.

So, here is what the Fed is thinking if they do invest in these companies - a company with poor management, myopic vision, no earning power, falling sales, lousy cars, negative ROE etc. promises safety of principal and a satisfactory return to the tax payers' money. Where the hell is capitalism? Why should these companies be saved?

The fact is, the bailout is not going to solve the long term problems. Even an Iacocca and the Federal loan could not help Chrysler from falling now (Actually, Daimler is one of the causes behind Chrysler's ills). Probably a way out could be to do away with myopic managers, put a new management team which is advised by managers like Ghosn, and study how exactly does Detroit plan to get itself out of the mess before committing hard earned money. That they plan to do this by investing in technology, and which is why they need capital sounds a hollow claim. The benefit of new technology is eventually going to go to the customers not to the owners. Technology is necessary but not sufficient. Another way to solve this is by breaking up GM and make a distress sale of the brands like the sale of JLR and forget about American auto companies. That can actually save more jobs, and bring in a new management.

Also read: http://online.wsj.com/article/SB122688631448632421.html

Virtue and Vice Effects in Economics

There is something called as the virtue and vice effect in economics. Modern economists hardly talk of this because it doesn’t lend itself to mathematical analysis. Economists seem to have what Munger calls physics envy – a never ending quest for precision though it may be unattainable and dangerously misleading. Richard Feynman says in a BBC interview “I have approximate answers, and possible beliefs, and different degrees of certainty about different things, but I’m not absolutely sure of anything, and there are many things I don’t know anything about.” It is indeed paradoxical that while physicists can accept to live with saying “I don’t know” economists (who are quite distant from science) pursue a relentless quest for complex mathematics and accuracy and get it precisely wrong many times. They’d better be called wannabe physicists.

Munger talks about the case of a Latin American economy in which people lost their morality and stole everything. Embezzlement was rampant and the economy soon reached a state of chaos. This thing eventually got fixed. If you thought some really good economist were at work, you’re way off the tangent. This case was not even found in the annals of economics, it was in the annals of psychology. A group of clever psychologists went and fixed the problem. The cash register seems to have done much for human morality than any of the religious establishments. What it did was to create a system where stealing was impossible. A system which is hard to defraud is very essential for a good economy.

The role of the cash register was played earlier by religion. Religions instilled guilt in the minds of people. They invented and perfected guilt over the years. It was the main driver which created ethos, and a sense of right and wrong. Economic crises seem to have a close correlation to the breakdown of virtues. The problem is not that rationality takes over religion, that’s actually good. The problem actually is that ethos is essential, and we still to a large extent depend on religion to maintain that. There is a need to develop alternative systems, like the cash register to maintain a system which is tough to defraud.

Let’s perform a thought experiment here on the present economic crisis. Forget economics for a moment, and think religion. So we think of the Seven Deadly sins. First of them is envy. The housing market was booming in the US, and it was so easy to make money by borrowing without collateral, and buying a house and trading it up as the prices rose. You looked stupid when your neighbour made a killing by taking on debt. Envy was a major factor in creating the crisis in the US. Lehman made money on leverage, so AIG looked stupid and so did so many others. The whole of the American economy had so much of leverage, and leverage is unsustainable. “If a thing can’t go on forever, it will eventually stop” is a tautology worth remembering. Envy was the dominating emotion behind leverage. If not for envy, you wouldn’t have cared how much the other guy made. Leverage killed the economy, but it was envy that drove leverage.

Investment bankers were making crazy money during the boom time. There has been so much of talk about unfair compensation for investment bankers. That was a sign of avarice. The dominance of greed is well known. In his book ‘Liar’s Poker’ Michael Lewis talks about gluttony in the trading floor of a well respected trading firm Salomon Brothers. There were even feeding frenzies on Fridays. As the religious economist would expect Jesus willed bad luck to Salomon. There are several examples in history. In a book named ‘Extraordinary Popular Delusions and Madness of Crowds’, Charles Mackay talks about some of these. It is not coincidence that morality and ethos are essential to a healthy economic system.

