06 October 2008

Participatory Note policy reversed

Newspapers report that the PN policy brought about by SEBI in October 07 to restrict foreign inflows and thus inflation, has been reversed by SEBI in its Board meeting today. This is a welcome move, even though both moves were reactive rather than strategic from the perspective of foreign exchange management by the government. See the SEBI Press Release (no direct link - click on the PR of 6th Oct).

PS: Percy Mistry khush hua.

PPS: The RBI has injected Rs. 200 billion by reducing CRR of banks by 50 basis points today. This should help the liquidity parched economy.

1 comment:

Manu said...

Mr. Mistry is awesome when he analyses the awful underpinnings...

He seems to be seriously curious and furious !

Read him here ->

Percy S Mistry: Illusions, delusions and self-righteous indignation
Percy S Mistry / New Delhi October 04, 2008, 0:13 IST
You can blame the former ‘masters of the universe’ for the havoc they’ve wrought, but bear in mind they’ve all taken hits of 60-100 per cent of their net worth.

The global financial crisis burst on the scene in August 2007. Things have unravelled dramatically since. The last 13 months have seen $600 billion of net worth written down by financial firms. Bear Stearns has been absorbed by JP Morgan. Northern Rock has been nationalised, following a stunning display of effete ineptitude by the UK authorities. Bank consolidations have occurred in a number of countries. Financial authorities everywhere have been anxious to avoid bankruptcies. Growing fear about the solvency of financial firms could lead to outright panic, triggering economic collapse. Over $1.6 trillion has been added by global central banks in special liquidity facilities to keep credit markets lubricated.

In September, the crisis entered its most dangerous phase. It became abundantly clear that the institution-by-institution, string-and-cellotape approach taken by central banks and treasuries was not working. On September 15, the US Treasury and Federal Reserve let Lehman Brothers go bankrupt (for silly brinksmanship by its head), to show that they were concerned about future moral hazard. That gambit backfired. Merrill Lynch immediately had to be absorbed at a bargain basement price by the Bank of America. AIG had to be “saved” next day with loans of $85 billion and ownership of 79.9 per cent by the US Treasury and Fed. The world is now at the edge of an abyss overlooking the disintegration of the structures of global finance. Investment banking as a discrete business model has got a heart attack and died. Over the weekend of September 27-28, there was a run on a Hong Kong bank, Washington Mutual was taken over by JP Morgan, and Bradford & Bingley was “Northern Rocked”! Then there was Wachovia, Hypo, five Irish banks, Fortis, Dexia and others. How many more to come?

On September 18, the Fed chairman and US Treasury secretary proposed the Troubled Assets Recovery Programme (TARP). [Note: How do you let former rivals at Lehman’s go bankrupt one day, save AIG the next, come up with a bill for $700 billion for TARP to save the system the day after, and keep a straight face, while going down on one knee to Nancy Pelosi begging for help? That kind of “chutzpah” takes Paulson-sized cojones fertilised in a febrile environment like Goldman Sachs!]

But to come back to the point: these toxic assets were seen by the Treasury and Fed as gumming up the credit system, and creating concerns within the financial community about everyone else’s solvency. Each bank now suspects the other is broke, but is intent on hiding that ugly fact. If Citibank is afraid that HSBC and JP Morgan might be insolvent, and vice versa, they are hardly likely to lend to each other, no matter how much central bank-infused liquidity they happen to be hoarding — and they are hoarding plenty at a cost.

Worse still, the global banking industry does not have the wherewithal to sit down collectively, net out the trillions of toxic assets they have issued to one another, reduce the gross size of the problem to its net elements, pass the netted out obligations to TARP and get on with normal life. The crisis is now political as well as financial. What has stymied systemic solutions to stabilise finance are loud academic, journalistic and political calls to: prevent future moral hazard; object rhetorically to taxpayer bailouts; ensure retribution; and exact revenge for this debacle being visited on an “innocent” (really?) public. When a financial crisis is politicised, the victims are reason and common sense.

We need to dispose of all the wrong (but understandably human) questions that obsess us, so as to get on with fixing what is broken. The most bandied about of these pragmatically pointless questions include: (1) Who is to blame? (2) Are they being punished enough? (3) Why should taxpayers bail them out? (4) How much more government oversight and regulation are needed? (5) What must we do to curb the “market” in order to socialise profits and privatise costs (that is, to reverse of what we think has been happening so far)?

