Weekend reading links

1. Large is not always good. Marc Levinson writes how the latest giant container ships have, instead of lowering transport costs and raising efficiency, has increased costs, reduced speeds, and created a host of other problems.

Discharging and reloading the vessel took longer as well, and not only because there were more boxes to put off and on. The new ships were much wider than their predecessors, so each of the giant shoreside cranes needed to reach a greater distance before picking up an inbound container and bringing it to the wharf, adding seconds to the average time required to move each box. Thousands more boxes multiplied by more handling time per box could add hours, or even days, to the average port call. Delays were legion... The land side of international logistics was scrambled as well. At the ports, it was feast or famine: Fewer vessels called, but each one moved more boxes off and on, leaving equipment and infrastructure either unused or overwhelmed. Mountains of boxes stuffed with imports and exports filled the patios at container terminals. The higher the stacks grew, the longer it took the stacker cranes to locate a particular box, remove it from the stack and place it aboard the transporter that would take it to be loaded aboard ship or to the rail yard or truck terminal for delivery to a customer. Freight railroads staggered under the heavy flow of boxes into and out of the ports. Where once an entire shipload of imports might be on its way to inland destinations within a day, now it could take two or three. Queues of diesel-belching trucks lined up at terminal gates, drivers unable to collect their loads because the ship lines had too few chassis on which to haul the arriving containers.

2. Gautam Bhan writes about the lop-sided nature of urban land distribution,

Despite the language of “encroachment” and widespread “land grab,” bastis (slums) are on a minute portion of city land — less than 0.6% of total land area, and 3.4% of residential land in the 2021 Delhi Master Plan. This tiny percentage supports no less than 11-15% but possibly up to 30% of the city’s population, most settled for decades. One example shows how skewed this number is. In 2017, parking Delhi’s 3.1 million cars used 13.25 sq km of land, or 5% of all residential area. Cars, then, have more space than the housing of workers, residents, and families.

3. Obituary in FT of Lee Kun-hee, Samsung's Chairman. Lee was a real business titan and a force behind South Korea's economic transformation.

Samsung, which pulled away from Hyundai to become the biggest of South Korea’s chaebol, or industrial groups, by a wide margin. The company is the largest maker of memory chips, smartphones and electronic displays, Samsung C&T built the world’s tallest building in Dubai and Samsung Heavy Industries is the world’s third-largest shipbuilder by sales. Other subsidiaries’ range from theme parks to insurance. It is for the transformation of Samsung Electronics, however, that Lee will be most remembered. Samsung was a minor player in the global technology industry when he took the helm in December 1987, succeeding Lee Byung-chull, his father and the group’s founder... Within five years, Samsung was the world’s biggest producer of memory chips underpinned by billions of dollars of annual investment, even during downturns. Despite this success, shoppers around the world continued to view Samsung’s consumer electronics as poorly designed and undesirable. Lee’s aggressive interventions to change this perception have now become legend. The most famous came in 1995, after the humiliation of finding that Samsung mobile phones he had given as gifts did not work. Two thousand Samsung employees at a phone manufacturing factory south of Seoul were instructed to don headbands marked “quality first” and gather outside. Thousands of phones and other electronic devices — with an estimated total value of $50m — were incinerated on a bonfire and the ashes were pulverised by a bulldozer.

As I blogged earlier, Samsung's spectacular success breaks the mould on several scared tenets of modern business organisation and management techniques. See this from The Economist.

3. Chandra Nuthalapati et al have a good study that informs significant gains for vegetable farmers from selling directly to supermarkets,

Even after controlling for differences in quality and other relevant factors, we found that imputed farmgate prices that farmers receive in supermarket channels are around 20% higher than the prices received in traditional channels for most of the vegetables considered. For some of the vegetables, price differences are even higher. We also found that selling to supermarkets involves lower transaction costs for farmers than selling in traditional markets, as supermarket collection centers are located closer to the villages and involve lower commission fees Higher prices seem to be needed as an incentive for farmers to deliver to supermarket collection centers, because supermarkets do not offer any other incentives to farmers. In other countries, where supermarkets often procure vegetables from farmers through contracts, farmers benefit from lower price risk or from inputs and extension provided as part of the contracts. In India, supermarkets procure vegetables without contracts, so that higher mean prices are important to ensure regular supplies. We found significant price incentives for comparable qualities. In addition, higher quality grades are rewarded in supermarket channels, which is often not the case in traditional channels. Our data showed that farmers who supply supermarkets typically sell their highest-quality vegetables in supermarket collection centers, whereas they sell lower-quality produce in traditional markets.

While this will surely have some positive effect, these are excessively big effects. Something going on here about the study.  

4. Bihar sugar mill industry fact of the day,

Around 1980, Bihar accounted for 30% of the country’s sugar production, and 28 functional sugar mills. It has now come down to less than 5% of the production, and has 10 mills... At the end of 2016-17, only about 2,900 of Bihar’s estimated 3,531 factories were operational, employing on an average 40 people each. The national average is nearly double, 77 workers. The average salary per annum per worker in Bihar then was Rs 1.2 lakh, again less than half of the national average of Rs 2.5 lakh.

5. FT has a long read on the emerging geo-political struggle in the Middle East between UAE and Turkey, motivated by ambitions in both countries to influence politics in other countries across the region. Their frontline is in Libya, where Turkey is supporting the UN-backed government and UAE is supporting the rebels led by Gen Khalifa Haftar. 

