FINANCIAL ANALYSIS - BOOK REVIEW - FAULT LINES - HOW HIDDEN FRACTURES STILL THREATEN THE WORLD ECONOMY

FINANCIAL ANALYSIS
BOOK REVIEW
FAULT LINES-
HOW HIDDEN FRACTURES STILL
THREATENTHE WORLD ECONOMY
Presented By…..
Mufaddal Nullwala

Contents:
1. Background
2. Challenges faced by U.S
3. LetThem Eat Credit
4. Exporting to Grow
5. Flighty foreign financing
6. Weak Safety Net
7. From Bubble to bubble
8. When money is the measure of all worth
9. Betting the bank
10. Reforming Finance
11. Broad Principles Of Reform
12. Eliminating “Too Systemic to Fail”
13. Resilience
14. Improving access to opportunity in America.
15. Multilateral institutions & their influence
16. Obtaining global influence
17. China andTheWorld
18. Persuading China
19. What lies Ahead for INDIA

FAULT LINES-
HOW HIDDEN
FRACTURES STILL
THREATENTHE WORLD
ECONOMY

Background
• Developing countries had spent using foreign borrowings.
After burning hands, decided to save.
• Developed countries borrowed from developing countries
and invested, especially on IT
• Dot com burst lead to contracting economy. US fed cut
interest rates but instead of reviving investments, lead to
house price bubble
Presented By….. Mufaddal Nullwala

• Securitization spread risk to unsuspecting people
• When Fed raised rates to cool housing market, banks refused to
refinance, people could not repay and bubble burst
• Questions
?Why money flooded US?
?Why US could not export itself out of recession?
?Why Fed kept rate so low so long?
?Why NINJA loans given?
?Why banks held securities on books?

• Fault lines
– Political stresses
–Trade imbalances
– Different financial systems ( arms length vs. relationship based)
interacted to finance trade imbalances
• Rising inequality and push for housing credit
• Instead of focusing on difficult / long term solution, politicians
pushed credit to low income

•When easy money of govt. met sophisticated, competitive
amoral financial sector, fault line developed
• History: when farmers fell behind industrial workers in industrial
revolution, easy credit caused bank failures during great
depression
• Export lead growth and dependency- when countries depend on
foreign consumption, fault line develops because indebtedness
limits further expansion

• Export dependency because target of rapid growth at expense of
domestic consumption
• Domestic companies limit competition thus leading to
inefficiencies
• Clash of systems
oWhen there is transparency and easy enforceability of contracts,
transactions do not depend on propinquity, financiers provide
long term finance directly to user
oWhere public financial info is limited, enforceability of contracts
depends on long term business relationships, banks etc. play
important part

• So when arms length financiers finance relation based systems,
do so through
Offer short term loans for quick withdrawal
Payments in foreign currency to avoid default through domestic
inflation / devaluation
Lend through local banks which have govt. backing
• Since relationship banking did not evaluate credit properly,
underperformance lead to pulling of credit hence crises

• Consequences to US financial sector
• All fault lines converged in US when money flowed from foreign
to US housing through Fannie Mae and Freddie Mac, banks RMBS
(outsiders assumed efficiency of arms length pricing)
• Since all institutions took same risks, chances of risk
materializing went up significantly i.e. political moral hazard
magnified economic moral hazard
• Source of fragility: interaction between govt. and finance system,
each with its own goals

Challenges that face us
•To create financial system which balances innovation vs. safety
• Marry good policies with good economics

LetThem Eat Credit
•Technology advances has increased productivity & eliminated
lots of traditional jobs. So income inequality has become severe
• During industrial revolution, people upgraded to high school
diploma but very few people can now upgrade to higher education
• Reasons for US falling behind in education:
Poor quality of learning experience
High cost of higher education
Rigor of higher education

Family instability in America, especially with poor
Creative disruption leading to earning volatility
Immigration
Reduction in tax on higher income
Entry of women in workplace
Weakening of unions
Supportive attitude of USA
Anti trust laws and estate taxes reduces concentration (refer
Capital in 21st century)
Since education is long term & difficult solution, Politicians have
expanded housing credit

• In US earlier, variable rate house loans were available for 5 yrs.
with single repayment at maturity and 50% of price as loan
• In 1930 depression, home loan defaults lead to creation of HOLC
and FHA. HOLC would restructure loans into fixed rate fully
amortizing loans. FHA would provide insurance for default. HOLC
closed on 1936 followed by Fannie Mae which issued long term
bonds to investors

Exporting to grow
• Elusive growth: Historically countries grew between 1-2%.
However exporting countries grew between 5-8% for some time
• Countries remain poor because
Poor human capital not poor physical infrastructure
Poor organization capital
• How early developers built org capital
Over time when existing people demanded
Foreign pressure