However visible the vices may be there ought to be rational reasons for proclaiming gloom. The problem is economics is complex enough that, if you believe that things are going to be fine, and the boom will last forever, you can find enough evidence to confirm your belief. Psychologists call this the confirmation bias. We simply reject information that disconfirms our belief. Which means you just cannot find rational reason unless you say ‘I don’t know if the boom is intact, I just want to find out.’ This is very different from saying ‘I hope the boom is on and I want to prove it.’

Morality gives a completely different perspective to economics. If economists had taken the moral triggers seriously, which they evidently didn’t, they would have probably been receptive to the doomsayers. There were people like Nouriel Roubini of the New York Stern University, who in 2006 predicted the crisis affecting the whole world. The economic fraternity though was in such a state of psychological denial that Mr. Roubini was laughed at. People will now say if we had been more receptive to Prof. Roubini, we could have save $700bn, and much more to the world.

Undermining the virtue and vice effects is a problem that economists face. Though it can not give exact answers, it most certainly can provide the impetus to look for evidence in the right direction. Religion seems to be one of the greatest economic inventions of all time.

On the LHC, Probability and Journalism

There was an editorial in the Indian Express on the 'hysteria' surrounding Large Hadron Collider Experiment. There was a fear propogated by a group of scientists that the accelerating streams of protons would cause a quasar to form, which on expansion could cause the end of the world. Well, the world did not come to an end. In any case, it would take about a year or so before the proton actually accelerates fully. It's going to take sometime before the naysers are proved wrong. Several scientists have allayed the fears, saying that this experiment is too small to swallow up the world. In science we trust, the sky will not fall.

The problem though was, the editorial misrepresented probabilities. Actually, the experiment was conducted because, the probability that the world would come to an end was zero. Even if there was a low probability that the world would end, the experiment wouldn't have been conducted. The editorial traversed the realms of nuclear physics first, and then probability, followed by human psychology.

It went on to point out a flaw in human thinking! It said "...a deeper problem in our society: overestimating the danger of small probability events." It was at this point i started thinking: "How can we overestimate the end of the world, even if there is a 0.0000001 percent chance?" The author made a gross mistake. He was either unaware of, or had completely forgotten what wieghted probabilty was. This made man appear stunted in his thinking, when he was actually using an intellectual gift, of instinctive weighting. It's something we always do when we prioritze. Infact, we get into problems often by underestimating events of low probabilty. There is a very small chance that some woman has AIDS, but if she does her clients are doomed!

What's wrong with fearing events of low probability? Was the attack on twin towers an event of high, or atleast reasonable probability? Did anyone ever think of it even in their dreams. Hell no! Was the bombing of Pearl Harbour an event of high probabilty? All great inventions in the world were events of low probability. High probability events are always gaurded against. It's only the low probability events that catches you out of the blue, and shapes history. It is almost always true that low porbability events are heavily weighted. The way low probability events shape the course of the world is the subject of a very famous book by Nassim Taleb titled 'The Black Swan'. The point is, probabilities might be low, but if those events do occur, they change the way the world works.

It's true that road accidents kill more people than terrorist attacks in the world. Terrorist attacks indeed are events of low probability. The editorial said, we were therefore stupid in spending more money on terrorism than on making roads safer. Here again, such a statement wouldn't have been made if the author had the slightest idea what sample spaces meant. In Surat, chances are that you can die of a road accident than a terrorist attack. Can you say the same thing for the Kashmir valley, or Afghanistan? Road accidents have a vastly huge sample space. Terrorists have specific targets, hence a smaller sample space. More accident deaths therefore don't mean terrorism is a smaller danger, it only means that the denominators are different.

In today's complex world, where there is an increasing need of specialization in every field. This applies to journalism as well. It is surprising why there is a degree called B.A. Journalism, where people learn nothing about specific domains. This kind of writng shallow and devoid of any science, is what we can expect to see if we still churn out journalists, who lack domain knowledge. For instance, the Wall Street Journal has an article which intends to do the same thing which this editorial did. The difference though is that, it was written by Dr. Michio Kaku, a popular theoritical physicist in the United States and was much more scientific in its treatment of the subject matter. Probably because journalists strongly gaurd our newspapers, we never get to know scientists till they get a Bharat Ratna. It's better writing is left to subject matter experts, even if it means editorials would cease

Climate Conundrum

The phrase climate change often renders an image of melting icecaps, rising sea levels, and other environmental changes. The environmental dimension is just one part of it. Not quite perceived by many are the sweeping changes taking place in the world of business and politics in an effort to respond to climate change.