Who is to Blame? If you ask the media and the public, it is investment bankers; former “masters of the universe” who have morphed into incontinent infants. Their response to any shock now is to wet their nappies or beds. In the public mind, these poseurs, criminals and thieves, for years bundled mortgages into complex securitised assets that no one could value, overlaid them with complex derivatives that no one could understand, paid credit rating agencies to rate these toxic securities AAA, and sold them to the unwary (other supposedly sophisticated financial institutions such as pension funds, hedge funds and asset managers) for enormous fees from which they paid themselves excessive bonuses. They called this “innovation”.

Are these guilty (bankers?) being punished enough? Public opinion is that the bankers are not being punished enough for what they have perpetrated. They are being bailed out by taxpayers. Governments should now put a lid on executive compensation if we are not to exacerbate future moral hazard. You have to hand it to socialists and democrats. They never miss an opportunistic trick! But let’s look at some facts. Looking at stock price movements over the last year, the shareholders of global banks have taken hits of about 60-100 per cent of their value. The managers involved have taken hits of 60-95 per cent of their net worth. It was disgraceful that Charles Prince of Citigroup and Stan O’Neal of Merrill Lynch got over $50 million for non-performance. But the value of their stock options has gone down by 70 per cent in the case of Mr Prince and 90 per cent in the case of Mr O’Neal. Creative destruction and punishment for stupidity is at work. That is capitalism. The people responsible for this mess have not got off scot free; except perhaps for George Bush and Alan Greenspan. Even poor Hank Paulson has taken a 70 per cent hit in the value of his Goldman Sachs stock.

Bloomberg reported on September 26 that just over $3 billion was paid to their teams of top executives by the five major investment banks (GS, MS, ML, LB and BS) in 2003-07; about 80 per cent of that was in stock options. That $2.4 billion in stock is now worth less than $300 million. The present value of the compensation paid works out to $180 million per year to 25-30 people, or an average of $7 million per executive. That is a ludicrous amount to pay for the delivery of abject failure. But it is a far cry from the annual $100-200 million embedded in the public mind, thanks to media exaggeration.

The top executives have taken a bigger hit. Jimmy Cayne was worth $1.6 billion last year in Bear Stearns stock. JPM bought it for just $61 million. So he took a haircut of $1.54 billion or over 96 per cent of his net worth. The same goes for Dick Fuld of Lehman’s whose $931 million of accumulated compensation in Lehman’s stock at its peak price is now worthless. He sold 3 million of 11 million shares for less than $500,000; the remaining 8 million have no value. How many could take a 95+ per cent hit on net worth and regard that as insufficient punishment? Media reporting of these executives getting off scot-free is therefore grossly misleading. It suggests that these absurd rewards have retained their original values, when they are now worth a mere fraction. But who has any sympathy for someone who has lost over 95 per cent of what he had, yet still has a few million left?

The author chaired the high-powered committee on making Mumbai an international financial centre

Source: BS Link 1

Percy S Mistry: Blame Bush and Greenspan, not just the bankers
Percy S Mistry / New Delhi October 06, 2008, 0:06 IST
Bankers are to blame but, in a macro sense, the crisis originated with the Fed and the government.

Bankers are at fault. At the meso (financial industry) level there can be no question that the financial services industry responded to a series of perverse incentives based on excessive: leverage, risk-taking and compensation. There was too much innovation of the wrong (value-destroying rather than value-adding) kind. But what do you expect a financial system — operating at Fed rates of 1-2 per cent for six years, yet expected to deliver returns of 6-7 per cent for pension funds based on their actuarial cash payout liabilities — to do? How do you deliver those returns without risk? The public would scream if pensions were not paid. And who was complaining when US house prices were rising at the rate of 5 per cent per month or the stock market was ballooning?

What should be condemned is that prices were allowed to rise so ridiculously without time-out being called by the authorities. Alan Greenspan claimed it was wrong for the Fed to prevent asset price bubbles! And financial newspapers thought he was the world’s greatest central banker! Markets can and do fail. But Japan has gone through 12 years of stagflation because of the unwillingness of its authorities to let creative destruction take place. China’s financial system is undercapitalised to the tune of $400 billion at least because of the refusal of the authorities to wipe out the value of NPAs from the books of its banks. But that is hidden. So which alternative is better and healthier? Quick, creative Schumpeterian destruction that compels rapid adjustment (traumatic though it is) or prolonged agony because of a refusal to recognise reality?

The bankers represent only the meso third of the problem. What about the macro and the micro?

