Karma + Economics = Karmanomics

Economic actions have consequences…And they will come to bite you in the @ss if you aren't careful

Nouriel Roubini and Niall Ferguson urges Eurozone program a la US TARP

Leave a Comment Posted by karmanomics on June 14, 2012

Under the present economic climate, the ECB and the Fed both look like they will be rushing to the electronic printing press. The pundits are urging the ECB to take action and warning of economic catastrophe and worse. Nobody has warned yet about WW-III but Roubini and Ferguson have come mighty close in this article in Der Spiegel). They have warned of Euro-zone disintegration. That is not going to be easy. The genie is out of the bottle already and going back to border controls and different currencies is going to be difficult. Difficult yes, impossible – No!

Roubini and Ferguson (I suspect Roubini probably feels this more urgently than Ferguson) urge the ECB to start a recapitalization of the banks with a program on the lines of the US TARP (Troubled Assets Relief Program). The acronym is so disarmingly innocuous – suggesting a waterproof sheet that would shield you from this (economic) storm – but the expansion sounds ominous, as it should! Roubini and Ferguson have suggested direct capital injection to the banks so that “In practice, the euro-zone taxpayer would become a shareholder in euro-zone banks”.

Here are their suggestions to avoid “moral hazard” of saving banks through this “direct capital injection”:

“To reduce moral hazard (and the equity and credit risk undertaken by euro-zone taxpayers through the recap and the deposit insurance scheme), several additional measures should also be implemented:

The deposit insurance scheme has to be funded by appropriate bank levies: This could be a financial transaction tax or, better, a levy on all bank liabilities — both deposits and other debt claims.
To limit the potential losses for euro-zone taxpayers, there needs to be a bank resolution scheme in which unsecured creditors of banks — both junior and senior — would take a hit before taxpayer money is used to cover bank losses.
Measures to limit the size of banks to avoid the too-big-to-fail problem need to be undertaken. In the case of Bankia, the merger of seven smaller caixas merely created a bank that was too big to fail.
We also favor an EU-wide system of supervision and regulation. If the euro-zone taxpayer backstops the capital and deposits of euro-zone banks, then supervision and regulation cannot remain at the national level, where political distortions lead to less than optimal oversight of banks.”

Now why don’t I see any suggestions that bank shareholders’ equity be wiped out or that the big banks with poor capitalization be forced to merge with their smaller or better managed cousins (with better capitalization)? This is what happened in the US after the LatAm crisis, the Mexican crisis and the Russian crisis. All these were serious threats to the banking system – not on quite such a scale as the current crisis. But the approach differed in that the weakened big banks were acquired by better managed players – like Bank of America was acquired by Nations Bank after BofA was affected by their lending to D.E. Shaw who had been hit badly by the Russian ruble crisis. If there are no good banks left to merge with, why not let businesses with money or outside investors buy the banks. After all, Citibank had a big chunk of its shares sold to a Saudi prince.

Let’s take the TARP program in the US which is urged as the good model for Europe to follow. Let’s se how it worked in practice. The banks were loaned money by the Treasury at an interest rate. How did the banks repay it? The Federal Reserve bought assets such as MBS and CDOs that were trading at cents to the dollar at a full 100 cents. A good question is – where is all this money from bad assets sold to the Federal Reserve? Part of the proceedings went to repay the treasury for TARP money and the rest was invested in treasury bonds for the most part.

The banks went happily away with this money and shored up their balance sheets. They then repaid the Treasury and also bought government securities with the rest of this money. The Federal Reserve had transformed the banks’ bad assets into good. Almost magically. No, not quite magically because these assets are still in the system on the Fed’s books. The zombie banks of Ireland are other examples of such largesse at the cost of the ordinary tax payer. Of course the banks repaid the money that was lent to them – they could easily repay it because they had found a buyer at inflated prices for their bad assets – which is why they had needed the bailout and the TARP money in the first place!

All the good the QE money did was to drive up the stock market again (well, the money had to be invested somewhere) and drive down treasury bond yields. Oh wait – so the government borrowing costs came down and still the deficit went up? Yeah! And the US is considered the model for the recovery. Unemployment is as high as it was before TARP. Nothing has changed. So why tout it a success? Well, the excuse is that if nothing had been done, we wouldn’t even have status quo and we’d have had a depression. Well, this sure feels like one right now!

I hope that the ECB doesn’t listen to Roubini! If any bailout happens, a bank nationalization wiping out bank shareholders is what is needed first. An orderly haircut should be imposed on all creditors including foreign creditors. The poor Irish honored their debts by borrowing from the ECB and paying foreign creditors in full. And their reward – possibly years of misery!

I say that Greece should default an exit the Euro if they know what is good for their citizens. So should Spain.

Uncategorized

Rights issues – “theoretical pricing”

Leave a Comment Posted by karmanomics on June 8, 2012

I’ve heard many equity mkt participants talk of Rights Issue pricing as if it were a trivial arithmetic calculation. As per most sources, this is how they arrive at “Theoretical price” of a firm’s share once it announces a rights issue:

If current share price is X and the rights issue is going to be in the ratio n:m at a price of Y, then
Theoretical ex-rights price = (X*n + Y*m)/ (n+m)

This might be how market participants view the likely ex-rights price but it is far from being based on sound financial theory!

