Month: October 2015 | Page 4

13 October, 2015

Why smart people fall for Ponzi schemes

Sometime back a friend called and had a rather peculiar question. He wanted to know how he could go about stopping one of his friends from peddling a Ponzi scheme.

This was a rather tricky question. Just explaining to someone selling a Ponzi scheme that he is selling a Ponzi scheme, does not really work. The first question I asked my friend was how was his friend doing in life? “He is doing well for himself,” said my friend with a chuckle. “He works in a senior position with a corporate and has managed to sell the scheme to at least ten people in the housing society that he lives in.”

“If he is working at a senior position, why is he doing this?” I asked my friend, and immediately realised that I had asked a rather stupid question. “I was hoping you would be able to answer that,” my friend replied.

This column is an outcome of that conversation.

Over the last ten years of writing on Ponzi schemes I have come to the realisation that many people who sell and in the process invest in Ponzi schemes are not just victims of greed or a sustained marketing campaign, as is often made out to be.

There is much more to it than that. Many individuals selling and investing Ponzi schemes (like my friend’s friend) come from the upper strata of the society, are well educated and know fully well what they are doing. In case of my friend’s friend he was selling a multilevel marketing scheme for which the membership fee is more than Rs 3 lakh. So, the scheme is clearly aimed at the well to do.

On becoming a member you are allowed to sell products, some of which cost as much as a lakh. Of course, you will also be making new members as well. The bulk of the membership fee paid by the new members you make, will be passed on to you. Hence, the more people you get in as members, the more money you make. Selling products is just incidental to the entire thing, given that a membership costs more than Rs 3 lakh.

This is a classic Ponzi scheme in which money being brought in by the new investors (through membership fee) is being used to pay off old investors (who had already paid their membership fee), with the business model of selling products providing a sort of a façade to the entire thing.

So, the question is why does the smart lot fall for Ponzi schemes? As John Kay writes in Other People’s Money—Masters of the Universe or Servants of the People: “Even if you know, or suspect, a Ponzi scheme, you might hope to get out in time, with a profit. I’ll be gone, you’ll be gone.”

People feel that the money will keep coming in. Or what the financial market likes to call ‘liquidity,’ won’t dry up. And this is the mistake that they make.
Kay defines liquidity as the “capacity of the supply chain to meet a sudden or exceptional demand without disruption…This capability is achieved…in one or both of two ways: by maintaining stocks, and by the temporary diversion of supplies from other uses.”

Kay in his book compares the concept of liquidity to the daily delivery of milk in the city of Edinburgh in Scotland where he grew up. As he writes: “In the Edinburgh of fifty years ago fresh milk was delivered everyday…At ordinary times our demand for milk was stable. But sometimes we would have visitors and need extra milk. My mother would usually tell the milkman the day before, but if she forgot, the milkman would have extra supplies on his float to meet our needs. Of course, if all his customers did this, he wouldn’t have been able to accommodate them.”

What is the important point here? That people trusted the milkman to deliver every morning. And given that they did not stock up on milk, more than what was required on any given day. If the trust was missing then the system wouldn’t have worked.

Take the case of how things were in the erstwhile Soviet Union. As Kay writes: “In the Soviet economy there was no such confidence, and queues were routine, not just because there was an actual insufficiency of supply – though there often was – but because consumers would rush to obtain whatever supplies were available.”

And how does that apply in case of Ponzi schemes? As I mentioned earlier, the individual selling Ponzi schemes feel confident that the money will keep coming in. Those they sell the scheme also become sellers. And for the Ponzi scheme to continue, the new lot also needs to have the same confidence.

In the milk example shared above, if people of Edinburgh had started hoarding milk, the liquidity the system had would have broken down. The confidence that milk would be delivered every day kept the system going. Along similar lines, the confidence that money will keep coming into a Ponzi scheme, gets smart people into it as well.

Of course, this confidence can change at any point of time. And if a sufficient number of people stop feeling confident, then the scenario changes. The money coming into the Ponzi scheme stops and the moment the money coming into the scheme becomes lesser than the money going out, it collapses. So that’s the thing with liquidity, it is there, till it is not there.

In my friend’s friend case, members down the line would stop making more members. Also, members who had bought the membership from my friend’s friend are likely to turn up at his doorstep and demand their money back.

And given that he has told membership to many people in his housing society, he can’t just get up and disappear, given that he is essentially not a scamster. He is a family man with a wife, children and parents, who stay with him.

Hence, he will have to refund them, if he has continue living in the housing society in a peaceful environment. How will he do that? Let’s go back to the definition of liquidity as explained above. Liquidity is maintained by “by maintaining stocks, and by the temporary diversion of supplies from other uses.” So my friend’s friend can pay up from the money he has already accumulated by selling these Ponzi schemes. If that is not enough, he can dip into his savings. And if even that is not enough, he can hopefully take the money being brought in by the new members (if at all there are people like that) and hand them over to the members demanding their money back.

