You can't properly blame the credit rating agencies (CRAs) for causing the current financial crisis, but that is what I am doing here.
The rôle of the CRAs is to evaluate the risk of securities and to issue ratings on types of securities as well as the securities themselves. Here I am mostly talking about the CRAs issuing credit ratings for certain types of debt obligations (eg. mortgage-backed securities) and the specific instruments that are issued (eg. the individual CDOs, CDSs, and so on).
In the USA, the two major CRAs, Moody's and Standard & Poor's, receive a sort of charter from the Federal government (they are two of the Nationally Recognized Statistical Rating Organizations) to issue the above ratings as well as they know how to. All investors have free knowledge of these ratings and are influenced by them in the following ways:
1) The value of every security has priced into it its CRA rating. That is, an artificially high rating has the potential to lead to bubbles of that security.
2) Some institutional funds are required to invest in securities based on their ratings. That is, a pension fund or money market fund may invest in only 'triple A' bonds believing its portfolio to be extremely low-risk; if the ratings are issued wrongly or in error, the above belief is misplaced.
3)The vast majority of investors have not the resources to perform due diligence on the majority of their investments (some of these may be obscure and highly complicated derivative instruments) and thus rely on the major CRAs to do this work for them. Thus the CRAs inspire confidence in the markets and confidence in them leads to higher economic activity and liquidity.
Needless to say, the CRAs failed to do their job. The very high rating of Iceland just prior to its bankruptcy and the crash of the 'triple A' mortgage-backed securities bubble should suffice as examples here. But how do their erroneous ratings implicate them as being responsible for the financial crisis? I give my reasons below:
1) Just after the world discovered there was a crisis in the 'subprime' market, the CRAs downgraded many asset-backed securities, sending prices tumbling. The US government's seal of approval of these CRAs' ratings created a vicious cycle of falling prices.
Many funds investing in these securities based on their high ratings now had to dump them (often for a heavy loss, especially after the recent fall in prices) because of the funds' rules. This forced selling, based on nothing more than a change in official opinion of some securities by the CRAs, compounded the financial crisis.
Of course, the firms whose debt got downgraded suffered the most as their borrowing costs (interest rates) shot up. (Banks and most other creditors have an obligation to follow the CRAs' ratings when buying debt.) This is not to mention that higher interest rates on mortgages mean that more loans are non-performing, which of course amplified the crisis by reducing the value of asset-backed securities.
2) For a world so previously so dependent on the CRAs' opinions, it was a shock for most people to see that these agencies' valuations and opinions were worthless. Suddenly, a 'triple A' rating meant zilch. This only sapped investors' confidence more, and the current impotency of the CRAs to influence and make confident the markets only led to sparse liquidity and credit (hence the term 'credit crunch').
Funds that invested based on the CRAs' ratings decided to hold cash (if they even existed any more), and many smaller companies could not issue debt because nobody trusted the CRAs' opinions (and nobody else did research on small companies).
It is very easy for me to write with the benefit of hindsight that the markets in the earlier part of this decade should not have trusted the CRAs as much as they did; that the funds' rules were putting blind faith in the CRAs; that pensioners and others who need low-risk,stable returns should have been more careful about their money; and that more investors should have evaluated the companies and securities they were investing in themselves instead of relying on the CRAs to make their decisions for them. But the state of the world as it existed prior to summer 2008 relied heavily on the CRAs, and this is why they cannot dodge responsibility for the current recession. Just as Freddie Mac and Fannie Mae had government approval to better facilitate mortgage lending, the major CRAs had Congress's approval to facilitate liquidity and confidence in the more obscure and complicated securities markets. And they failed.
Not only do I blame the CRAs for causing what has happened already so far in the financial crisis, I blame them also for illiquidity and non-confidence that will stay in the markets at least until, in my opinion, late 2010. I assign blame to the CRAs for giving current investors no basis upon which to invest their money, which will be saved and not contribute to economic activity. That is, an average investor who has no means (except at prohibitive cost) to perform risk control and due diligence can no longer trust the CRAs' opinions, and will choose to put his money into a savings account instead of fueling the markets with liquidity.
Below, I will give some reasons why I believe the above state of affairs came into being, and what I believe to be a solution:
1) All employees of a credit rating agency are investment banking rejects. This is of course a generalisation, but there is some truth to it because working for a CRA has none of the glamour (and a fraction of the pay) of working in a similar rôle at another financial organisation such as a bulge-bracket bank.
The agency does not have the talent or resources to properly issue ratings on the wide variety of securities that exist today, and I believe that this is a major reason why they failed to successfully predict the current recession.