The UAE accuses Mr Erdogan of colonial delusions, supporting Islamist groups and forming a hostile axis with Qatar, its Gulf rival. The belief in Abu Dhabi is that wealthy Qatar provides the funding, and Turkey the muscle as Mr Erdogan seeks to position himself as a leader of the Sunni Muslim world. “Turkey has many things to answer for, with its long-term attempts — in concert with Qatar and the Muslim Brotherhood — to sow chaos in the Arab world, while using an aggressive and perverted interpretation of Islam as cover,” Anwar Gargash, the UAE’s minister of state for foreign affairs, wrote in the French magazine Le Point in June as tensions over Libya soared. Sheikh Mohammed, known colloquially as MBZ, is spearheading the Arab push against Turkey’s influence... The UAE, which has an indigenous population of just 1.5m but is one of the region’s wealthiest countries, has long punched above its weight. Since the 2011 Arab uprisings rocked the region, Abu Dhabi has deployed tens of billions of petrodollars to bolster allies across the Middle East and Africa through trade, aid and the use of military resources. The Gulf state’s foreign investment and bilateral aid to eight countries including Egypt, Pakistan and Ethiopia, has totalled at least $87.6bn since 2011, according to the American Enterprise Institute, which analysed publicly available data.

Turkey is today the hub for the region's dissidents, especially Islamists, who pose an existential threat to the monarchical autocracies. UAE's normalisation of relations with Israel should be seen in this backdrop - an attempt to ingratiate itself in the West, against Turkey.

A related issue is the intensification of the stand-off between Armenia and Azerbaijan over the Armenian enclave of Nogorno Karabakh in Azerbaijan. One important reason for the breakage of the Russia-brokered truce which has held since 1994 has been Erdogan and Turkey, which have aggressively armed and supported Azerbaijan, thereby emboldening it. A humanitarian disaster is now unfolding which has displaced nearly half of the enclave's population. 

6. From Ananth, this article by Norman Doidge on the problems with RCTs in medicine,

An important review of RCTs found that 71.2% were not representative of what patients are actually like in real-world clinical practice, and many of the patients studied were less sick than real-world patients. That, combined with the fact that many of the so-called finest RCTs, in the most respected and cited journals, can’t be replicated 35% of the time when their raw data is turned over to another group that is asked to reconfirm the findings, shows that in practice they are far from perfect. That finding—that something as simple as the reanalysis of the numbers and measurements in the study can’t be replicated—doesn’t even begin to deal with other potential problems in the studies: Did the author ask the right questions, collect appropriate data, have reliable tests, diagnose patients properly, use the proper medication dose, for long enough, and were their enough patients in it? And did they, as do so many RCTs, exclude the most typical and the sickest patients?

7. The reality with Uber's misleading minimum wage adherence claim.

Drivers will be guaranteed earnings — 120 per cent of the local minimum wage — though with a significant caveat: Uber won’t count the time drivers are waiting to be matched with a passenger. When you factor in that period, a Berkeley study suggests that Uber’s promised $15.60 minimum an hour instead becomes, on average, just $5.64, once adjusted for driver expenses such as fuel.

8. This shocking story of the flight of ABC's Beijing Correspondent from China tells everything about today's China, which clearly does not abide by any rules applicable for civilised nations.  

9. A rare example of expose of corruption in the defence forces, which is without doubt at least a pervasive as elsewhere (perhaps even more given the lack of external oversight). The problem though with dragging CBI, CVC etc into investigating works, especially those done in places like Ladakh during the ongoing stand-off, is that it could backfire badly and end up delaying and derailing even those critical and time-bound works. 

10. Talking of burying your head in the sand, and Eugene Fama, in this interview, is a great exhibit. The level of obduracy on financial markets, negative rates, private debt, impact of central bank policies, business concentration and so on is stunning. Virtually every paragraph is an exercise in denial of reality. Evidently Fama is living in a different world. 

11. Economist hails Aditya Puri as the world's best banker!

The attributes are very old-fashioned,

First, Mr Puri’s management style, which features a clear vision, microscopic attention to detail, blunt speaking and a knack for retaining talent... The second factor is strategic discipline. Mr Puri intuited that Indian consumers and firms would be a consistent money-maker and has stuck to that view. He took the sophisticated processes used by foreign banks and used them to target local retail and commercial clients. The result is a large branch network, half of which is outside cities. The firm’s cash-machine and credit-card networks are the largest among India’s private banks. Mr Puri stayed away from foreign ventures and investment projects, avoided lending to India’s indebted oligarchs, and financed HDFC’s balance-sheet through deposits rather than debt... The final element is HDFC's approach to technology—though not a pioneer, it is a fast follower.

12. A Livemint story of the PLI scheme for mobile phone manufacturing, which has a five year allocation of Rs 41,000 Cr. This about the success of the segment as well as the distance to be travelled, 

India had two mobile manufacturing units in 2014. By 2019, there were over 200. The number of mobile handsets produced shot up from 60 to 290 million in the same period; the value of handsets produced jumped 10 times to $30 billion... China exported phones worth over $100 billion in 2019; Vietnam over $35 billion. India exported less than $3 billion in 2018-19.

Even with the PLIs, India stays below Vietnam and China on cost-competitiveness,

Assuming that $100 is the cost of producing a phone without subsidies, China can make it at $80 after factoring in the incentives the country provides. Similarly, the cost of manufacturing a phone in Vietnam. The PLI scheme bridges some of India’s deficit. The manufacturing cost, after factoring in PLI and other subsidies, totals $92-$93.