My argument is that the ex-rights issue price depends entirely on what you expect the rights equity proceeds to be invested in! The formula above applies only if the Net Present Value of the cashflows from the new project is zero! Now we have three possibilities. For the sake of simplicity I am assuming that the riskiness of the new business is the same as that of the core business. Why? Or else we’d need to look at a revised discount rate for all of the equity – effectively treating the firm as a conglomerate. Rather than do that and apply a revised discount rate to the combined cash-flow, I prefer to look at the cash-flow change without assuming a change in risk. Just makes it easier to view this conceptually.

It might for instance be invested in an area more profitable and of faster growth than the core business, in which case the post-rights-issue price should be higher than that calculated by the simple math that market participants use.
If, on the other hand, the rights issue proceeds just extend the core business, the ex-rights share price ought to be exactly the same as that given by the simple mathematical formula. But this is by no means an assumption that follows automatically. Questions might arise such as – why was it not possible to fund this extension of core business through normal accruals? Did the management not foresee this opportunity? Again, in both above cases, we make another implicit assumption – that the capital structure is maintained to be the same as before the rights issue. Some might quibble about this last bit and argue that capital structure is immaterial to share price. I beg to differ. As Miller-Modigliani’s proposition has as a key assumption the absence of taxes, I think that we can safely assume that the tax-shield effect causes firms to assume some leverage. There is also a wealth of literature that shows that with firm-size, leverage increases in most advanced capital markets.
Of course, there is a 3d possibility – that the rights issue proceeds will be invested in a business that is either of slower growth or lower profitability than the core business. This would be typical of a conglomerate. Unless this enhances strategic position in the industry, this should be a negative on the share price as soon as the rights issue is announced.

Where market efficiency is very weak, I guess people just live in a hall of mirrors and value = perceived perception of value by other people So the “theoretical price” might be right in practice even if it is not really theoretically correct. Perhaps we might start titling it “practical price”…

Facebook: Valuation after the revised filing with March 2012 numbers

2 Comments Posted by karmanomics on April 30, 2012

My valuation had suggested ~$25.13/share at the top-end and a total EV of $63Bn to Facebook based on an analysis I’d published here on this blog. Now it looks like I had been overoptimistic about their revenue growth. Monetization has been slower than I’d anticipated even though DAU (Daily Average Users) growth has exceeded my projections. To some this might seem like a good sign – that there is plenty of potential for revenue growth. I come back to my original thesis – that Facebook is a fairly mature company with several years of revenue and even more years of operations before its filing an S-1. Do not expect radical changes in monetization even though management might like to tout that line. Don’t swallow that bait.

FB revenues have grown only 44.73% YoY ($1,058Mn in 1Q2012 Vs 731Mn in 1Q2011) even as expenses have shot up 97.38% (to $677Mn from $343Mn an year back). To me, such torrid growth in costs is only a sign of a struggle to propel revenue growth. But as a relatively mature company, I’d expect Net Income growth on a YoY basis. Facebook has actually seen its YoY Net Income decline from $233Mn to $205Mn over 1Q2012.

Btw, of the 526Mn DAUs, 488Mn were DAUs who accessed FB over mobile devices (directly or indirectly through Likes and signing in through FB to other sites). FB still doesn’t have a clear monetization strategy for mobile. Google, on the other hand, has a clear monetization strategy for mobile through powering search over mobile devices.

Let’s give a thumbs-down to the FB IPO until they come down to a realistic valuation and offer investors a fair degree of control. Right now, almost every single Investment Bank (both big and small) have been roped into peddling the IPO so that nobody is left out of the party and now there is nobody who might reveal that the Emperor is not wearing any clothes! Retail investors beware! And dump any fund from your 401-K if it invests in the FB stock!

This is so reminiscent of the last dotcom boom that I don’t know whether to laugh or cry! In the words of the inimitable Yogi Berra, “This is Deja Vu all over again!” Now companies have revenues, but valuations are still insanely high. Now all that is needed is for Ben Bernanke to make some remarks about “irrational exuberance” and then start another asset bubble in real estate by cutting rates. Wait, there is no room to cut rates any more. But the Fed can still buy more worthless assets at 100 cents to the dollar and print more money to pay for it. Now isn’t that the next round of quantitative easing the market is anticipating? So maybe FB at $63Bn might still be all right if the Fed releases another trillion dollars into the system!

Equity Research, Finance, Uncategorized At what price should I buy Facebook, business, Deja Vu, dotcom boom, Facebook, Facebook shares, FB, mature company, QE3, technology, The Facebook IPO

FB: What is Facebook worth? At what price should I buy Facebook?

5 Comments Posted by karmanomics on February 7, 2012

What is Facebook worth? At what price should I buy into the Facebook IPO? Is Facebook really worth $100Bn?

845 million monthly active users is surely an impressive user base for any service. The question on everyone’s mind is “Should I try to get into the Facebook IPO? At what price is FB worth it?

If you want to read through my assumptions and the way I arrived at the valuation and defend it, read on. If you want to skip straight to the numbers, then scroll all the way down!