The only solution I can think of for this problem is for the CRAs to have an official mandate from the government, and with Federal backing offer high efficiency wages to its employees to attract the best talent available.
2) As the CRAs are mostly paid by bond issuers, there is a major conflict of interest which tends to inflate ratings. I see no way to avert this conflict of interest except by having the CRAs nationalised and having only the government provide it with revenue.
Conclusion
I think that the era of CRAs wielding disproportionate influence in the credit markets has ended, and that we have entered a new low plateau of economic activity because of the loss of confidence. I do not think that the CRAs can gain their prestige and status back, so there will (have to) be some new institutions to take their place. Until then (I'm guessing this will take about two years) low business confidence will be the major player in the markets.
Showing posts with label economic analysis. Show all posts
Showing posts with label economic analysis. Show all posts
Monday, 23 February 2009
Wednesday, 30 April 2008
Konvergence theory
Epilogue [to my thoughts] and prologue [to this note]
Reality is for losers.
Normative
Convergence theory, or the catch-up hypothesis (Abramovitz 1986), can be summarised as follows:
Setting the variable x as time and the variable y as any proxy for divergence as you see fit, the convergence function is:
y=a/x+b+E, where the constant a>0, the constant b is any real number, E is the error term, and x>0
Most economists like to accept this highly idealised model, attributing any deviation to the error term E. This is perhaps broadly similar to how economists use the A technology or productivity parameter in growth models. But here, I show below, the overly idealised model is neither accurate nor is it unavoidable to use.
A more realistic model of convergence, henceforward called konvergence to distinguish between Abramovitz's (1986) model and my own, is shown below:
1) y=a/x+b+E for 0<x<π where the constant a>0, the constant b is any real number, and E is the error term;
2) y=cx+F for π<x<µ where the constant c>0 and F is the error term;
3) and convergence in the conventional shape for x>µ.
Positive
For later.
Reality is for losers.
Normative
Convergence theory, or the catch-up hypothesis (Abramovitz 1986), can be summarised as follows:
Setting the variable x as time and the variable y as any proxy for divergence as you see fit, the convergence function is:
y=a/x+b+E, where the constant a>0, the constant b is any real number, E is the error term, and x>0
Most economists like to accept this highly idealised model, attributing any deviation to the error term E. This is perhaps broadly similar to how economists use the A technology or productivity parameter in growth models. But here, I show below, the overly idealised model is neither accurate nor is it unavoidable to use.
A more realistic model of convergence, henceforward called konvergence to distinguish between Abramovitz's (1986) model and my own, is shown below:
1) y=a/x+b+E for 0<x<π where the constant a>0, the constant b is any real number, and E is the error term;
2) y=cx+F for π<x<µ where the constant c>0 and F is the error term;
3) and convergence in the conventional shape for x>µ.
Positive
For later.
Tuesday, 15 April 2008
Perfect capitalism and perfect communism
Theory
There's a theory that says the following: extreme left on the political scale eventually meets up with extreme right. That is, communism in its most perfect and pure form is identical with capitalism in its most perfect and pure form. This comes close to being the truth, except for one quite major detail, as I show below.
The most queer thing about pure unadulterated capitalism, for me, is that it does not assume the need or existence of nation-states. The nation-state system is merely a byproduct of politics. "Imagine no countries", if you will.
Another concept that is an integral part of our world, but not of classical and neoclassical economic theory, is distance. In the twenty-first century, in an age of intense globalisation, we are moving towards reduced transport and communication costs. But the "death of distance" is not merely far away; it is impossible.
The practical existence of these two concepts, the nation-state system and distance, is not presupposed by economic theory. This goes a long way in explaining the following three things.
Firstly, and most obviously, that factor prices are not equal all around the world. Barriers to free trade exist due to the existence of different countries, and in any case distance makes it impossible to outsource things like manual labour.
Secondly, that we are not all a light-brown colour. Again, the existence of nations and distance makes it impossible for the gene pool to be all mixed up.
Thirdly, and finally, that some areas of the world are poorer than others. Convergence theory, despite its utter lack empirical evidence to support it in the real world, would work in a classical or neoclassical world (if there were any divergence in the first place).
In a perfectly capitalist world, therefore, all prices would be equal all over the world, factor prices would converge, and all people would be equal by their colour of skin.
Notice that in this perfectly capitalist world, if every single person faced exactly the same prices for goods and services, the same factor prices, and if everybody had the same colour of skin, he would be equal to everybody else. (I have not yet figured if this equivalence is merely by definition, but I suspect not.) If the total amount of utility in such a society were denoted by E, and there were n people in this society, each person would have E/n.