2007 saw the IPCC (inter governmental panel on climate change), headed by Dr. RK Pachauri give its verdict: the climate is changing and we ourselves are largely to blame. The question now is not whether to act or not, but how to respond to climate change in a sensible way. Climate issues rank high on the political agenda; needless to say comprise much of rhetoric. Quite obviously climate change and related regulatory reactions will have significant implications on the world economy.

According to the IPCC, general warming of the earth is almost certain, rainfall patterns will change, and heat waves will become more frequent. The weather gods will become more capricious and we may see more Katrinas and Ritas. On one hand extreme weather events will cause destruction to plant machinery and crops, while on the other planning of future events would become complicated due to increased uncertainty. These are the twin factors which would have economic significance.

The first repercussion is increased financing costs. Institutions which lend to weather exposed sectors like agriculture, would expect a higher premium for the increased risk they are taking. Industries which have to reckon heavy losses due to the vagaries of the weather would find it difficult to finance themselves. Secondly, governments can no longer afford to sit quiet on potential climate threats and will be forced to take regulatory actions. This will result in growing climate protection efforts, which will result in higher costs. Regulations which aim at improving parameters such as heating efficiency, insulation, and low carbon technology are likely to be put in place. On the brighter side, some industries like construction and renewable energy do benefit, the costs however trickle down to you and me. Finally, climate change has the potential to change consumer behaviour. Increased awareness is already reflected in consumers’ efforts to conserve energy and support reparation efforts.

The key challenges in tackling some of these economic ramifications are

• Funding climate related technological advances

• Reducing the costs of greenhouse gas emissions

• Distributing weather risks effectively

• Create monetary incentives for environment friendly behaviour

Keeping these in mind, a lattice work of instruments and strategies needs to be evolved to respond to climate change in a sensible way. With the help of suitable financial instruments, it is possible to create incentives for climate protection, fund climate protection strategies, and share unavoidable risks effectively.

Emissions’ trading is an effective tool to augment efficiency of climate protection efforts on a global level. The Kyoto Protocol regulates green house gases like carbon dioxide, methane, nitrous oxide, sulphur hexafluoride, and fluorocarbons. All these emissions are converted to carbon dioxide equivalents, and measured. These measured quantities are used to issue emission certificates.

The Kyoto Protocol and the auxiliary agreements describe diverse emission certificates. At the outset, a distinction is made between emission rights and emission credits from project based mechanisms. In the first case, there is a ration of emission rights, which can be traded among the emitters of greenhouse gases. This includes the EU allowances that are traded in the EU emissions trading system and the assigned amount units (AAUs) that are intended for international trading. In the second case, credits can be obtained from additional climate protection projects in third countries and used to meet their own reduction target. A distinction is made according to whether the projects are realised in another industrial country (Joint Implementation) or in a developing country (Clean Development Mechanism, CDM). Another option provided for in the Kyoto Protocol is the realisation of carbon-sink projects at home, for instance in the form of afforestation. This results in so-called removal units (RMUs). Finally, it is possible to generate tradable project-based credits in the form of verified emission reductions (VERs).

The emission of greenhouse gases is a global problem; however, emerging markets and developing countries have been exempted so far from the Kyoto Protocol’s quantitative reduction commitments. All else being equal, the capping of greenhouse gases can often be realised at much lower cost in emerging than in industrial countries. This is where the Kyoto Protocol’s project-based mechanisms kick in. They allow emission credits (CERs and ERUs) from additional climate protection projects in third countries to be credited to the own reduction target. However, to prevent the industrial nations from buying their way out of any reduction commitment at home, there are limits to how much can be credited to their own reduction targets.

The trading of carbon credits is a lucrative opportunity for Indian companies and India in general. Indian companies can develop their own CDMs and sell their carbon credits to developed nations which have specific reduction targets under the protocol. Carbon credits have made climate protection a viable business prospect. Thanks to carbon credits, climate protection need not be at the mercy of benevolence.