I would look at the valuation in two steps

1. What is the potential to monetize the user base through advertising and other means? Note: People familiar with the economics of internet advertising should probably skip this section!

2. Is there any potential to increase the user base or deepen potential for monetization?

Monetization of current user base

There is overwhelming agreement that online advertising improves brand awareness. But can online advertising spending grow at the fast pace it has so far? Print ads might move increasingly online (the rise of local advertising through the internet comes to mind) as more print media houses try to establish and monetize their reader base online. The NYTimes, the Wall Street Journal and the Financial Times are but three examples of this trend. Newspapers and magazines have long subsidized content with advertising and there is no reason to suspect that the same model may not be used online. Google, Facebook and many other providers of services are actually using the same principle – that their users are a good target audience for advertising and that their service can be subsidized (or supported entirely as is currently the practice) through advertising.

Now the interesting fact is that these service providers have not been able to charge for the service. Anyone who followed the growth of Google mail might remember YHOO and MSFT trying to entice users into buying a premium mail service with higher storage limits and higher attachment sizes. Google entered the fray and grew exponentially because they offered for free what others were trying to charge for. A new entrant that was hungry for market share thus grew from just being a one-trick pony in search into its current mammoth position and made portals all but obsolete. People’s internet usage pattern changed significantly. iGoogle is an attempt at encouraging more of a portal-like experience by allowing each user to customize and create their own portal! Google news upset many publishers and syndications by allowing people to read the news without leaving Google.

Now here comes Facebook and it wants to encourage precisely the same sort of behavior. But it tries to go even further than Google and wants every user interaction on the web to be through its interface. You might even think of it as the cable box equivalent or the remote. In the US, print media advertising is likely to be replaced more and more by online advertising. I am not arguing with that or what eMarketer predicts about the size of the online ad market. I’ll say though that I expect the growth of online advertising will slow down because the market has matured substantially (the recent Google earnings in Q4 might be a reflection of that – volumes went up 34% while pricing declined 8%).

I agree that Facebook and Google both allow marketing campaigns to be more precisely targeted. But then again, that is an efficiency improvement on ad spending. That is all. The overall ad spending cannot and should not increase just because of growth of online advertising. Entertainment content over Television still remains more attractive for advertising because of the sheer reach (and the CPM for even prime-time TV is $25 or so which is comparable to highly targeted online CPMs for premium content which can reach $20+) and has high potential for regular reinforcement. Besides, it is a multi-pronged attack on the consumer’s consciousness. Online advertising is far more discreet. I would argue that a CPM that approaches Prime-time TV is an indication that online advertising spending is starting to mature. This has already started to happen in the US.

What does Facebook bring to this world? The potential for even more targeted advertising so that more sites can generate CPMs that approach the $20 mark because they are likely to be able to customize advertising based on user profile? Possibly. But how much of this will remain with Facebook and how much will go to the Publisher? A good indicator is the upside the publisher has from increasing his revenues through better placement. Now this seems like a win for everyone – the Publisher, the Ad-buyer and of course Facebook!

As an aside, this point (that targeted ads get a Publisher higher revenue) is missed by both the NYTimes DealBook article today criticising how Facebook measures its Daily Active Users. Needless to say, the NYTimes DealBook article cites Barry Riholtz’s blog voicing the same critcism who is also wrong for stating that “they cannot be marketed to” if they do not go to Facebook’s site. Well, they can be marketed to more effectively on the site they do visit by signing in using their facebook account (The Huffinton Post is cited as an example) and the Publisher of that site can target ads far more effectively and can claim premium pricing for the ads sold. This upside in pricing gets split between Facebook and the Publisher. Neither of these writers seemed to appreciate how internet marketing works.

Think of Facebook as a filter for content. You will start seeing what your friends like or recommend or have read. Now this would weed out a lot of publishers from the Web who offer marginal content. The web will become a manageable place with a Times Square of sorts. But many such places could exist because of the potential to micro-segment the users with the wealth of data that Facebook collects. So yes, this will offer a good deal for publishers with great content but will be a disaster for the less premium publishers.

So we’ve answered the first of the two questions we wanted to examine and have concluded that there is definite value that someone like Facebook could bring to the world of online advertising.

But let’s look at the potential ad revenue from each individual user. To answer that would be to also answer the second question – whether there is any potential to increase the level of monetization or increase the number of users – either of which will bring growth to Facebook.

Potential for increasing monetization and for increasing user base

Let’s start with a disclosed number – the 483Mn DAUs (Daily Active Users) that Facebook has in December 2011. Now, take into account that this was holiday season and people would both have more time on their hands a reason to want to be active and send messages to friends and family. But let’s start with that number anyway.

Now consider another number – the 2.7Bn likes and comments on average over Q4 2011 (Oct-Dec 2011). If we assume that the 483Mn DAU is representative of the quarter, this translates to 5.6 interactions by each DAU every day. ~~the whole quarter. So this implies that the average Facebook user just has 5.6 comments/ likes over the whole quarter! That strikes me as not being quite active.~~ The edit above is thanks to one of the commentators who pointed out this error – that the no: is daily not over the whole quarter.