• Strategy of Late developers
Start with low cost technologies to frontiers of innovation
Country saving were directed through largely captive financial
system to favored few firms
Government protected firms through import tariffs and
restrictions
–The commanding heights- only France andTaiwan grew rich
because of contribution by state firms

•Typically government officials are not measured and incentivized
for efficiency and are rule bound. Also government is monopoly
and cannot run out of money
•Typically information required is distributed in society. Reporting
to govt. distorts information while market prices reflect the
information without biases
•Taiwan supported textile through tariff, easy loans and
purchasing goods. Also created PVC plant which became Formosa
plastics group

• Philippines: corruption resulted in favors to inefficient people
• Since households do not grow, low earned income and interest
income plus high taxes lead to low consumption.
• Exports make firms efficient and work at scale. Also incentives
like forex, export credit etc. provided by govt. add to growth
• Missing turn:With large domestic markets, Brazil and India were
slow to push firms towards export

Flighty foreign financing
• Developing countries used to get low cost loans from IMF.
Subsequently western banks recycled petro dollars to these at
arms length.
• Savings and investment: Even after developing org capital,
countries limit foreign borrowings as inefficient use forces
problems during repayments
• Financial sector is producer based economy: Brazil spread is 10%.
Households find difficult to borrow. No credit histories, poor
judicial system, borrow from money lenders @high rates

• Mexican crises: domestic savings dropped to 3.3%, foreign
investors reduced money so govt. converted short term debt to
short term bonds indexed to dollar peso rate. But when foreigners
withdrew, reserves depleted and US+IMF gave loan
• China: Overcapacity is dangerous
• Conglomerates likeTata, Birla have huge advantage because of
poor domestic financial system

• EastAsian crises: ‘Arms length’ financing ‘relationship based’
banking, exacerbated by depreciation of JapaneseYen leading to
Japan being popular with investors
• Reforms: India liberalized leading to efficient producers and
borrowing consumers.

Weak safety net
• US unemployment benefits are short term (since made in
depression to make things efficient). But now jobs are taking long
time to recover (23 month 1991, 38 months 2001).When politicians
internalize lessons (Bush Sr.), push for low int. rates thus bubbles.
Also healthcare tied to jobs
• With Internet, just on demand hiring and temporary jobs
• US: politics, absence of strong unions, poverty concentrated in
races, large and mobile economy etc.

• Problem with discretionary stimulus:Workers don’t know how
long recession will be, lag of fiscal and monetary policy, discretion
tends to abuse. Ex cancer, RE breaks.
• Also foreign countries dependent on US wait for stimulus
deepening fault line

From Bubble to bubble
• Bernanke explanation of good times: lucky, efficient industry and
better mgmt. of monetary policy
• Fed’s objectives: Maintaining stable employment and stable
prices in US. But both are incompatible
• So try to keep economy at its potential growth rate by targeting
inflation

• Int. rates:Through controlling sort term int. rates, influence long
term int. rates. And low rates mean more wealth retention and
creation, less attractive to save
• Response to .Com burst 2001: Low int. rates lead to increase in
house prices but jobs were not available and inflation low. Because
imports were cheap and were forcing industries to become
productive
• When started increasing int. rates by 25bps, risk premium fell
hence long term rates fell!

• Increasing rates reset home repayments stopping home price
appreciation leading to defaults
• Increased asset prices because of many factors like increased risk
taking, more foreign money and expanding credit
• So money going abroad for riskier assets (more returns)came
back to US making US into hedge fund (investing in risky assets
financed by debt issued

• Housing: reinforcing cycle of prices, no way to short prices rise
easily.
• No check on credit growth as
a) relation between credit growth and inflation was tenuous
b) b) assumption that credit problems are history with arms
length banking
• Even if very high inflation, small movement of int. rates changes
future expectations drastically
• Greater fool theory

• Greenspan Put:Will continue supporting short term int. rates, will
not prick bubbles but support the fall out. So wall street went on
overdrive
• Monetary policy and financial stability: to give up role of party
popper is politically easy but risky to economy

When money is the measure of all worth
• Bankers have nose for making money, they are measured only by
money made (not real goods produced), they find edge in taking
advantages of unsophisticated players (govt.), banking behavior
tends to be self reinforcing, there is safety in numbers
• New century: gave money for poor quality loans because of
housing policies. Judgment calls of loan officers are imp but cannot
be automated. New entury bank filed bankruptcy during 2008
crisis