The second class of members in our lattice is pretty simple - climate related investments. There is an investment theme evolving, which tries to demarcate sectors which profit from climate change, and sectors that don’t. Firms involved in renewable energy, companies offering solutions to adapting to climate change. Growing investor interest eventually reduces financing costs for these companies. It also gives a fillip to better capital allocation.

The third class is - a market for catastrophe and weather risks. Reinsurance is a typical example. Reinsurance is where insurance companies are insured by other insurers against mass catastrophes like tsunamis and hurricanes. It’s not significant in a country like India, but a big business in developed economies. Natural catastrophes are huge in terms of the volume of disaster, potentially affecting a whole region, this is where reinsurance helps. Another example would be cat bonds – a special purpose vehicle issues bonds which are used to fund contingency claims. This class of instruments enable efficient risk sharing. Many other members of the lattice are in the nascent stage of their genesis.

Of all the complex mechanisms to tackle climate change, carbon credits are the most relevant from the Indian perspective. Indian companies have already started to realise their potential, and are developing clean mechanisms. Carbon credits are increasingly being seen as supplementary products. There are trillions at stake to curb fossil fuel pollution, switch to clean energy.

Whether all these instruments are significant to climate protection is unclear. What is clear though is there is a lot of money involved. The future of all these treaties is uncertain. Bush’s successor may object to Kyoto protocol style of emission curbs. Though waning American hegemony is very much alive. While the countdown is on to save the planet, world leaders will bargain on treaties with monstrous complexities.

The gap between the need for action and political rhetoric is widening. Almost all global summits on climate change have been plagued by finger pointing. Who should foot the bill of climate change is still a nagging question. Uncertainties are a part and parcel of doing business.

Dog days for the dollar

The year of the rat certainly seems bleak for the American economy. The US economy seems to be in one of the worst crises in the recent times, and pundits are working hard to save the US economy from the brinks of recession. 2007 in many ways saw the beginning of the end of the übercurrency. At the beginning of the last century, the Great Britain pound had the status. The United States of America was just emerging then. The story of how USA became a leader is history and the US economy is now in a mess, with a consumption boom fuelled by borrowed money. The wheel of fortune has turned, and time is running out for the dollar. Here’s why.

Web 1.0 at it’s time was considered revolutionary. The late 1990s was characterized by frenzy over dot-com. It promised to take lesser mortals into the land of milk and honey. What followed was the busting of the dot-com bubble, taking the American stock exchanges through the doldrums. Alan Greenspan was at the helm of affairs in the Federal Reserve, and he promptly trimmed down the interest rates. Lower interest rates set in motion a consumption boom, which seemed to have set the economy right. The subtler ramifications though weren’t palpable until late 2006.

Dozens of interest rate cuts post dot-com and September 11^th had increased the money supply. Interest rates were slashed from 4.5% to 1% in two years[1]. Think of monetary supply as a string wound over a pulley. Too loose is of no use. Too tight and it will snap. Gradually the Fed took up the slack, but far slower than it had let it out. Monetary policy was too loose, and created the perfect conditions for the next bubble.

The growth of the US Economy post the dot-com bubble is interesting, and in hindsight is responsible in a way for the current turmoil. Lower interest rates meant borrowing was cheaper (cheap credit). This kicked off a quest for higher returns. Financial engineering was used, and the availability of advanced computers made, complex calculation easier. Diverse asset classes were combined to create financial instruments like collaterized debt obligations (CDOs). The risk was ‘measured’ using complex mathematical formulae. The methods were perceived to be sound because the mathematics was elegant. Pundits suffered the ‘man with a hammer syndrome’ – to the man with a hammer, every problem looks pretty much like a nail. This enabled banks to lend customers with poor credit rating.

Poor housing credit was shielded by innovative structures and rising home prices. This made credit cheaper. Loans to borrowers with poor credit history (subprime) accounted for almost 15% of all loans in 2006, that’s 1.2 trillion dollars.[2] Consequently home prices rose, leading to a consumption and investment boom, thus increasing the GDP. Subprime credit kept escalating to dangerous levels till August last year, when realization finally dawned. Much of the perils of the US Economy can be attributed to the subprime crisis, and more bad news is yet to come. The crisis has the potential to start of a dangerous chain reaction.