And remember that we are still looking at DAUs and not the vastly higher number of MAUs (Monthly Average Users). But even the DAU number is reaching a plateau with Q42011 seeing the worst QoQ increase in DAU (Daily Active Users) since 2009 (which is where the figures start). See the table below.

Facebook's Daily Active Users - Reaching a Plateau?

DAUs as the prime driver for both volume and pricing

Now I’ve tried to project Facebook revenue using DAUs as the primary driver for growth. Some people might say that this doesn’t capture the potential as the no: of interactions (likes/comments) could go up and increase potential for capturing some more commercial potential there like what Comscore refers to as “Ads with Social” – where friends of a person who likes or comments on a brand/ purchase/ article/ movie/ event get ads with a personalized message such as “Joan likes this!”.

I must say that I considered that possibility but rejected it thinking that this argument is flimsy because the core product has remained constant over time. Sorry – I think that it is unlikely that usage patterns will change drastically over a multi-million DAUs. Besides, an increase in user interactions would only come at increased Traffic Acquisition Costs (through new features, tie-ups with other players like Zynga). So this would probably dilute margins. So to use a simple model, let’s stick to DAUs as the core driver for estimating revenues in terms of potential interactions that can be sold.

I’ve used DAUs as another driver as well – for pricing power. Simply put, the more users Facebook has, the more targeted its ads can be and the more an advertiser would like to pay for it.

People might also criticize me of failing to account for revenue share from what Facebook calls Payments and other such uses of the Facebook Platform. Well, my defense is that these are also linked to DAUs and is very intimately tied with average interactions per DAU.

Another argument against upside from increased interactions:

I would also argue that Facebook is mature and should not be regarded a startup now. How likely is it that people are any more active on average than they already are? I’ll say that the fanatic users would already be on it. You might convert a few new users into fanatics but most new users are likely to be less active than the average user now. So let’s consider the average no: of interactions as constant.

Incidentally, Google also reported in the midst of its Q4 (which was greeted with howls) that its Google+ now has 90Mn+ users and has doubled its users from just a quarter back. Any social network benefits from what economists like to refer to as a positive network externality – a snowballing effect of sorts after a critical mass has been reached. If you look at the Facebook numbers you would see a similar effect. Each time users in a new region adopt Facebook, there is a sudden spurt in the DAUs. But as we might see soon, as Google+ gains users, Facebook will lose out on potential number of interactions as its control over its DAUs time decreases. So we might even see the average no: of user interactions on Facebook go down over time.

Look at google – search has remained the good majority of its revenue even after so long. A significant chunk after that is accounted for by Gmail ads. Internet usage patterns evolve only over time. So a radical shift is unlikely. So let’s assume that the average no: of interactions over Q42011 for Facebook as constant over time (both for past and future).

Simple revenue model illustrating Facebook revenue with two drivers for revenue both dependent on DAUs

Pricing power increases
Potential commercial interactions

So here is a revenue model that I’ve devised that seems to fit the actual annual data below not too badly. Cells marked in blue are my assumptions. Other cells are either calculated or from the S-1 filing.

Simple revenue model using DAUs seems to fit historic data quite well

Dilution, dilution, dilution! Control, control, control!

Let’s look at the number of shares offered 117.097Mn of Class A shares with one vote each. Class B has 10 votes each (at least it has only 10 unlike Zynga’s insane voting rights that give Pincus 70 votes for each of his shares). What’s more, there are a lot of Class B shares out there – 1,758,902,390 of them.

On top of all this, Mark Zuckerberg has an option to purchase another 120Mn Class B shares which he apparently plans to immediately convert to Class A shares. I am not familiar with this structuring, so excuse me if this table seems to overstate the no: of shares by those 120Mn shares.

Potential outstanding shares:

Substantial dilution projected over 2012 as per existing options

I still haven’t factored in the 2005 equity plans and 2012 equity plans which could add a further 72Mn shares. But at over 2.5Bn shares, that is just rounding error in EPS. Oh and the public who subscribe to this IPO will have voting rights of 0.49% though they will hold nearly 4.7% of the Mkt. cap. Again, whether this worries you depends on how comfortable you are with the management team. But any board that allows structuring like this is a board I will not want or trust. I think the SEC should prohibit different classes of stock.

P&L projections and per share values

I’ve used the same revenue model I’ve mentioned before to make the revenue projections below. These are what I regard as the most optimistic – where DAU base does not decline and commercial potential from interactions continues to be tapped into aggressively.

DAU growth --> Monetization opportunities increase, but new geographies with lower ad rates prove a drag on pricing

Ad rates are much lower (as much as 50% lower in even in countries such as Singapore) in newer Geographies where FB userbase is increasing. This will prove a drag on pricing and has been factored into the revenue expectations.

Even as I expect DAUs to grow at 29% YoY well into 2012 and at 14% into 2013, let’s examine what this translates to in terms of earnings. Below are my P&L projections and EPS projections. To take away the effects of stock option expensing (so that I don’t double-count the effect of dilution), I’ve provided an estimate of earnings without expensing stock options but shown EPS on a fully diluted basis with these options.

Good, but not stellar!