Interesting thing about the extent of subsidy, which is very significant,

The scheme is also a massive discount on India’s current value-add, the advisor mentioned above explained. Manufacturers in India import most of the components and the assembly value ranges between 8% and 15%. “If 15% is the assembly price, an incentive of 6% is almost a 50% discount," he said.

These are very instructive numbers. If even with assembly, India is not able to compete with Vietnam and China, that's disturbing. But perhaps, this underscores the need to localise component production to become competitive. That will hopefully happen in due course and the PLI scheme will expedite. But till then, the incentive is a massive subsidy cost being incurred. If it does not catalyse component manufacturing, then this can just as well be described as a corporate freebie.

13. The IPO of Ant Financial to raise about $35 billion, the world's largest ever, has attracted a staggering $2.8 trillion of orders from more than 5 million individuals, a sum which exceeds the value of all stocks listed on exchanges in Germany or Canada. For retail investors, the simultaneous listing at Shanghai and Hong Kong was oversubscribed more than 870 times. The company has a billion users and more than $17 trillion in yearly payment volumes.

14. Gillian Tett points to the alarmingly low CDS recovery rate projects with the recent corporate bond auctions. 

Most CDS contracts stipulate that financiers need to know what a company’s cheapest available bond will be worth at the point the company defaults. That’s because CDS contracts make investors whole by paying them the bond’s original face value minus its market value. When a company goes bust, financiers hold an auction to determine the market price, and the resulting prices offer one guide to what creditors think the company’s remaining assets are worth. Over the past decade, the average CDS auction prices have moved in a band between 10 and 60 cents on the dollar, but have generally been between 30 and 40 cents. However the nine US auctions conducted in the year to August produced an average price of just 9 cents — and just 2.4 cents if you look at the worst four: Chesapeake, California Resources, Neiman Marcus Group, and McClatchy.

Worsening matters, bondholders are being continuously shortchanged, 

And because loans take priority over bonds in a bankruptcy, the practice has also weakened bondholders’ claims, sparking fights in some bankruptcies... Bondholders’ claims have been further undermined by debt exchanges and stealthy asset transfers, including one known as the “J-Crew trap door”. Named after the recently bankrupted US retailer, it refers to a manoeuvre pulled off by the company’s private equity owners in 2016 in which they transferred intellectual property rights across to new lenders, out of the reach of the original creditors. Similar tactics have emerged at other troubled groups such as Travelport.

And all this is being driven by the search for yield among investors,

Indeed, four-fifths of US loans issued last year were “covenant-lite”, that is they had little or no control over borrower behaviour, up from one-fifth at the start of the decade. That is because investors are so desperate to chase returns in a zero-rate world that they no longer dare to impose covenants. Indeed, the hunt for returns is so frenzied that junk bond yields have plunged from 12 per cent in March to below 6 per cent. Cheap money, in other words, is enabling some zombie companies to stagger on, even as creditor value shrivels — until they collapse.

15. Fascinating article about the QR Code, the low-profile but functionally valuable invention in 1994 by Masahiro Hara to track components in car factories. Its use took off with its adoption by Ant Financial to make mobile payments through Alipay, and has not looked back. It was the crucial link which enabled the use of mobile phones for digital payments. It's now being used for everything from digital payments to browsing dinner menus online. 

Mr Hara worked at Denso Wave, part of a components group allied to Toyota, which used barcodes to label components in plants. But the barcode, first used in an Ohio supermarket in 1974, could be hard to use — as anyone who has tried to scan a bag of frozen peas will know — and did not hold much information. He solved the data constraint by making the QR code a two-dimensional square instead of a horizontal strip, allowing it to store up to 4,200 characters compared to 20 on the barcode. His team also conquered the time-consuming awkwardness of barcodes — every QR code includes three squares at its corners that help scanners to focus rapidly (hence, quick response). Japanese carmakers found it very useful: it saved some workers from having to scan up to 1,000 barcodes a day. 

This is one more to the point I've been making that Alibaba is a more entrepreneurial e-commerce engine than Amazon,

The QR code enabled Ant to pioneer mobile payments in China through its Alipay super app. The renaissance of QR codes, after years of half-baked efforts by US advertisers and retailers to use them for marketing campaigns and shopping vouchers, shows that it takes time for the strengths of some inventions to emerge.

And this is interesting, an illustration of how non-patenting of such general purpose ideas can have large positive externalities,

But Denso Wave realised that the QR code had greater potential and did not enforce its patent rights. That enabled others not only to use it free but make variations for their industries. The invention knocked around for a decade without finding another compelling use until Alibaba, the Chinese ecommerce group co-founded by Jack Ma, realised it could be used for payments. Shopping in the US and Europe, both online and in stores, is mostly done with payment cards, but the QR code offered an alternative.

It was the industry's good fortune that the QR Code was not invented in the US by the likes of Apple, who would have immediately patented it. 

16. A summary of the changes incorporated in the regulations proposed to implement the new labour codes in India. 

Markets are inefficient because they are efficient?

The Efficient Market Hypothesis (EMH) and market efficiency in general has been the subject of much debate in the aftermath of the sub-prime meltdown. Popular conception of EMH has it that asset prices cannot deviate significantly from its fundamentals, an untenable hypothesis given history and especially the recent events.

In this context, a more nuanced understanding of the concept of efficiency may help us appreciate the issue in its right perspective. Efficiency has two dimensions - market prices reflect all publicly available information about the fundamentals and the prices are fundamentally unpredictable. The popular inferences from these two dimensions are that they ensure that "prices are always right" and "it is impossible to beat the market on a sustained basis" respectively.