Loan defaults by subprime borrowers have already happened – chain initiation. Credit standards inevitably need to be tightened, EMIs will increase as interest rates reset upwards. Apart from increasing the number of unsold homes, it will increase defaults (the chain initiating step). Now unsold homes cause housing prices decline. No one buys when prices are set to decline, so investment in housing declines. Recalling that poor credit was shielded by rising home prices, it is easy to see that falling home prices takes you back to the first step. Jobs are lost due to both declining housing prices and falling investment in housing. This leads to lower consumption, and the GDP growth slows. Wow!

The subprime crisis can’t be rubbished as a mere housing crisis considering that the US housing market accounts 20% of world GDP, and 60% of US GDP. Secondly it is also a banking crisis – a crisis of liquidity and a crisis of collateral. It has been each of these and also a crisis of central banking. Central banks were very much present at the genesis, as asset prices swell and credit markets hypertrophied. What was spectacular in America was the ability of a large number of subprime borrowers – those with poor records – to take out mortgages and buy homes, lured by cheap credit and the delusion that home price could only go up.

Authority: “Credit and asset-price booms can leave an awful lot of wreckage behind them. The casualty list after America’s housing crash includes: an overhang of unsold property; a huge fall in construction; the risk of weakening consumer spending as house prices falls; a trail of bankruptcies; big write-downs among the investment banks; and the unprecedented seizing up of some financial markets on both sides of the Atlantic” - The Economist

If we seek to examine, if the actions of the Fed after the crisis are going to do anything to help, the picture seems dismal. Not so long ago, the Fed announced a rate cut, ripples were felt here and the Sensex sure did respond with a smart gain. It’s hard to fathom how it’s going to help solve the crisis. Lower interest rates were one of the contributing factors for the crisis.

Then there was an American version of populism. Mr President’s office decided to keep initial teaser rates frozen for a ‘certain’ category of subprime borrowers. Firstly that’s akin to heralding “it’s ok if you default, the government will bail you out”. Secondly the idea spells trouble for lenders, and they will factor the risk of freezing in the future, leading to higher interest rates. The idea was to prevent homes from going into immediate foreclosure that would accelerate price declines, but law of nature says that ‘what has gone up by irrational exuberance has to come down’.

There was also a plan of providing low interest loans to holders of mortgage backed securities – the banks. This however is the wrong sort of protection, and a misplaced idea to bail out the banks. Such a measure would have been necessary if the banks were suffering from insolvency, but the problem is one of liquidity. This actually amounts to increasing the money supply – a causal factor of inflation. The housing bubble was a symptom of inflation. So it’s hard to see how inflation can be tackled with more inflation.

The newly created credit will help borrowing by institutions at low interest rates, and help investing at higher yielding currencies like the INR. Something similar happened in Japan and was christened the “Yen Carry Trade”, looks like it’s going to happen in America. The correct thing to do would have been raise interest rates, and curb money supply. This would have created a bigger crisis at that time, but would have averted serious future problems. The Fed in my opinion just lacked the conviction to put its foot down and take bold actions.

It looks like the outlook for the American and the world economy is bleak, but there is a silver lining. We can hope that the emerging markets like China and India will come to the rescue by growing at a rapid rate. Global economies are highly intertwined, so if the Asian juggernaut keeps rolling, it could be America’s aspirin. However this also means that Asian dependency on America is reducing, and the world would soon need the dollar less.

India can thrive on this chaos. The turmoil in the debt market and the US economy, would slowly lead to the easing of oil prices. The rupee is rising so imports will become cheaper. There will be a global realignment of currency which would benefit India. The slowdown in US will begin to script a domestic consumption story. India may actually benefit after a small transition period.

It’s too simplistic to conclude that the Fed did all the wrong things. Instead all moments of choice were catch-22 situations. What would have happened if the Fed reacted differently is anybody’s guess. My hunch is that the American economy would recover after a slowdown without going into a recession. However, one thing is clear – the dollar’s hegemony is shaking.

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[1] http://www.federalreserve.gov/releases/h15/

[2] http://www.responsiblelending.org/pdfs/CRL-foreclosure-rprt-1-8.pdf