Earnings growth is at a CAGR of 105.3%. If I consider earnings adjusting for stock compensation expenses, this slips slightly to 93.3%. Note that I am talking about the Net Income across all shareholders. As we are looking at EPS and Net Income across all shares after the IPO, I am doing this to be consistent.

With the tremendous dilution in stock after the IPO, I would say that it’d be tough to deliver earnings growth over 2012 at least as can be seen by the diluted EPS growth projected at a CAGR of 90.9% from 2011 to 2013 (Diluted EPS from $0.46 to $1.68).

At what price would I buy Facebook?

Let’s take a proven competitor for online advertising, Google. They trade at a P/E of just 12.25 for FY12E. Let’s be doubly generous and use a P/E of 15 for FY13E for Facebook. That gets me a price of 15×1.68 = $25.13!

Even at $25.13/share, Facebook will be worth a massive $63.2Bn! I think that is probably close to what it is really worth. Paying anything more would be flirting with the chance that they can power earnings growth in new ways and exponentially grow their revenue per user.

Note: Stocks mentioned in this article are FB, GOOG, ZNGA. I do not hold any position in any of these stocks and do not plan to initiate a position in the next 90 days.

Equity Research, Finance

The sandy foundations of the recovery?

Leave a Comment Posted by karmanomics on February 6, 2012

The US economy added 243,000 jobs in January. This is after a period of nearly a year of small increases in consumer debt. Consumer debt outstanding (excluding mortgages) started reducing going into the 2009 and kept dropping as households started paying off or defaulting. The bottom was reached in Q32010 when it reached $2.39Tn (the peak was $2.56Tn in 2008). Since then, consumer credit has risen to $2.48Trillion (seasonally adjusted figures as per the Federal Reserve Statistical Release for November 2011 released on Jan, 9, 2012).

My hypothesis is that consumer debt cannot increase much more beyond its current level. Simply because just debt servicing will be so burdensome that another economic shock and a deleveraging process is inevitable.

Let’s start with the annualized wage bill which is $6.7Tn (excluding pension contributions which we must exclude as it should go towards funding retirement). Let’s add Proprietors’ income to this as we could conceive of this possibly being dominated by small business owners. Anybody with rental income or Personal income receipts through interest or dividend will not be considered towards having income that can service revolving debt such as a credit card or non-revolving credit such as an auto-loan (simply because for those with assets, it makes economic sense to retire or reduce that high interest loan with lower rate investments they own).

Here is a small table showing what I just defined above to look at the Consumer Debt Servicing Ability of the whole economy.

	2011
	I	II	III	IV	Consumer Debt Servicing Ability
Personal income	12846.9	12955.3	12979.6	13062.2
Compensation of employees, received	8172.5	8219.7	8250	8327.4	8,327.4
Wage and salary disbursements	6578.2	6617.1	6641.9	6708
Supplements to wages and salaries	1594.4	1602.7	1608.1	1619.4
Proprietors’ income with inventory valuation and capital consumption adjustments	1095.6	1106.5	1113.7	1115.5	1,115.5
Rental income of persons with capital consumption adjustment	385	396.9	406.3	428.6
Personal income receipts on assets	1777.2	1802.3	1794.2	1789.1
Personal current transfer receipts	2328.1	2347.3	2336.6	2331.9
Less: Contributions for government social insurance, domestic	911.5	917.4	921.2	930.2	(233.2)
Less: Personal current taxes	1365.9	1396.2	1408.5	1448.5	(1,047.1)
Equals: Disposable personal income	11481	11559.2	11571.1	11613.8	8,162.5

There are two worrisome points here

The total outstanding consumer debt is a full 30.4% of disposable personal income. Note that this excludes mortgages. Most people spend 20-25% of income on rent or on a mortgage. Just interest service on the consumer debt will send a shock into the economy once we emerge out of this current low interest regime and its teaser 0% interest rates. Oh, and also note that the $2.48Tn is before the Christmas spending.
Here is a direct quote from the Federal Reserve Statistical Release as it explains the November 2011 release: “Consumer credit increased at an annual rate of 10 percent in November. Revolving credit increased at an annual rate of 8-1/2 percent, and nonrevolving credit increased at an annual rate of 10-3/4 percent.”

What do I find worrying about that second statement? That this coincided with the addition of over 243,000 non-farm jobs. The growth in manufacturing (50K jobs) was nearly all in durable goods manufacturing and this has probably been fueled by increased consumer spending through borrowing. Another big contributor was leisure and hospitality with 44K jobs. This increases my suspicion that what we are seeing is just a dead-cat bounce of sorts of consumer spending which won’t be sustained.

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India’s money multiplier and worrying implications for growth (or lack thereof)

Leave a Comment Posted by karmanomics on December 18, 2011

The velocity of money in India

See the figure below. It compares the monetary base and GDP. See what is wrong with India?

Nominal GDP Vs Money Supply - India and US

Here is a broader hint. It compares the velocity of money. Undoubtedly, the US is far more sophisticated and you’d expect a money velocity higher than India. But India, puzzlingly, has a money velocity close to 1 (and that is by simply annualizing the quarterly GDP figures from Jul-Sep 2011). Risking the use a mixed metaphor, has everyone else been pretending to ignore that this elephant has no clothes?

