U.S. Banks, Financial Services Industry, and U.S. and Global Economy

As the U.S. awaits the stress tests of the banks, the debate on how to restructure the U.S. and Global financial services industry continues.

The restructuring of the U.S. and Global financial industry will probably be successful only when two major issues are reviewed. The first relates to (generally non-transparent and sometimes excessive) securitization of loans, and the second relates to (sometimes indiscriminate and unsound) integration of banking, investment and insurance activities under one umbrella. Lack of evident transparency, and serious moral hazard problems make these two issues major challenges.

There are two empirical and policy questions. One, does regulated and transparent securitization of loans help in the credit flow (with some multiplier effect) and business in general? Two, does regulated and prudent level of integration of banking and investment activities add more value to the economy?

The answers are not evident, and the policy and expert opinions appear to be evolving as the evidence is not clear.

The vibrancy of the financial services industry and the U.S. economy from about 1981 (when President Ronald Reagan encouraged deregulation and liberalization) to about 2007-2008 appear to indicate that securitization and integration of financial activities have helped the U.S. and global economy. What my have undone it are the excesses and complete dergulation. So the answer to the structural issues might be consideration and legislation of thoughtful regluation(s) and regulatory mechanisms. That's the approach of Secretary Tim Geithner, and President Barack Obama's economic team (they appear to tacitly agree that repeal of the Glass-Steagall Act, and the enactment of Commodity Futures Modernization Act may have accelerated such excesses).

The other view is that securitization of loans is empirically and theoretically unsound, and that banking and investment activities must be separated. No amount of regulation will help if these fundamental changes are enacted. Krugman says, "Underlying the glamorous new world of finance was the process of securitization. Loans no longer stayed with the lender. Instead, they were sold on to others, who sliced, diced and puréed individual debts to synthesize new assets. Subprime mortgages, credit card debts, car loans — all went into the financial system’s juicer. Out the other end, supposedly, came sweet-tasting AAA investments. And financial wizards were lavishly rewarded for overseeing the process.

But the wizards were frauds, whether they knew it or not, and their magic turned out to be no more than a collection of cheap stage tricks. Above all, the key promise of securitization — that it would make the financial system more robust by spreading risk more widely — turned out to be a lie. Banks used securitization to increase their risk, not reduce it, and in the process they made the economy more, not less, vulnerable to financial disruption."

Joseph Stiglitz observes, "In theory, the administration’s plan is based on letting the market determine the prices of the banks’ “toxic assets” — including outstanding house loans and securities based on those loans. The reality, though, is that the market will not be pricing the toxic assets themselves, but options on those assets.

The two have little to do with each other. The government plan in effect involves insuring almost all losses. Since the private investors are spared most losses, then they primarily “value” their potential gains. This is exactly the same as being given an option."

Economic Growth Models of China and India: Role od Foreign Direct Investment

India has been growing about 6 percent annually, compared to China’s much more impressive10 percent average annual growth rate. India has achieved its growth through a combination of improvement of skill sets, diversification of the economy, stimulation of consumer demand, entrepreneurship and competition. China’s growth comes from almost twice the amount of domestic investment in new factories and equipment, and almost ten times higher (compared to India) foreign direct investment (FDI). China has adopted the model of investing resources to propel growth and India has adopted a model of efficiency and productivity to stimulate growth.

Empirical studies have shown that the relationship between economic growth and the amount of foreign direct investment (FDI) is ambiguous at best. Foreign Direct Investments in primary sector appear tend to have a negative effect on growth but investments in manufacturing sector appears to be positive. But the impact on the service sector is ambiguous. There are several macro-economic illustrations of the tenuous relationship between FDI and growth. For example, Japan, Korea, Taiwan and others achieved remarkable growth with relatively low FDIs. On the other hand, Brazil which was the darling of FDIs in 1960s stumbled. In the 1980s, China received very little FDI, and yet the country grew faster and more virtuously than its later growth.

Thus FDI appears to be neither strongly correlated to nor be causative of the economic growth. Generally, FDI is a result of growth. In summary, China may have achieved substantial growth in 1990s and in the last decade through huge (but not so efficient) infusion and utilization of FDI.

Poverty Alleviation Programs, and the Economies of China and India

While India has been consistent in liberalizing its economy in the last two decades, it has also kept its attention on the challenge of poverty. Accordingly, India has designed and implemented poverty alleviation programs with varying degrees of success. India’s focus on alleviating poverty as growth program is both effective and prudent given the large numbers -- over 300 million Indians live in poverty (The comparable number for China is about 100 million). China, on the other hand, has focused more on top-down economic trickle down with aggressive tax rebates and other incentives to large firms.