• Assigning blame: Arms length banking, if not retained, does not
foster long term thinking
• Rating agencies AAA with high returns was because of govt.
support. Eventual payers are taxpayers

Betting the bank
• In normal times, the correlation between mortgage loans is low.
But correlations were higher because low quality mortgages
coming from concentrated areas
• Banks kept them in books because default was remote and
financing drying up was small possibility – AIG started credit
default swaps and resulted in receiving bail outs from government
• Since tail risks, ignored leading to increased chances of them
occurring
•Default risk
•Liquidity risk
•Assumptions that refinancing will never dry up

• Search for alpha: Especially during competition,
• Risk taking at top: CEO were out of touch : excellent pay now but
top ppl joined when pay was low and job boring
• Also vying for prestige, pressure form shareholders : dance when
music is playing
• Shareholders: markets having rational expectation does not
mean they have perfect foresight

• Board forced to take risk, equity markets pricing reflected same
• How govt. helping hand hurts: Govt. hand behind banks, bond
holders getting fully paid, herd mentality for risks

Reforming finance
• Serious Reforms required.
“Financial Sector Actually Helps Economic Growth or it a Side
Show”
• Democratization vs. Debt: Financial sector improves living
standard for all but credit becomes debt if more debt taken than
can be repaid

Broad Principles Of Reform
•Competition (ProsVs. Cons)
•Too low prices
•Underpricing of risk
•Financial Innovations
•Reduce the incentives and Price distortion
•Manage Expectation of Government Intervention
•End Gov. subsidies to financial institutes
•Enact cycle Proof Regulation
•Comprehensive, non-discretionary, Contingent, and cost-
effective

Eliminating “Too Systemic to Fail”
•Keeping institute from becoming systemically imp.
•Prohibit mergers and encourage break ups
•Regulate the risk exposure and concentration in system
•Release the exposure info to public
•Building better buffer
•Making Financial firms easier to resolve
•Impose appropriate loss on debt holders
•Regulators to function as bankruptcy court

Resilience
•Resource
•Redundancy
•Phasing out deposit insurance

Improving access to opportunity in America
• Improving quality of human capital
Disadvantages begin early- family, drugs etc.
Non-cognitive skills
Amount of schooling
Quality of schooling- teachers, pedagogy, class size, technology,
competition
Help for and in college- access for poor
Job apprentice & training

• Security and safety net
Contingent but predetermined unemployment insurance
Universal healthcare
Savings
Government capacity

Fable of bees replayed
Bernerd Mandeville (1719)
“whilst Luxury
Employ’d a Million of the Poor,
And odious Pride a Million more
Envy itself, andVanity
Were Ministers of Industry;
Their darling Folly, Fickleness
In Diet, Furniture, and Dress,
That strange, ridic’lousVice, was made
The veryWheel, that turn’d theTrade”
Frugality and borrowing are two sides of a coin, one cannot
exist without other.

G-20 and IMF
•Established in Sept 2009 for Global Economic
Cooperation.
•“We will work together to ensure that our fiscal, monetary,
trade, and structural policies are collectively consistent
with more sustainable and balanced trajectories of
growth”.
•Politics is always Local and there is no constituency for
global economy.

Multilateral institutions & their
influence
•Two ways to Approch
•WTO : quasi legal
•IMF : politician accepts only when needed
•With IMF
•No set of clear rules
•Reforms are case to case basis
•Reforms are hard to pull off

Obtaining global influence
•Reach out to Public
•Political parties
•NGOs
•Influential Personalities
•School and university Classroom
•Use technology
•Eg: Climate Change
•Public Has Longer Horizon than Government.

China andTheWorld
•Concerns as Renminbi pegs to dollar
•JudgingWhat is unfair is difficult.
•Cost Of Undervaluation.
•mirrors US policy leading to bubbles
•controls credit but harms local firms and people
•Makes it dependent on Foreign Demand
•Capital intensive in a abundant supply of labor.
•banks invest inefficiently

Persuading China
•Reforms attractive to household and middle class
•Bond markets and equity markets
•Expanding retail credit

What lies ahead for India
• Reasons for optimism-Youth Population, HighValue Services,
technical frontier, growth aspects.
• Impediments: Infrastructure, clear land titles
• Inefficient government so poor education, health etc., no options
in law/ order/ governance, corruption, support of few who benefit
• Progress: Panchayats , technology, education, democracy

FINANCIAL ANALYSIS - BOOK REVIEW - FAULT LINES - HOW HIDDEN FRACTURES STILL THREATEN THE WORLD ECONOMY

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FINANCIAL ANALYSIS - BOOK REVIEW - FAULT LINES - HOW HIDDEN FRACTURES STILL THREATEN THE WORLD ECONOMY