India's puzzlingly low velocity of money

*Sources for data are the Money Supply figures for India from the Reserve Bank of India (RBI) release on 2nd December, 2011. The GDP figure for India is from the Ministry of Finance dated 16th December 2011. Comparable US figures are from www.EconStats.com. For the sake of simplicity, I’ve just annualized India’s GDP figures by multiplying the quarterly figures for Jul-Sep 2011 by 4.

^I’ve used Indian M3 which includes a negligibly small (0.04%) of “Other Deposits with the Reserve Bank” in addition to Currency, Demand Deposits and Time Deposits. The US M3 is not published any more. I’ve used the US M2 which includes Currency, Demand Deposits, Other Checkable Deposits and Savings Deposits including Money Market Deposit Accounts. Again, the data sources are as mentioned in the note above.

Wait, there is more

Here is the clincher. Jul-Sep 2011 Nominal GDP growth in India has been reported at 16.0% while GDP growth at constant prices is 6.9%. You may ask what is wrong with that! Well, normally you would expect that nominal GDP growth equal Money Supply growth (assuming that the money velocity remains constant). In a country such as India where terms such as “inclusive banking” is being bandied about and whose economy is supposedly growing more sophisticated, I’d argue that the money velocity should be increasing as money changes hands more quickly with more avenues to spend. Consumer credit growth certainly seems to reflect that. But YoY M3 growth for Jul-Sep 2011 for India is 16.3%. Oops. Some heads should roll for this badly cooked up data.

There are only two explanations:

Indian GDP growth has been underestimated considerably. Difficult to believe because the formal economy’s share should have been growing over time. If not, that is a different issue. But it is still worrisome if that were the case.
India has actually undergone a recession of sorts with inflation being vastly underestimated. The only thing that was masking it is the huge hose that has been pumping money into the system.

Is India about to implode?

India has Greece’s inefficient yet pampered government, the same tax evasion, the same lack of productivity and yet it has shown surprising resilience in the global downturn. Many India experts explain it by citing the large percentage of domestic economic activity and the huge percentage domestic services account for in the country’s GDP. The growing fiscal deficit of the central government is largely the result of expanding public spending through cash-transfer schemes to the rural poor, the increase in salaries to public sector employees and the huge subsidies for diesel, kerosene and LPG. In past years, this deficit was papered over by disinvestment proceeds - in other words, one-time gains used to offset expenses that are recurring.

India, like Japan, usually finances a large portion of its fiscal deficit by channeling household savings. This had, in the past, crowded out industry from investing. In the midst of all the global euphoria about a Goldilocks-scenario and the attractive external borrowings rate, India Inc. went on a borrowing spree both for overseas acquisitions and to fund domestic investments. Unfortunately for them, credit markets are now tightening globally just as consumer borrowing has started to dry up the traditional channels for government borrowing in India. You can guess what the Indian government did to meet its borrowing needs.It did what irresponsible and populist Latin American governments and African governments have done and with largely the same results – printed more money resulting in inflation and an asset bubble. The Reserve Bank of India’s balance sheet has ballooned even more than the Federal Reserve’s during the last few years – of course, only in % terms! Inflation has been rampant even for essentials. Some critics point to the higher input costs for rural agriculture courtesy the Indian government’s cash-transfer schemes. However, what has been missed are the even more worrisome hyper-inflationary trends in assets – particularly real estate. A decade back, the average Indian homeowner did not have a mortgage. Now, second mortgages are being advertised as a way to unlock the value of your home equity. Sounds familiar?

India’s current account deficit (due chiefly to its oil imports) has usually been met by remittances and FDI inflows. Portfolio inflows also helped. This flow has lost steam off late. India’s growth story is starting to lose its luster as its stock market seems overvalued (a valuation of $1Tn+ against a GDP that is just $1.4Tn despite the poor access to equity markets for most SMEs), poor corporate governance and lack of investor protection discourages further FDI inflows and the cracks are only too apparent to savvy investors of every stripe – except for the Indians themselves who want to cling on to the belief that this is their hour! Now all the chickens are coming home to roost! The rupee is weakening due the growing capital account deficit. Inflation can not be tamed due to the RBI’s appeasement of government borrowing by printing money even as rising oil import costs ripple through the economy creating inflation even in the absence of other inflationary factors.

The economy has moved into slower growth orbit (or even negative growth if you look at the most recent Index of Industrial Production figures) even as demand for luxury goods (or what passes for it in India) booms. Again, this is possibly to be expected in any monetary expansionary boom where the proceeds of the expansion have been snagged by a chosen few. The Indian growth miracle is no miracle but a mirage. If you don’t want the roof to cave in on you, I suggest you get out and watch with the deepest sympathy the unfortunates who continue to sleep through the alarm bells.

Economics, India

Fighting, Martial Arts; Economic theory and the real world

Leave a Comment Posted by karmanomics on November 15, 2011

Economic Theory has come a long way. Or has it? Instead of simple logical real world models that the likes of Keynes and Hayek used, we now find most economists using sophisticated mathematics that is an entirely different language. And if you don’t understand it, then surely it must be fantastic and correct! Reduced to its essence, that is all mathematics is – just a language with a grammar and syntax all of its own.