However there are enough reasons to believe that such highly simplified inferences may not be correct. It needs to be borne in mind that prices reflect only the "publicly available" information, and not "private" (or insider) information that is inevitable in such complex systems. Even more importantly, it also does not reflect the information about small and fleeting mis-pricings that are used by the likes of high-frequency traders. There have been even recent examples of wild market fluctuations largely attributable to the actions of such traders.

Further, as I have blogged about earlier, systemically too prices are extremely vulnerable to even small shocks administered through the random actions of noise traders/trading. Therefore deviations from the fundamentals will be a commonplace feature of equity markets.

In this context, Chris Dillow points to a new working paper by Brock Mendel and Andrei Shleifer where they claim that "rational but uninformed traders occasionally chase noise as if it were information, thereby amplifying sentiment shocks and moving price away from fundamental values". They show that even without large numbers of noise traders and significant sentiment shocks, a small numbers of these noise traders can have an impact on market equilibrium disproportionate to their size in the market. They write about how sophisticated but uninformed investors learn from prices,

"... such investors may entertain more complicated models and use other public information, such as bond ratings, in forming their demands... If ratings agencies usually do a good job of assessing the riskiness of bond offerings, it may be rational for uninformed traders to use these ratings as a rule-of-thumb to assess underlying value. On those occasions when the ratings agencies are wrong, this will induce correlated mistakes among the mass of uninformed traders, which will overwhelm the price impact of any better-informed traders in the market. It is only when the direct news about valuations reaches the uninformed investors that the market would correct itself. In this example, uninformed traders would rationally end up chasing noise thinking that it reflects information."

In other words, markets go wrong because sometimes rational but uninformed traders mistakenly believe that a price rise is driven by informed traders and not by noise traders and these noise traders, however small, occasionally carry enough momentum to tip the scales in favor of their trend. But as Chris Dillow rightly points out, this deviation from fundamentals "is only possible because very often prices really are right and do embody genuine information" and therefore "markets are occasionally inefficient precisely because they are so often efficient".

Interestingly, in view of the considerable range of non-fundamental information on market psychology (animal spirits of the market participants) that prices reflect, Rajiv Sethi has written that EMH be renamed as the invincible markets hypothesis (IMH)!

Update 1 (18/10/2013)

John Cassidy has a nice article that debunks the notion of efficiency with financial markets.

EMH or IMH?

I have blogged earlier about the two-fold implications of the EMH - that prices reflect all publicly available information (both events that have occurred and those that markets expect to happen) about the underlying intrinsic value of financial assets (strong form of efficiency) and prices of these assets are fundamentally unpredictable (weak form of efficiency).

The first implies that since price of an asset accurately reflects the (appropriately discounted) stream of earnings that it is expected to yield over the course of its existence), price signals can be relied upon to efficiently allocate resources among the various sectors within the financial markets. The second means that it is impossible to beat the market on a sustained basis by arbitraging on mispricings (and therefore passive index funds are more efficient investments than actively picking stocks).

Rajiv Sethi has an excellent post that draws the distinction between the allocative and informational efficiency dimensions of EMH, with the former corresponding to the strong and the latter to the weak forms of efficiency respectively, and argues that neither are states of efficiency. He writes,

"Prices may indeed contain "all relevant information" but this includes not just beliefs about earnings and discount rates, but also beliefs about "sentiment and emotion." These latter beliefs can change capriciously, and are notoriously difficult to track and predict. Prices therefore send messages that can be terribly garbled, and resource allocation decisions based on these prices can give rise to enormous (and avoidable) waste. Provided that major departures of prices from intrinsic values can be reliably identified, a case could be made for government intervention in affecting either the prices themselves, or at least the responses to the signals that they are sending. Under these conditions it makes little sense to say that markets are efficient, even if they are essentially unpredictable in the short run."

In view of the considerable range of non-fundamental information on market psychology that prices reflect, Rajiv Sethi prefers that EMH be renamed as the invincible markets hypothesis (IMH)!

More debates on EMH

The much debated Efficient Market Hypothesis (EMH) revolves around two implications of the claim that market prices are efficient - prices of all traded financial assets reflect all known information (and therefore market prices are always right) and nobody can predict the market it on a sustained basis (and thereby beat it continuosly).

Nick Rowe has two interesting observations on the EMH

1. In the first Nick Rowe explores the interaction between the extent to which EMH is believed to be true with the extent to which it is actually true by using a standard demand-supply curve. He writes,

"The downward-sloping (hence "demand") curve shows the extent to which EMH is true as a function of the extent to which people believe EMH is true. At one extreme, if nobody believes that EMH is true, so people believe there is no relation between market prices and fundamental values, then each individual has a strong incentive to research carefully the fundamental values of assets before buying and selling, and so market prices will reflect all the information available to everyone, so EMH will be true. At the other extreme, if everyone believes EMH is true, so that market prices already reflect all available information on fundamental values, then no individual has any incentive to collect and process that information, and everybody picks assets by throwing darts, or buys the index, so market prices will not reflect any available information on fundamentals, so EMH will be false.

The upward-sloping (hence "supply") curve shows the extent to which people will believe that EMH is true as a function of the extent to which it is actually true. If EMH is totally false, people will (eventually) learn that it is false, and that it is sensible to collect and process information on fundamental values. If EMH is true, people will learn that too, and won't bother to collect and process information. There will probably be lags in both curves. There will be a lag in the supply response if learning the extent of market efficiency takes time and experience. There will be a lag in the demand response if it takes time for market prices to drift away from fundamental values when people stop collecting information and start throwing darts instead. Maybe you can get a cobweb model out of these lags...