Perfect communism, by definition, has everybody equal. If the total amount of utility in a perfectly communist society were denoted by e, and there were n people in this society (same as the perfectly capitalist society above), each person would have e/n.
How do we compare these? It is clear that a comparison would involve analysing E and e to see which is bigger. Now how do we calculate relative values of E and e?
Imagine the state of the world as it is today, and imagine converting it into a perfectly capitalist system. By removing all barriers to trade, one can conservatively estimate that world GDP would double. By removing all barriers to international migration, world GDP would double again. Kill distance: its death would (I'm guessing here) increase world GDP tenfold. Remove away politics and nation-states: GDP would increase another tenfold (I'm again guessing). If € denoted present-day utility, it is abundantly clear from the above that E >>> €.
Now imagine the process of converting today's world into a perfectly communist system. Everybody's utility will decrease until the level hits the utility level of the person with lowest utility. In other words, everybody receives the lowest common denominator of utility. Given that the world today is unequal, at least one person's utility level decreases when making the transition to a perfectly communist world. The proof is sufficient to show that e <<< €.
Now, e <<< € <<< E. Assuming transitivity, e <<< E.
Thus both perfect capitalism and perfect communism have everybody equal, but the average utility of people living under perfect capitalism is much higher than the average utility living under perfect communism. This better expressed by the following statement: capitalism makes the economic pie bigger for everyone, eventually having everybody receive an equal slice; communism merely cuts up the pie into equal slices, not caring about each slice's value.
Personal reaction
I am currently a conservative because I believe that we can make the economic pie bigger. Much bigger. But equality is an anathema to me. So if we start liberalising the world economy to such an extent that perfect capitalism looks on the horizon (unlikely, but still), I will certainly turn to the left.
There's a theory that says the following: extreme left on the political scale eventually meets up with extreme right. That is, communism in its most perfect and pure form is identical with capitalism in its most perfect and pure form. This comes close to being the truth, except for one quite major detail, as I show below.
The most queer thing about pure unadulterated capitalism, for me, is that it does not assume the need or existence of nation-states. The nation-state system is merely a byproduct of politics. "Imagine no countries", if you will.
Another concept that is an integral part of our world, but not of classical and neoclassical economic theory, is distance. In the twenty-first century, in an age of intense globalisation, we are moving towards reduced transport and communication costs. But the "death of distance" is not merely far away; it is impossible.
The practical existence of these two concepts, the nation-state system and distance, is not presupposed by economic theory. This goes a long way in explaining the following three things.
Firstly, and most obviously, that factor prices are not equal all around the world. Barriers to free trade exist due to the existence of different countries, and in any case distance makes it impossible to outsource things like manual labour.
Secondly, that we are not all a light-brown colour. Again, the existence of nations and distance makes it impossible for the gene pool to be all mixed up.
Thirdly, and finally, that some areas of the world are poorer than others. Convergence theory, despite its utter lack empirical evidence to support it in the real world, would work in a classical or neoclassical world (if there were any divergence in the first place).
In a perfectly capitalist world, therefore, all prices would be equal all over the world, factor prices would converge, and all people would be equal by their colour of skin.
Notice that in this perfectly capitalist world, if every single person faced exactly the same prices for goods and services, the same factor prices, and if everybody had the same colour of skin, he would be equal to everybody else. (I have not yet figured if this equivalence is merely by definition, but I suspect not.) If the total amount of utility in such a society were denoted by E, and there were n people in this society, each person would have E/n.
Perfect communism, by definition, has everybody equal. If the total amount of utility in a perfectly communist society were denoted by e, and there were n people in this society (same as the perfectly capitalist society above), each person would have e/n.
How do we compare these? It is clear that a comparison would involve analysing E and e to see which is bigger. Now how do we calculate relative values of E and e?
Imagine the state of the world as it is today, and imagine converting it into a perfectly capitalist system. By removing all barriers to trade, one can conservatively estimate that world GDP would double. By removing all barriers to international migration, world GDP would double again. Kill distance: its death would (I'm guessing here) increase world GDP tenfold. Remove away politics and nation-states: GDP would increase another tenfold (I'm again guessing). If € denoted present-day utility, it is abundantly clear from the above that E >>> €.
Now imagine the process of converting today's world into a perfectly communist system. Everybody's utility will decrease until the level hits the utility level of the person with lowest utility. In other words, everybody receives the lowest common denominator of utility. Given that the world today is unequal, at least one person's utility level decreases when making the transition to a perfectly communist world. The proof is sufficient to show that e <<< €.
Now, e <<< € <<< E. Assuming transitivity, e <<< E.