I had signed up for a seminar with a couple of the best trainers in the world for Muay Thai and Krav Maga. When one of the participants asked a question about the move that we were being taught to disarm someone with a gun, they both said something profound. It boiled down to this: ”The real world is messy. You can’t boil down all the variables to just a few and then you find yourself being surprised and unable to react because you are wondering which would be the right move and you are trying to reduce the messy situation into variables that you are familiar with. We could tell you that this is the right way and show you a great demo and leave you feeling satisfied with the elegance of it. But hell, the real world fights are never that way! And if you don’t train for the real world, then you might as well not fight! We can teach you the basic principles and from there it is all deductive logic based on the unique situation you find yourself.”

Austrian economists and behavioral economists might have found themselves nodding along in agreement. My main bone of contention with most economists (and 99% MBAs and 99.99% financial engineers) is that all their mathematical modeling is just their way of trying to adapt a messy real world problem to the tools they have at their disposal (as limited as they may be). Their excuse is that: “Well, for the math to work, we have to make the problem tractable”. In other words, your tool is a hammer and you have one nail and three screws and you just hammer them all in

Great men across all professions are people who think independently and are heretics at heart (due apologies to Ryan Hoover of Charlotte Krav Maga for borrowing this line about him being a heretic – hopefully he is mollified by being considered a “great man”).

Human beings do not act rationally. We don’t even make important decisions rationally. Think about how you ended up in your current profession or job. Was that a rational choice? Happenstance at best…Or think about whom you ended up marrying (or dating) or your decision to stay single! Rational? You chose your profession, the location and your firm based on what might seem like laughably poor information in hindsight!

Yet most economics insists on modeling the world based on human beings making rational choices and does not even do a good job of accommodating the diverse tastes and preferences they have. Well, to make the problem tractable…and yet they wonder why they leave with a bloody nose at every economic downturn Are these the smartest guys in the room?

Let’s assume that they are right and that human beings do act rationally! When then there would be practically no income inequality! Imagine that you are entering high school and thinking about what career to choose (you would choose at that point in your life because that would be rational). Forecasting the growth in certain industries and the likelihood of other people choosing to enter that industry and foreseeing a marginal skill shortage compared to other industries you choose to specialize in that profession. Of course, being completely rational, you also recognize your limitations and you choose where you can maximize your income. If everyone else chose rationally like you, then the skill shortage must indeed be marginal as anyone who can obtain those skills who sees an incremental benefit will try to re-skill himself. Professions that are seeing an oversupply (economists for instance as currently?) will start seeing fewer applicants majoring as these professions offer lower returns. So in an ideal world that obeys economic laws of supply and demand and rational expectations you’d see little unemployment and little income disparity (costs of training will rise to meet the demand for it and compensate more or less for the benefits of increased income).

Now how many young people have chosen rationally? How many Economics Ph.d. candidates are out there looking at bleak employment prospects?

Uncategorized Austrian School, Behavioral Economics, Economics, Education, Rational Expectations

Solving the US housing problem

1 Comment Posted by karmanomics on November 4, 2011

Solving the housing problem

President Obama’s new plan is likely to be as unsuccessful as his last. Apart from generating refinancing fees for the banks, lowering a mortgage payment will stop the slide in housing prices only temporarily (if the only thing that is holding the economy back is the housing bubble’s overhang, then interest rates will rise as soon as we fix this and either the underwriters for fixed rate mortgages take a hit or homeowners start paying more in mortgage payments).

A bailout for those who took on mortgages far more expensive than they could afford is also not the solution. Apart from artificially propping up home prices temporarily, it would not address the underlying problem – that housing across the country is overvalued.

In the aftermath of the dot-com bubble, if the government had proposed to bailout households who had lost a substantial amount of their 401Ks in the stock market, how would you react? People who did not participate in the greed for bigger houses or bigger potential gains have to share some of the pain for their bad decisions. But so should the banks who encouraged them to take on bigger loans!

Here is what I have to suggest:

Every mortgage (including ones not in trouble currently) should be considered for re-evaluation based on the current home price. The homeowner should then have an option to

a. Accept the new value of the home price as his new mortgage value. In this case, the bank who holds the mortgage should be allowed to have a 50% stake in any home equity (defined as the value of the home minus the mortgage value) whenever the mortgage holder either sells the house or closes the mortgage. Here the bank takes a temporary hit in the form an immediate write-down of the mortgage value but then ends up with a mortgage that encourages the homeowner to participate in the hope of sharing eventual upside to the housing price. The pain is shared by both parties and the best thing of all would be that the government (meaning all of us taxpayers) need not spend a penny!

b. Stay with his current mortgage

c. Hand over his mortgage and the home to the bank and be given 50% of his payments to the mortgage so far excluding interest. What would the bank do with such homes? Sell them to property management firms!

d. Choose to stay in the home for the current rental value and hand over title of the home to the Bank. The Bank gets any possible equity upside in future years and can hand over management of the home to a property management firm and could even potentially sell it to a property management firm. This is just a rental, but a rental which is rent-controlled for the life of the mortgage.