Looked at with 20:20 hindsight, this crisis originated in a macro sense with the US Federal Reserve and the Bush administration. Since the dot.com bubble burst in 2000, and in the aftermath of 9/11/01, the Bush administration ran unprecedented fiscal and current account deficits to finance: bizarre wars, tax cuts and egregious public over-consumption, all fuelled by debt bought by the rest of the world. Such insane profligacy was financed by a massive Fed-blown bubble of liquidity. Estimates of the cumulative excess liquidity bubble blown by the Fed to finance these and other private follies range from $8 trillion to $12 trillion. The US Congress was equally culpable, for letting government borrowing limits expand so elastically. So one should be sceptical of the righteous indignation of posturing politicians. The US administration, Congress and Fed were the three main macro-culprits in blowing the money bubble. Gordon Brown in the UK is now doing the same thing as is Silvio Berlusconi in Italy. Japan did much the same between 1991 and 2005 but not at the world’s expense; mostly at its own.

Until 2007, all of this excess dollar liquidity went into asset price inflation. US and EU property price increases and stock price increases amounted to about $8 trillion of real estate stock and market cap revaluation in 2000-07. Commodity price inflation (especially oil prices) absorbed another $3 trillion.

Average house prices in the US are now reverting slowly to a multiple of 7-8 times average annual incomes, rather than the 14-15 multiple which they reached at peak and which was unsustainable. This revaluation through de-leveraging is traumatic in the short term, but healthy in the long term. It is a good example of how the market works to shake out its own excesses. That needs to be applauded, not condemned. Only an Indian socialist mindset would condemn it as dislocating, as if the socialist alternative delivered anything better. Markets may fail occasionally. But by and large they still work better than governments do. Let’s not lose sight of that.

What about the micro- or individual-level failure? The Bush tendency to over-borrow and overspend was mirrored and exacerbated by ‘buy-now-pay-later’ citizens (not just in America but around the world, including India) indulging in consumption excesses, not out of present or future income, but by exerting leverage. Therefore, when we look for whom to blame, we should be looking in a mirror! When markets fail, it is invariably because people do. What about individuals who over-borrowed to avoid losing out on the house price boom? What about their auto loan, credit card, refrigerator, washing machine, TV, and holiday debt? Are they not to blame as well for being irresponsible and overstretching their credit take-on? Have we finally created a credit culture where it is always the fault of the supplier of credit when indulgence in excess is concerned, rather than its user, who is always blameless? If so, we are in for even more trouble.

And what about the regulators who let all this happen? This was not just market failure but regulatory and monetary failure on an even grander scale. Have they lost their jobs yet or seen their net worth fall by 70-100 per cent? We in India are extolling the virtues of the RBI for saving us from this mess. But what about the excess liquidity created in India to stabilise the exchange rate that has resulted in 13 per cent inflation? It is not just a cost-push effect, as alleged. We have created too much money and not let the market work to suppress demand (because of subsidies) and curb price rises. We have created enough money for inflation to rise well above what it should have risen to (around 8 per cent) and yet we are congratulating our wise policy-makers? Alice in Wonderland would have been amazed.

Why should innocent taxpayers be bailing out irresponsible banks? As the crisis unfolds, righteous indignation sweeps the world; resonating most loudly in that ultimate rotunda of hypocrisy, the US Congress. Legislators and erudite commentators allude endlessly to taxpayers “bailing out” rotten banks and criminal bankers. They add up the cost of saving Bear Stearns, Merrill Lynch, Fannie Mae, Freddie Mac, AIG and TARP.

But what was the cost of letting Lehman Brothers go bankrupt, in terms of collateral damage and the aggravation of endemic fear which tipped the system over the edge? It was a gamble that failed spectacularly. It triggered the necessity of coming up with a $700-billion bailout funded by taxpayers. Well let’s examine the terms taxpayers and bailouts a bit to help understanding.

Are these taxpayers the same people who over-borrowed on their mortgages, thought spiralling house prices would keep going up and never down, and have now defaulted? Are they the ones who used home-equity lines to go on spending binges, which they are now reluctant to pay the price for? Are these the same people who need their salary checks or their pensions to be paid (which won’t happen if credit chokes up) and who need loans to educate their children or cope with their vacation bills? What will happen to these taxpayers if banks fail on an industry-wide basis? So who is actually being bailed out? The banks? Or the taxpayer as the eventual beneficiary of credit markets working and returning to normalcy?

The author chaired the high-powered committee on making Mumbai an international financial centre

(On Tuesday: What bailout? The treasury will earn a profit)

StatsGuru will appear on Thursday

Source: BS Link 2

Percy S Mistry: What bailout? The treasury will earn profits
Percy S Mistry / New Delhi October 7, 2008, 0:14 IST
If the financial system stabilises, the US economy would benefit by 2-3% in terms of avoiding lost output.

The question now is: what is the cost of the alternative to the “bailout”, that is, do nothing and let financial institutions around the world collapse like dominoes? What would the cost be of that?