Of course, by doing this he will only be postponing the problem, given that he would have to later deal with the new members.

Long story short—he is screwed!

The column originally appeared on The Daily Reckoning on Oct 13, 2015

9 October, 2015

Of Japanese deflation, global money printing and quest for economic growth

The human obsession with economic growth has perhaps been best captured by E.B. White in an essay called A Report in January published in January, 1958. The essay is a part of a book titled Essays by E.B. White.

In this essay White writes: “The theory is that if you shoot forty thousand deer one year you aren’t getting ahead unless you shoot fifty thousand the next, but I suspect there comes a point where you have shot just exactly the right number of deer. Our whole economy hangs precariously on the assumption that the higher you go the better off you are, and that unless more stuff is produced in 1958 than was produced in 1957, more deer killed, more automatic dishwasher installed…more heads aching so they can get the fast fast fast relief from a pill, more automobiles sold, you are headed for trouble, living in danger and maybe in squalor.”

This obsession with economic growth has been at play in the aftermath of the financial crisis which broke out in September 2008, when the investment bank Lehman Brothers went bust. The central banks and governments all around the Western world unleashed an era of easy money, by printing money and maintaining low interest rates.

This was done in the hope of people borrowing and spending more. So, with interest rates remaining low, people were likely to buy more homes, more cars, more consumer goods and so on. And in the process there would be more economic growth.

Most central bankers did not want the Western world to turn into another Japan. Right through the eighties, the Japanese stock market and the real estate market had huge bubbles. These bubbles burst towards the end of the eighties. And it is widely believed by economists that the Japanese economy never recovered from this. It entered into an era of deflation (the opposite of inflation, when prices fall).

When the economy is in a deflationary scenario, people tend to postpone their purchases in the hope of getting a better deal. Once this starts to happen, the business earnings start to fall. This leads to businesses cutting costs by firing people among other things. All this impacts economic growth. Businesses cut prices further, in the hope of persuading more people to buy things. And so a deflationary cycle sustains itself.

This is something that Western central bankers wanted to avoid. And this led to the unleashing of an era of easy money, which continues. In fact, as Raghuram Rajan, the governor of the Reserve Bank of India, recently said in a speech: “The canonical example here is Japan, where many are persuaded that the key mistake it made was to slip into deflation, which has persisted and held back growth.”

There is a great fear that what has been happening in Japan will happen in large parts of the Western world as well, if central banks don’t act and flood their financial systems with money.

In fact, Andrew Hallande, the Chief Economist of the Bank of England recently suggested the elimination of paper money. This would allow central banks to impose negative interest rates (which some central banks have already tried in Europe). When there is a negative interest rate on deposits, the bank will charge people for depositing their money in a bank account. This will lead to people spending their money instead of keeping it in a bank account, where its value will fall because of a negative interest rate. The spending that follows because of negative interest rates will lead to economic growth.

This is only possible if there is ‘only’ digital money and no paper money. If banks apply negative interest rates as of now, people can simply withdraw that money in the form of paper money and keep it under their mattresses or wherever they want to. Hence, Hallande’s suggestion of only digital money to revive economic growth.

Such suggestions come from the fear of deflation. But the question is are things in Japan as bad as they are made out to be? James Rickards in his book The Death of Money, talks about a speech where he heard a former deputy finance minister of Japan, Eisuke Sakakibara, speak.
“He [i.e. Sakakibara] made the often-overlooked point that because of Japan’s declining population, real GDP per capita will grow faster than real aggregate GDP.”

What this basically means is that because of declining population in Japan, even if the overall Japanese economy does not grow or grows at a very slow pace, there will still be more economic growth per person in Japan.

As Rickards writes: “Far from a disaster story, a Japan that has deflation, depopulation, and declining nominal GDP can nevertheless produce robust real per capita GDP growth for its citizens. Combined with the accumulated wealth of the Japanese people the condition can result in well-to-do society even in the face of nominal growth that would cause most central bankers to flood the economy with money.”

In fact, Rajan made a similar point in his recent speech. As he said: “A closer look at the Japanese experience suggests that it is by no means clear that its growth has been slower than warranted let alone that deflation caused slow growth. It is true that after its devastating crisis in the early 1990s, Japan may have prolonged the slowdown by not taking early action to clean up its banking system or restructure over-indebted corporations. But once it took decisive action in the late 1990s and early 2000s, Japanese growth per capita or per worker looks comparable with other industrial countries.”

This becomes clear from the accompanying table:

In fact, one of the fears of deflation, as explained earlier, is that it leads to unemployment. Nevertheless that doesn’t seem to be the case in Japan. As Rajan said: “Japanese unemployment has averaged 4.5% between 2000-2014, compared to 6.4% in the US and 9.4% in the Euro area during the same period. In part, the Japanese have obtained wage flexibility by moving away from the old lifetime unemployment contracts for new hires to short term contracts. While not without social costs, such flexibility allows an economy to cope with sustained deflation”

So, it’s time that central bankers take a re-look at the entire Japanese experience and revise their views on the idea of deflation.