Why would this work?

This avoids the problem of moral hazard! Those who took the risks share the losses. But they are incentivized to keep their end of the bargain. This would also restore confidence quickly by clearing up the uncertainties about possible future impairment to the Banks’ balance sheets. This is a market-based solution and should be acceptable to all parties.

What are the potential pit-falls?

The biggest possible issue is how to manage the possible holes that would immediately develop on Banks’ balance sheets. Well, I suggest that Banks be given the right to amortize these losses over three years. This would give them a tax-shelter assuming they are profitable otherwise. It would also give them a chance to sell their equity stakes in homes across the nation and reduce the gap left by the write-down of the mortgages. They could also sell homes (where homeowners opt for above options c or d) to property management firms who in turn could sell a recurring revenue stream with possible capital gains to pension funds and other long-term investors looking for yield better than treasury.

Another issue is that finding home-buyers would still be difficult if a lot of new firms come on the market. There are many immigrant workers (legal and illegal) who do not invest in a home because they do not know how long they can stay and work here. I suggest that these workers be given a choice now to buy a house whose mortgage is between 20-30% of their monthly income and in return be given a work-permit (not citizenship) for 20 years. The holders of these work permits will need to pay Social Security taxes on their pay but will not be eligible for social security or healthcare upon their retirement. They will also not be eligible for unemployment benefits or Medicare/ Medicaid during their stay. Some might argue that adding more workers now is what we need least. But these workers are already in the country and working! Giving them the freedom to work for anybody they choose (like holders of Green Cards) would ensure that their wages are not lower than Americans of similar qualifications.

What are the potential gains?

We would, first and foremost, be defusing the slow slide of housing prices and the resulting decline in household finances. We would be creating a huge demand for housing, helping workers who are possibly vulnerable to exploitation and helping to shore-up social security. This would ensure that Banks actually share some of the pain they helped inflict and get housing speculators to share the pain for their part in the housing bubble.

Economics

The real diagnosis for the US economy’s ills!

Leave a Comment Posted by karmanomics on November 4, 2011

Listened to the speech by Dr. Sachs. I think that to paraphrase him “the diagnosis is wrong”. His whole hypothesis seems to be that the US needs more investment in education. I think that is not true. Look around you and see where college education is getting people. Just deeper in debt mostly.

In my opinion, what is destroying this country is trade – unfettered trade!

The truth about Credit Scores – courtesy the new Consumer Protection Bureau

Leave a Comment Posted by karmanomics on August 9, 2011

This is one of the first things that struck me speechless when I was reading through the Report to the Congress by the Consumer Finance Protection Bureau (CFPB). The CFPB is one of the few elements of Frank-Dodd that has endured even as it has been diluted on many other fronts. By the way, even the CFPB has been undermined in many ways to make it a toothless paper tiger rather than the watchdog that Frank-Dodd had intended it to be. President Obama could have used Frank-Dodd as his signature piece of legislation instead of the lame-duck health reform that finally we ended up with. But he chose otherwise and everyone in Congress conveniently forgot that during the days of the crisis and the bank bailout, the Frank-Dodd bill was one of the promises made. Most of these promises have been reneged on. In its current form, Frank-Dodd is so diluted that its provisions may no longer be sufficient to prevent the events of 2008 from recurring.

But let’s move on to the report by the CFPB. Here is a direct quote from one of the first pages.

“When a consumer purchases a score from a CRA, it is likely that the credit score that the consumer receives will not be the same score as that purchased and used by a lender to whom the consumer applies for a loan. This could occur if the score the consumer purchased is an educational score that is not used by lenders, but differences between the score a consumer buys and the score a lender buys can occur for other reasons as well.”

Why has this not gotten widespread press attention? This new bureau has made two startling revelations that every consumer in the US would have been shocked by:

That the credit report that Banks see are completely different from what you see (even if you buy a credit report from all three national credit reporting agencies)
There is such a thing as an “Educational score” that is NOT used by lenders (such as banks)

Now I wonder if this “Educational Score” is what is being sold by all credit card companies now as a Credit Monitoring service. See the Capital One service for example (Disclaimer: Not that I have anything against Capital One in particular but I tried to find examples for Credit Monitoring from JP Morgan Chase and failed to find any).

One of the things that it promises is

“Credit Score
See what creditors see when evaluating whether or not to extend credit to you.”

Now, does this seem to suggest that you get the same thing that Banks get to see about your Credit Score? I would think so. This service was being pushed really hard to me as I signed up for a card with them and I had to be quite adamant in my refusal. Even then, I didn’t suspect that I may have been offered a service with little to no value as the credit score that I get to see may have little or no connection with what the Banks get to see. Wonderful! So one of the main reasons why people might sign up for the service is something that is misleading or of little to no value.

If this is what the CFPB has gotten us in its few days of existence, I say that the Government has finally delivered something to consumers and tax payers for the billions we gave the banks to bail them out. Write to your congressman today and ask for the original Frank-Dodd provisions to be reinstated!

Consumer Advocacy, Credit Card Fees, Finance, Uncategorized

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