Per recent World Bank Reports (2007 and 2008), a 10 % reduction in poverty would both boost the growth rate by about 1% and increase the foreign direct investment by about 8%. So far India to continue its impressive growth, one of the critical components of the strategy has to be poverty reduction programs that add assets to the society (Prahalad 2004, Sen 1997). And this is where political pluralism has been so advantageous. The relentless focus on the poor and disfranchised by various political parties particularly the Indian socialist and regional parties has been very beneficial for economic growth. The balance that the Indian political and economic policy makers have achieved is now the recommended economic strategy by the recent World Bank Reports (2007, 2008). This policy is a direct result of the wonderful pulls and pushes created by the political democracy.

Overall, political pluralism and democratic polity have proved to be excellent prescription for India’s economy (Huang 2008). Sure there have been many false starts and erroneous policies but there have been no calamitous decisions. The country has not gone through traumatic experiences of Latin America (where many economies collapsed because they followed market-economy without adequate supervisory mechanisms) or other parts of Asia (Asian currency crisis) or East European countries (inflation and stagnant growth). As Sen (2005) has observed, “India's long argumentative tradition and toleration of heterodoxy, going back thousands of years, has greatly helped in making democracy flourish with such ease.” China does not have the benefits of political pluralism.

The U.S. and Global Financial Services Industry

Reported below are some interesting (recent) observations U.S. and Global Banking Challenges, and Potential Restructuring Plans.

In sum, the restructuring of the U.S. and Global financial industry will probably be successful only when two major issues are reviewed. The first relates to securitization of loans, and the second relates to integration of banking, investment and insurance activities under one umbrella. Lack of evident transparency, and serious moral hazard problems make these two issues major challenges.

Professor Paul Krugman (Princeton University), New York Times, March 27, 2009
"Underlying the glamorous new world of finance was the process of securitization. Loans no longer stayed with the lender. Instead, they were sold on to others, who sliced, diced and puréed individual debts to synthesize new assets. Subprime mortgages, credit card debts, car loans — all went into the financial system’s juicer. Out the other end, supposedly, came sweet-tasting AAA investments. And financial wizards were lavishly rewarded for overseeing the process.

But the wizards were frauds, whether they knew it or not, and their magic turned out to be no more than a collection of cheap stage tricks. Above all, the key promise of securitization — that it would make the financial system more robust by spreading risk more widely — turned out to be a lie. Banks used securitization to increase their risk, not reduce it, and in the process they made the economy more, not less, vulnerable to financial disruption."

Professor Joseph Stiglitz (Columbia University), New York Times, April 1, 2009
"In theory, the administration’s plan is based on letting the market determine the prices of the banks’ “toxic assets” — including outstanding house loans and securities based on those loans. The reality, though, is that the market will not be pricing the toxic assets themselves, but options on those assets.

The two have little to do with each other. The government plan in effect involves insuring almost all losses. Since the private investors are spared most losses, then they primarily “value” their potential gains. This is exactly the same as being given an option."

Economist Keiichiro Kobayashi, voxeu.org, April 1, 2009
"However, as we move beyond the emergency response stage and face the challenge of correcting the fundamental problems that caused the financial crisis, things appear to be quite different. Watching how President Obama has had to continually struggle to work with Congress, I cannot help but realize, all things considered, that politicians in the US, or those in Europe for that matter, are not much different from their Japanese counterparts."

Professor Peyton Young (Oxford University), Financial Times, April 1, 2009
"A more straightforward plan would be strongly to encourage banks to auction off tranches of toxic assets without providing subsidies to the purchasers. This would involve fewer gimmicks and produce prices that more nearly reflect the assets’ true economic value. If these auctions do not generate enough activity to clean up the banks’balance sheets, the government will have to seize control of insolvent institutions temporarily and sell off their bad assets over a period of time, as happened in the wake of the S&L debacle of the 1980s."

Professor Jeffrey Sachs (Columbia University), The Huffington Post, April 6, 2009
"The earlier criticisms of the Geithner-Summers plan showed that even outside bidders generally have the incentive to bid far too much for the toxic assets,since they too get a free ride from the government loans. But once we acknowledge the insider-bidding route, the potential to game the plan at the cost of the taxpayers becomes extraordinary. And the gaming of the system doesn't have to be as crude as Citibank setting up its own CPPIF. There are lots of ways that it can do this indirectly, for example, buying assets of other banks which in turn buy Citi's assets. Or other stakeholders in Citi, such as groups of bondholders and shareholders, could do the same."