Thus both perfect capitalism and perfect communism have everybody equal, but the average utility of people living under perfect capitalism is much higher than the average utility living under perfect communism. This better expressed by the following statement: capitalism makes the economic pie bigger for everyone, eventually having everybody receive an equal slice; communism merely cuts up the pie into equal slices, not caring about each slice's value.
Personal reaction
I am currently a conservative because I believe that we can make the economic pie bigger. Much bigger. But equality is an anathema to me. So if we start liberalising the world economy to such an extent that perfect capitalism looks on the horizon (unlikely, but still), I will certainly turn to the left.
Wednesday, 2 April 2008
Economics of the Rugby Sevens
After a week of hard economics revision, I had a three-day break at the Hong Kong Rugby Sevens. The four countries I am presently associated with [India, Hong Kong, Australia, and England] either did not play or did not play very well. But I thoroughly enjoyed myself nevertheless. Below are some of my thoughts about the economics of the Sevens.
Ticket prices
A three-day ticket cost HKD 1080. But I think that the price could have been raised considerably without any loss in total revenues earned. In my opinion, the price elasticity of demand at the current price is very inelastic, which means that prices can rise along with rising total revenue. This is due to huge demand for Sevens tickets: Hong Kong Stadium was absolutely packed on Saturday and Sunday, and many many people simply could not get hold of tickets. This implies excess demand of a product that is available only in limited amounts; the solution is to raise prices. I approximate that prices can rise to HKD 1600 or thereabouts to make price elasticity of demand unitary; that is, up to the above price, total revenue will rise. Furthermore, there is no close substitute for going to the Sevens, so the cross-price elasticity will also be very low.
Absence of price discrimination
The organisers of the Sevens clearly have a monopoly due to the control of inputs (only they can get so much rugby and beer at the Hong Kong Stadium at the same time) and the network effect (being seen at the Sevens is cool). But they sell every ticket at the same price. As I have said above, the overall price needs to rise, but practising some price discrimination would help raise total revenues even more. The South Stand is the only stand where alcohol is allowed to be consumed, so it is obviously very popular. Being the stand where the party is, there are very long queues to get in. At one point the queue was over 4 hours long, and later it was closed off because the South Stand was full. Selling South Stand tickets at, say, HKD 200 above the normal ticket price would eliminate queues and allow for higher revenues. On Sunday, I woke up at 4.30 in the morning to help get two rows of seats for the man who gave me a free ticket. There were so many people trying to get the same two rows; clearly, price discrimination is needed here too. I realise that this price discrimination would result in higher costs for the organisers -- more guards will be needed to check the different tickets, for example -- but these could be factored into the price hikes.
I obviously feel rather guilty for missing three days' worth of revision, and that's why I wrote this economic analysis of the Sevens. But only now do I realise that the opportunity cost of writing this has been the loss of 20 minutes of sleep. Bah!
Ticket prices
A three-day ticket cost HKD 1080. But I think that the price could have been raised considerably without any loss in total revenues earned. In my opinion, the price elasticity of demand at the current price is very inelastic, which means that prices can rise along with rising total revenue. This is due to huge demand for Sevens tickets: Hong Kong Stadium was absolutely packed on Saturday and Sunday, and many many people simply could not get hold of tickets. This implies excess demand of a product that is available only in limited amounts; the solution is to raise prices. I approximate that prices can rise to HKD 1600 or thereabouts to make price elasticity of demand unitary; that is, up to the above price, total revenue will rise. Furthermore, there is no close substitute for going to the Sevens, so the cross-price elasticity will also be very low.
Absence of price discrimination
The organisers of the Sevens clearly have a monopoly due to the control of inputs (only they can get so much rugby and beer at the Hong Kong Stadium at the same time) and the network effect (being seen at the Sevens is cool). But they sell every ticket at the same price. As I have said above, the overall price needs to rise, but practising some price discrimination would help raise total revenues even more. The South Stand is the only stand where alcohol is allowed to be consumed, so it is obviously very popular. Being the stand where the party is, there are very long queues to get in. At one point the queue was over 4 hours long, and later it was closed off because the South Stand was full. Selling South Stand tickets at, say, HKD 200 above the normal ticket price would eliminate queues and allow for higher revenues. On Sunday, I woke up at 4.30 in the morning to help get two rows of seats for the man who gave me a free ticket. There were so many people trying to get the same two rows; clearly, price discrimination is needed here too. I realise that this price discrimination would result in higher costs for the organisers -- more guards will be needed to check the different tickets, for example -- but these could be factored into the price hikes.
I obviously feel rather guilty for missing three days' worth of revision, and that's why I wrote this economic analysis of the Sevens. But only now do I realise that the opportunity cost of writing this has been the loss of 20 minutes of sleep. Bah!
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