The visible costs of these serial “bailouts” are estimated at over $1 trillion. But this adds apples and oranges. There is a difference between: (a) liquidity being provided by the Federal Reserve (which does not cost taxpayers a dime) to lubricate seized-up credit markets, and (b) funds being sought by the US Treasury, not for public expenditure but for the purchase of a stock of securities (collateralised by mortgages on houses whose prices are collapsing but will recover some years from now) issued by investment banks. It has been done before quite successfully (thrice in the US and more recently in Sweden and Japan). So what is all the fuss about?

At the end of the day what is likely to happen is that the Troubled Asset Relief Programme (TARP) will use $700 billion to buy out about $2 trillion (in face value) of toxic securitised assets that have no meaningful market price right now. That would immediately create additional “capital headroom” of about $160-200 billion for the banks, allowing for an 8-10 per cent capital adequacy requirement. It may result in a further $40-50 billion being written back in capital. The big unknown is whether that will be enough. Present estimates of the amount of recapitalisation required for the global financial system range from $500 billion to $1 trillion. It is difficult to see where that capital is going to come from when the share prices of financial firms are so depressed, and sovereign wealth funds are gun-shy.

The benchmark established by Merrill Lynch a few months ago when it sold a bundle of the toxic securities was 22 cents per dollar of face value. That is regarded (by the Fed chairman, among others) as a “fire sale” price. Allowing for a 35-50 per cent premium over that price, one would expect most reverse auctions (unless they are rigged) to result in a price of around $0.30 to $0.33 per dollar. Held to maturity, or stripped down, unbundled, and reconfigured over time it would not be unreasonable to expect these assets to be disposed of at prices of between $0.60 and $0.75 on the dollar when normalcy returns, house prices stop plummeting, and mortgage delinquencies decline.

Assuming (quite reasonably) that this happens, the US Treasury stands to recover between $1.2 trillion and $1.6 trillion (if not more), for an outlay of $700 billion. Discounting for the time value of money, that is a return of 20-35 per cent on $700 billion. So where is the bail-out? If the financial system is stabilised as a result of this measure (a big “if”, supposing that banks can be recapitalised sufficiently quickly) and credit starts flowing normally again, the net immediate benefit to the US economy could be up to 2-3 per cent of GDP or about $300-400 billion in avoiding lost output.

How much more government oversight and regulation are needed? Much has been said about the failure of regulation being as responsible for this crisis as the failure of financial markets, banks and bankers. Some of it is right. But it is not clear that more regulation would have avoided the problem. The risk is that more of the wrong kind of regulation might worsen the situation by impeding the normal flow of credit because of exaggerated concerns about risk and regulatory micro-management of financial firms. Real market and regulatory failure occurred in the US, which has among the most rule-based regulatory regimes in the world. Its central bank is the prime regulator. It is a system which is the most fragmented, with mortgage lending and insurance being regulated at state rather than federal level, resulting in repeated failures. It is not clear whether the alternatives (greater oversight, more regulation, and so on) would necessarily have achieved much better outcomes.

Much has also been said about the failure of regulation in the UK, where regulation was unified and separated from the central bank. But Northern Rock was not a failure of regulation as much as it was a failure of judgement on the part of the key human actors involved. It showed up the dangers of appointing academics to positions that should be occupied by people with practical knowledge of how markets actually work and how financial firms react in a crisis. The contrast between the intellectual dithering of the top level UK authorities and the US Fed with each turn of the screw, and the decisive, pragmatic responses of the US Treasury Secretary (an experienced market operator), could not be more stark.

The real arguments about regulation for the future are yet to come. Many of the actions taken will be aimed at fighting the last war, not the next one. The best option is to ensure that the incentives for self-regulation are designed to work better than they did, and that financial system regulation is unified and not fragmented. It is also better for regulation and supervision to be separated from a monetary authority to avoid cascading conflicts-of-interest and cloud central bank judgement about its previous errors.

What about “socialising profit” and “privatising cost”? The present crisis has brought out the stark problems of privatising profit only for the eventual costs of market failure to be socialised. If TARP works, that prospect will be reversed. But in the final analysis these questions and arguments are hollow. In as extreme a crisis as this, when confidence in the financial industry is lost, the only option left is to deploy heavy artillery involving the credit of the state. That is because the state is only instrumentality that can legitimately print money to meet its obligations. But, like nuclear weapons, that option is best used as a deterrent in extremism, rather than one which is invoked regularly. When that happens, the public begins to believe that finance is an area in which markets either do not work, or create so much systemic and social risk, that the credit and authority of the state should underpin the credibility of the financial system at all times, and not just in extraordinary ones.

The author chaired the high-powered committee on making Mumbai an international financial centre

Source: BS Link 3

P Manohar Bhat