If a change in the market structure (allowing short sales?) made the market a more efficient processor of information, that would be represented by an upward/rightward shift of the demand curve. Note that a shift in the demand curve would be partly offset by a movement along the curve. A decrease in the costs of collecting information would be represented by a leftward/upward shift in the supply curve (more people collect information, thereby acting as if they believed EMH were false. Again, the shift in the curve is partly offset by a movement along the curve."

2. It has often been argued that EMH is more a figment of the imagination (or abstruse theoretical models) of ivory tower academics and is almost unknown among traders. Taking a cue from this, Nick Rowe draws the distinction between EMH from the perspectives of the Econ Dept, for whom it makes a lot of sense, and the Business School where it makes much less sense.

About the difference between the two schools, and more specifically between business and economics, he writes that the Business School asks the question, "How can I maximise profits?", while the Economics Department teaches the question, "When you put a bunch of people together, each one trying to maximise profits, what happens?". He writes,

"The Biz Skool student says "I'm going to start a hamburger stall on Main street; it's a great profit opportunity!". The Econ Dept student should not reply "Don't be silly; if it were profitable to start a hamburger stall there, someone would already have done it!". The Biz Skool student is merely doing what the Econ Dept student's theory says he will do: hunting for profit opportunities. And if all the Biz Skool students did follow the Econ student's advice, then there would be an opportunity for profit, and the Econ student's theory would be wrong... EMH applied to markets for financial assets is no different from EMH applied to markets for hamburgers. Are you a player/entrepreneur? Or an observer/economist?"

Failure of the rational economic agent?

The search for an explanation for the sub-prime mortgage bubble led financial and economic crisis leads us to debates about whether it was a failure of forms of ownership and control mechanisms - private ownership (and capitalism) Vs public ownership, markets Vs government regulation etc.

One of the arguments being made is that the crisis has exposed the weaknesses inherent in the "efficient markets" hypothesis, that underpins both modern financial and real economy markets. That the markets cannot always efficiently allocate resources among competing investment alternative, is amply demonstrated by the sub-prime mortgage bubble. But, as Chris Dillow points out, this line of reasoning runs into problems with the recent happenings in the financial markets - you can't beat the market on a consistent basis (thereby confirming EMH), but prices deviate massively away from "fundamentals" (or the presence of fat tails, going contrary to EMH).

In another post, Dillow points to two specific reasons for banks failure to self-regulate - rational self-interest led individuals to create and hold "toxic assets" that jeopardized the interests of banks’ owners, and chief executives lacked the knowledge (or ability or incentives) to control a complex sprawling bank. Interestingly, these reasons are the same as that we commonly attribute to government failures - bureaucrats failing to act in the public interest, and central planners lacking the knowledge (or ability or incentives) to control the economy!

I am inclined to go with Dillow's argument that the only way to explain this is by reasoning that markets and institutions, both public and private, are populated by individuals, who are themselves constrained by "bounded rationality" and often prisoners of their own vested interests. In the first case, even if markets are not efficient, bounded rationality constrains traders from profiting from small and minuscule mis-pricings and profiting from fleeting opportunities.

There is another argument that the financial crisis is an indictment of traditional capitalist ownership structures and not free markets. This is explained by the moral hazard and information asymmetry inherent in the principal-agent model modern financial institutions, and the difficulty in managing complex financial instruments and markets. While the former is related to the conflict between the self-interest of the managers and that of shareholders, the latter is a natural consequence of the bounded rationality of human beings.

Is Modigliani-Miller theorem the next casualty?

The dramatic events in the aftermath of the bursting of the sub-prime mortgage bubble has destroyed many reputations and repudiated much of the theoretical edifice of modern finance including the famous Efficient Market Hypothesis (EMH). The latest casualty may be the Modigliani-Miller theorem, the cornerstone of corporate finance, which states that under cetain conditions (absent taxes and in an efficient market) a firm’s value is unaffected by its capital structure (deb-equity ratio).

The Economist points to the evidence that MM theory may not hold - in the form of the reluctance of leverage-hungry bankers to increase their equity base on the grounds that "equity is too expensive and will have a knock-on effect on the price of credit". This arguement that flies in the face of MM theory, comes in the face of the tumultuous events of the past twelve months that have highlighted the need for banks to have deep enough equity buffers to cover for losses and the cost of any potential bailout.

As The Economist explains, "This theory says that although equity owners demand a higher return than creditors, their required rate of return on each unit falls as the amount of equity rises, since profits after interest become less volatile. The cost of debt falls too, since creditors have a bigger buffer beneath them. The firm’s blended cost of capital is unchanged, and is driven largely by the risk of the firm’s assets, not how they are paid for."

The article points to "quirks in the real world", which comes in the way of MM by making debt very attractive and equity costly and therefore uncompetitive, atleast in case of banks

1. The tax-deductibility of interest costs give debt an advantage and incentivize financial institutions to gorge on debt. In the lead up to the sub-prime crisis, leverage had accordingly become the pivot that amplified the gains of many banks, leave alone hedge funds and private equity firms.

2. Banks enjoy the advantage of using their deposits (which are liabilities), in addition to their equity, to fund their assets, and having these deposits covered with government backed guarantees. Other creditors too now enjoy a near-explicit government guarantee.