Greetings, and Return to Posting and Writing

Greetings.

Belated as it may be, I wish you a prayerful Passover, Easter, and New Year (various parts of India celebrate New Year in the months of March and April such as Baishaki, Vishu).

I got very busy with some personal and professional matters, and hence I have not written or posted for the last eight months or so. However, I am returning to writing and posting

Thank you for your understanding.

The quandry of optimal timing of the announcement of the vice-presidential choices

When should Barack Obama and John McCain announce their vice-presidential choices? The objective would be to get maximum coverage and electoral bounce from the announcement. And here is the description of the timing quandry for each candidate.

Barack Obama is expected to return from his current Afghanistan, Iraq, and European foreign policy tour on or about July 28th. The Beijing Olympic games begin on August 8th and end on August 24th. The Democratic party convention begins on August 25th and ends on August 28th. (The Republican party convention begins on September 1st).

So Obama has to announce his vice-presidential choice at the convention (he would not obviously announce during the olympic games) or between about July 8th and about August 3rd or 4th so that the Obama campaign can enjoy 3-4 days of comprehensive news coverage -- the vice-presidential choice is likely to generate substantial free publicity. The announcement at the convention is a bit too risky. Further, Obama's birthday is on August 4th, he would be 46 years of age, and that would be a wonderful occasion to showcase the youth of Obama (and conversely, the age of McCain -- 72 years.) So an announcement is likely to be made between about July 28th and August 3rd or 4th.

What about John McCain? He will certainly wait to know Obama's choice before he makes the final decision. That means that McCain has two options given the fact that McCain also will not make the announcement during the olympic games -- August 8th to August 24th and it is a protocol to lie low during the other party's convention (in this case, the Democratic party convention which is between August 25th and August 28th).

Therefore, one alternative for McCain is that he can make the announcement immediately after the Democratic party convention i.e. on August 29th or 30th or 31st and before the Republican party convention begins on September 1st. That would limit the post-convention electoral bounce for Obama after this monstrously publicized acceptance speech on August 28th. But the problem of announcement on August 29th or 30th is that the announcement is that the announcement may also be contaminated with substantial discussion of McCain's age (72 years old) and comparison with Obama's youth and age (47 years). Actually, the interaction between the positive glow from the Democratic party nomination acceptance speech for Obama and the unfavorable coverage of McCain's age could turn out to be an even biggest boost for Obama.

The other alternative is that McCain can follow Obama immediately on or about August 3rd or 4th: let us say, Obama announces his vice-presidential choice on August 3rd, McCain can make his announcement immediately on August 4th or 5th and that would neutralize any electoral bounce that Obama may get from his vice-presidential choice. But then Obama's birthday on August 4th poses the same problem of discussion and comparison of the ages of the candidates.

So, while it is fairly obvious that the optimal time frame for the announcement of his vice-presidential choice is July 28th - August 3rd or 4th for Obama but it is not clear what is the optimal time frame for McCain (immediately after Obama in early August or immediately after the Democratic party convention in late August).

Differences in preference measurement

There is an anomaly in the public preference measurement and polls regarding the choices in the U.S. Presidential elections between Senators McCain and Obama. Here is the empirical anomaly --

The daily tracking polls/preference measures (i.e. continuous time-series data) appear to show a smaller (1-3 points) lead for Senator Obama. See Gall Up and Rasmussen Report numbers. But the more static preference measures appear to suggest a larger lead (6-9 points, see recent Quinnipiac, CBS/New York Times, ABC/Washington Post, Reuters/Zogby polls) for Senator Obama.

Why is this? Not clear. Some obvious explanations are not plausible. Polls are not taken in the same time periods. No that can be a reason because time-periods overlap. Polls are taken by different organizations. That can not explain it -- for example, the preference measurement by the USAToday/Gall Up (Gall Up organization conducted the poll) found a larger lead for Obama than Gall Up's own tracking poll in June.

So we have to fall on the general explanations i.e. differences in sampling methods, sample sizes, and modeling specifications etc. Sure but these explanations are not quite satisfying because there appears to be convergence in the preference measures both in the time-series data (1-3 points) and the more static data measurement (6-9 points).