3. Further the deposits are priced at the Central Banks' short term interest rates, whereas the returns they make (or interests they charge) on their long term debt (or loans) are much higher. This coupled with access to unlimited short-term liquidity, thanks to the generous liquidity auction windows, means that banks do not have to worry about financing their short-term liabilities even if mismatches arise.

4. Further, the prevailing low interest rates means that the cost of raising debt is minimal compared to the returns available from the numerous investment alternatives. America’s mega-banks typically paid a blended annual interest rate on borrowings and deposits of 1-2% in the second quarter.

5. Finally, armed with the confidence (and resulting moral hazard) and societal/systemic underwirting that they are "too-big-to-fail", banks prefer smaller equity buffers and periodic bailouts over big equity buffers that push up the price of credit but make things safer.

The solution to keeping banks honest and covering the cost of potential bailouts from a systemic crisis include raising the ratio of equity to risk-adjusted-assets (or capital adequacy ratio) or even simple asset based reserve ratios, knockout ratio (ratio of gross NPAs to equity), force creditors to take the hit, have a layer of convertible debt (that gets used up after the equity is covered) etc.

In defence of MM theorem, it can be argued that the aforementioned "quirks in the real world" means that the pre-conditions required for it to hold - absence of taxes, bankruptcy costs, and asymmetric information, and efficient market - are not available.


Update 1 (20/3/2010)

The MM Theorem states that a firm’s value as a business enterprise is independent of how it is financed, i.e, its debt (leverage) to equity ratio. The debt-equity ratio determines how the risky cash flow from operations is divided among creditors and owners, but it does not affect whether the firm is fundamentally viable as an on-going concern.

As Greg Mankiw points out, the rate of return on equity should be endogenous (dependent) to the degree of leverage - if a bank is less levered, its equity will be safer, and the required rate of return (for both equity and debt) should fall. However, a bank with little or almost no leverage (and making loans with its own capital) will not play any "maturity transformation" role that conventional banks and other intermediaries play by borrowing short and lending long. And it has for long come to be accepted that this maturity transformation is a crucial feature of a successful financial system.

In other words, as Mankiw puts it, the debate is between whether as the Modigliani-Miller theorem says leverage and capital structure are irrelevant, or as many bankers claim they are central to the process of financial intermediation. However, given the central role played by maturity mismatch in all banking panics and financial crises, it is a moot point as to what value maturity transformation has. Do the benefits of our current highly leveraged financial system exceed the all-too-obvious costs?

Trend momentum and bubbles - an asset pricing model

The post-mortem after the sub-prime mortgage crisis has called to question many of the fundamental tenets of modern financial and capital markets theory, none more so than the ability of efficient market hypothesis (EMH) to explain the risk-return dynamics in asset pricing and the build up of bubbles. The prevailing belief, arising from the modern financial theories, that market prices were efficient - prices of all traded financial assets reflect all known information and nobody can predict the market and thereby beat it on a sustained basis - gave no place for harmful aberrations like asset bubbles and therefore rendered the need for intrusive government regulatory interventions superfluous.

Dimitri Vayanos and Paul Woolley (full paper here) are the latest to question the relevance of EMH, relegating it to a more specific and limiting case of asset pricing, and propose their version of asset pricing model "in terms of a battle between fair value and momentum driven by principal-agent issues", in which "investment agents’ rational profit seeking gives rise to mispricing and volatility".

The trace the crucial flaw in existing capital market theories as the assumption that prices are set by the army of private investors with investors investing directly in equities and bonds, ignoring the reality of professional intermediaries -banks, fund managers, brokers - who, as agents, trade on behalf of the overwhelming majority of their principals, the investors. This delegation, coupled with the incentive distortions in the prevailing executive pay structures, creates principal-agent problems and mis-aligns the interests of investors and intermediaries.

Vayanos and Woolley introduce agents into their asset pricing models and point attention to the importance of price trending or momentum which are commonly observed in financial markets. As momentum builds up on a sector (or an asset class), funds invested in value sectors/assets (or those with traditionally strong fundamentals) languish and cause investors to demand (on their fund managers) higher returns by switching to the trend (or growth) sectors/assets, thereby further adding to the momentum on those growth sectors/assets. Faced with the risk of losing their investors, value managers are left with no alternative but to join the growth bandwagon and the trend momentum. They write that asset pricing becomes a battle between fair value and momentum, and propose a rational theory of momentum and reversal based on delegated portfolio management,

"Momentum is incompatible with an efficient market and has proved difficult to explain in the traditional framework... Central to the analysis is that investors have imperfect knowledge of the ability of the fund managers they invest with. They are uncertain whether underperformance against the benchmark arises from the manager's prudent avoidance of over-priced stocks or is a sign of incompetence. As shortfalls grow, investors conclude incompetence and react by transferring funds to the outperforming managers, thereby amplifying the price changes that led to the initial underperformance and generating momentum... rational profit seeking by agents and the investors who appoint them gives rise to mispricing and volatility. Once momentum becomes embedded in markets, agents then logically respond by adopting strategies that are likely to reinforce the trends.

Explaining the formation of asset pricing in this way seems to provide a clearer understanding of how and why investors and prices behave as they do. For example, it throws fresh light on why value stocks generally outperform growth stocks despite offering seemingly poorer earnings prospects. The new approach offers a more convincing interpretation of the way stock prices react to earnings announcements or other news. It also shows how short-term incentives, such as annual performance fees, cause fund managers to concentrate on high-turnover, trend-following strategies that add to the distortions in markets, which are then profitably exploited by long-horizon investors."

Building up on the momentum trading model of asset pricing, Mark Thoma outlines three pre-conditions to generate a bubble,

"First, an idea that makes people believe that higher returns are available without assuming more risk needs to be present. Second, there must be a source of liquidity to inflate the bubble. This can come from external sources such as high saving or low interest rate policy, or it can come from reallocation of existing investments (e.g. when people in the U.S. stopped loaning to foreign governments prior to the Great Depression so that they could chase the higher returns at home). And third, there must be regulatory and/or market failures that allow the bubble to inflate with little or no resistance."

In other words, asset bubbles can get blown even without a liquidity build-up by mere reallocation of investible funds to the momentum sector/assets (itself a market failure). The perception that there is some great idea at work that is driving up these prices can come from different sources. During the Great Depression, it was the conviction that electricity and the internal combustion engine (among other technological advances) had ushered in an era of higher productivity; the dot com bubble promised higher productivity from the internet; and in the present crisis, financial innovation coupled with the idea that policymakers and the market could maintain the Great Moderation led to the idea that higher returns could be generated without a corresponding increase in risk.

EMH and the role of arbitrageurs

The Efficient Market Hypothesis (EMH) has borne the brunt of the attacks against modern financial engineering and theories in the aftermath of the bursting of the sub-prime mortgage bubble. The EMH had argued that prices of all traded financial assets reflect all known information and any new random information is immediately traded into the price of the asset or any deviation from the true value (by a noise trader) of the security is swiftly traded away. This also has been taken to mean that nobody can predict the market and thereby beat it on a sustained basis. Now here comes more "stakes through the heart of EMH".

In a superb post at Baseline Scenario, Mike Konczal points to a classic 1997 paper by Andrei Shleifer and Robert Vishny, The Limits of Arbitrage, which illustrated the difference between the conventional models of arbitrage, which required no capital and entailed no risk, with the real world where both assumptions fail. They argue that professional arbitrage, typically done by traders with other people's capital, "becomes ineffective (in bringing security prices to their fundamental values) in certain circumstances, when prices diverge far from fundamental values". Such extreme circumstances and the associated volatility exposes arbitrageurs to "risks of losses and the need to liquidate the portfolio under pressure from investors in the fund". Konczal refers to the role of arbitrageurs thus,

"(Arbitrageurs) will take prices that are out of line and bring them back into line, making a good fee and making prices reflect all available information, the very building block necessary for EMH to work... (They) can’t do their job if they are time or credit constrained. Specifically, if they are highly leveraged, and prices move against their position before they return to their fundamental value – if the market stays irrational longer than they can remain solvent – they’ll collapse before they can do their job."

In other words, under certain cirumstances, markets may deviate from the true value and the arbitrageurs may fail to price in or trade away the deviation, thereby negating the EMH. In these circumstances, traders face actual constraints over scarce resources such as time and capital and fail to get to the other side of the trade.

Arbitrage is defined as the "simultaneous purchase and sale of the same, or essentially similar, security in two different markets for advantageously different prices". Arbitrageurs perform the important role of aligning prices across all markets, in accordance with the "law of one price" and thereby keeping the markets efficient. Accordingly, in their absence, prices can stray away from their true values, leaving the market vulnerable to manipulation and bubbles.

Konczal argues that bond and forex markets, where it is either easier to calculate valuations or to go after Central Bankers attempting to maintain non-market exchange rates, attracts arbitrageurs. In contrast, stock markets - with their difficulty of valuations and long delays in realizing gains - and housing markets with the lack of instrumenbts to directly hold postions in the housing market, are not very attractive for arbitrageurs. This post-facto rationalization sits in well with the relative volatility levels across these markets in the build-up and aftermath of the sub-prime bubble.

About the claim that nobody can systematically beat the stock market, implying nobody can predict a market crash, Richard Serlin writes,

"For EMH to be wrong, or very far from the truth, all you have to show is that you can predict with just a substantial degree of accuracy. So, if you can just show, for example, that the odds of a stock market crash are far higher in years when the P-E ratio is much higher than average (or for housing crashes the buy-rent, or price-household income ratio), or that the expected risk-adjusted long run return is much lower than average, or other “anomalies” (anomalous to the EMH) like this, then you can show that the EMH is substantially far from the truth."

And about the strong possibility of deviations from true value persisting and staying beyond the reach of arbitrageurs,

"A smart rational investor is limited in how much of a mispriced stock he will purchase or sell by how undiversified his portfolio will become. For example, suppose IBM is currently selling for $100, but its efficient, or rational informed, price is $110. It must be remembered that the rational informed price is what the stock is worth to the investor when added in the appropriate proportion to his properly diversified portfolio of other assets. Such a savvy investor will purchase more IBM as it only costs $100, but as soon as he purchases more IBM, IBM becomes worth less to him per share, because it becomes increasingly risky to put so much of his money in the IBM basket. By the time this investor has purchased enough IBM that it constitutes 20 percent of his portfolio, the stock may have become so risky that it’s worth less than $100 to him for an additional share. At that point he may have only purchased enough IBM stock to push the price to $100.02, far short of its efficient market price of $110. Thus, if the rational and informed investors do not hold or control enough—a large enough proportion of the wealth invested in the market—they may not be able to come close to pushing prices to the efficient level."

Update 1 (10/4/2010)
Denis Gromb and Dimitri Vayanos review the "limits to arbitrage" – whereby arbitrageurs cannot always raise the capital they need - and argues that regulation incentivising or even forcing arbitrageurs to take less risk could make everyone better off, arbitrageurs included. However, as they write, there is no unanimity on what is the best approach to achieve this - risk-based capital requirements or taxes and subsidies or a lender of last resort policy or asset purchase programs or something else?

Thaler on EMH

I really like this article from Richard Thaler. The description of Efficient Market Hypothesis (EMH) is excellent,

"The EMH has two components that I call "The Price is Right" and "No Free Lunch". The price is right principle says asset prices will, to use Mr Fama’s words "fully reflect" available information, and thus "provide accurate signals for resource allocation". The no free lunch principle is that market prices are impossible to predict and so it is hard for any investor to beat the market after taking risk into account."

And on the "price is right" component and examples of the deviation from it,

"As early as 1984 Robert Shiller, the economist, correctly and boldly called this 'one of the most remarkable errors in the history of economic thought'. The reason this is an error is that prices can be unpredictable and still wrong; the difference between the random walk fluctuations of correct asset prices and the unpredictable wanderings of a drunk are not discernable... The prices of closed-end mutual funds (whose funds are traded on stock exchanges rather than redeemed for cash) are often different from the value of the shares they own. This violates the basic building block of finance – the law of one price – and does not depend on any pricing model... When 3Com, the technology company, spun off its Palm unit, only 5 per cent of the Palm shares were sold; the rest went to 3Com shareholders. Each shareholder got 1.5 shares of Palm. It does not take an economist to see that in a rational world the price of 3Com would have to be greater than 1.5 times the share of Palm, but for months this simple bit of arithmetic was violated."

While clearly stating that "markets can be wrong and the price is not always right", he draws two lessons for the "free lunch" component,

"The first is that many investments have risks that are more correlated than they appear. The second is that high returns based on high leverage may be a mirage. One would think rational investors would have learnt this from the fall of Long Term Capital Management, when both problems were evident, but the lure of seemingly high returns is hard to resist. On the price is right, if we include the earlier bubble in Japanese real estate, we have now had three enormous price distortions in recent memory. They led to misallocations of resources measured in the trillions and, in the latest bubble, a global credit meltdown. If asset prices could be relied upon to always be "right", then these bubbles would not occur. But they have, so what are we to do?"

In defense of EMH

The sub-prime mortgage crisis may have battered many reputations, and questioned many of the fundamental tenets of modern finance like the Efficient Market Hypothesis (EMH) and Modern Portfolio Theory (MPT). However, in an excellent post, Edward Glaeser argues that bubbles and market irrationality doesn’t mean that markets are inefficient (prices do not reflect all relevant information and shares are under- or over-valued) and thereby abound with easy arbitrage opportunities.

He makes the distinction between "inefficiency" and "irrationality" and points to an old paper by Brad DeLong, Andrei Shleifer, Larry Summers and Robert Waldmann which showed that less-than-rational (or irrational) "noise traders" could move markets even when rational traders have arbitraged away all the free lunches. He writes,

"The market may be buffeted by strange forces, but those people who claim to be able to earn fortunes by understanding those forces are more likely to be charlatans than those who argue for the continuing relevance of the EMH. Still, recognizing the occasional madness of markets can provide a bit of investment guidance. The difficulty inherent in finding free lunches means that buyers can’t just buy a house, or a mortgage-backed security or a stock, trusting that the market has priced things correctly. A house doesn’t become a good buy just because some other idiot paid a fortune for a similar home down the street. A similar fool may not be around when you are looking to sell."

Update 1
Jeremy Siegel writes in defence of EMH (prices of securities reflect all known information that impacts their value), "The hypothesis does not claim that the market price is always right. On the contrary, it implies that the prices in the market are mostly wrong, but at any given moment it is not at all easy to say whether they are too high or too low... CEOs of the failed financial firms or the regulators who did not see the risks that subprime mortgage-backed securities posed to the financial stability of the economy. Regulators wrongly believed that financial firms were offsetting their credit risks, while the banks and credit rating agencies were fooled by faulty models that underestimated the risk in real estate."

Update 2
Rajiv Sethi argues that though it is possible to detect bubbles it is difficult to make money using that information - "the eventual size of the bubble and the timing of the crash are unpredictable. Selling short too soon can result in huge losses if one is unable to continue meeting margin calls as the bubble expands. Trying to ride the bubble for a while can be disastrous if one doesn't get out of the market soon enough".

He goes along with Richard Thaler in claiming that EMH may be only partially correct. While recent events have reinforced the claim that you can’t always beat the market or atleast can't do so without taking on more risk, it may not be correct to argue that "the market price is always right", especially given the widespread evidence of bubbles (despite Fama's denial).

Nick Rowe's take on EMH is very incisive and reflective of how differently academics and traders view EMH, "From the Econ Dept perspective, watching the players play, the Efficient Market Hypothesis makes a lot of sense. From the Biz Skool perspective, as one of the players playing, the EMH makes much less sense."

Update 3
Mark Thoma writes, "There are two versions of the efficient markets hypothesis, a strong version and a weak version. According to the strong version prices accurately reflect the underlying intrinsic value of financial assets, but the weak version only requires that prices be unpredictable, they don't have to accurately reflect fundamental values. The strong version is, well, too strong and it seems clear that this condition is not satisfied in asset markets, at least not on a continuous basis. The weak version, however, does have support (though even here there is not universal agreement). The distinction between the strong and weak versions, and the assertion that the weak version holds even if the strong version does not, is often used as a defense of the efficient markets hypothesis."

In light of this, Rajiv Sethi rephrases EMH as Invincible Market Hypothesis.