Meanwhile, Japan seems to be getting ready for more money printing. As they say, the more things change, the more they remain the same.

The column originally appeared on October 9, 2015 on The Daily Reckoning

9 October, 2015

Mr Jaitley, for war on black money, make political funding digital and through cheques. No cash.

By September 30, 2015, those who had black money hidden abroad had to declare it to the government. On this “declared” black money, the government will charge a tax of 30 per cent and a penalty of 30 per cent.

From the numbers that have been put out by the ministry of finance, and the fact that in the last one year the government has spent a huge amount of political capital on it, it’s clear that the effort to unearth black money that has moved abroad has been a complete flop.

During the compliance period offered by the government, 638 declarants declared assets and income amounting to`4,147 crore. There is perhaps more black money hidden just in Lutyens’ Delhi. Given that the government is levying a 30 per cent tax and 30 per cent penalty on this money, the total revenue collected from this effort would be `2,488 crore. This is not even a drop in the ocean of black money in this country.

In response to these poor collections, finance minister Arun Jaitley wrote on his Facebook page: “The bulk of black money is still within India. We thus need a change in national attitude where plastic currency becomes the norm and cash an exception. Being seized of this problem, the government has been working with various authorities in order to incentivise this change. The opening of a large number of payment gateways, Internet banking, payment banks and the emerging reality of e-commerce will prompt the use of banking transactions and plastic money rise significantly.”

With the rise of plastic money, the hope is that the total amount of black money generated in the Indian financial system will go down. With plastic money it is fairly easy to keep track of transactions and hence tax them. While this may or may not happen, there is a simple thing that Mr Jaitley and the Modi government can do to kickstart their war against domestic black money.

It should be made compulsory for political parties to receive donations only through the plastic money route and in the form of cheques. Given that it is so passionate about unveiling the black money in the country, the Bharatiya Janata Party can take a lead on this and start taking in donations only through the plastic money and cheque route, shunning all cash donations.

One bogey that can be raised against this suggestion is about those who do not have a bank account. How will they donate money to a political party if they want to?

The ministry of finance in a press release dated September 4, 2015, had said: “The achievement under Pradhan Mantri Jan DhanYojana (PMJDY) is heading towards saturation. Initial demand for bank accounts was expected to be around 7.5 crore (75 million). However, so far close to 18 crore accounts have been opened. 15.74 crore Rupay Debit cards have been issued.”

If these numbers are to be believed, then most Indians now have access to a formal banking channel. They also have access to debit cards. And this can be used to make donations to political parties as well.

While everyone who has a debit card may not know how to use them currently, it can be easily taught. Prime Minister Narendra Modi has communicated extensively on asking people to give up their subsidised cooking gas cylinders. He can do the same with Rupay debit cards. The government can run ad campaigns around it as well, explaining how these cards are used.

Once donations made to political parties move away from cash, there will be an audit trail. No black money will go into the funding of political parties, breaking the nexus between politicians and those who have black money (read traders and businessmen). Once black money stops political funding, political parties and the government (the present government and the ones to come) are more likely to crack down on domestic black money. Until then they will only make statements because there is no incentive to crack down on black money.

Also, political parties should be brought under the ambit of the Right to Information (RTI) Act. The current government is against this move. In an affidavit submitted to the Supreme Court in late August 2015, the Modi government had said: “If political parties are held to be public authorities under RTI Act, it would hamper their smooth internal working, which is not the objective of the RTI Act and was not envisaged by Parliament. Further, it is apprehended that political rivals might file RTI applications with malicious intentions, adversely affecting their political functioning.”

I guess the only reason the government is opposing political parties being brought under RTI is because then people can file an RTI and be able to get the funding details of political parties. And that is something no political party is comfortable with.

At the state level, real estate companies are big financiers of political parties. Real estate is where most black money gets invested. Once political parties are brought under RTI, this nexus can start to unravel as well.

The nation has a genuine problem of black money. The problem is well known. The solutions to it are also well known. The question is, will our politicians do something about it or will they just keep talking about it?

My bet is on the latter. Yours?

The column originally appeared in The Asian Age and Deccan Chronicle on Oct 9, 2015

8 October, 2015

Why EMIs and interest rates fall more on front pages of newspapers than real life

Regular readers of The Daily Reckoning would know that I am not a great believer in the repo rate cuts leading to an increase in home buying and as well as consumption, with people borrowing and spending more, at lower interest rates. Repo rate is the rate at which the Reserve Bank of India (RBI) lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans.

A basic reason is that the difference in EMIs after the rate cut is not significant enough to prod people to borrow and buy things. Further, they should be able to afford paying the EMI in the first place, which many of them can’t these days, at least when it comes to home loan EMIs.

These reasons apart there is another problem, which the mainstream media doesn’t talk about enough. All they seem to come up with are fancy tables on how interest rates and EMIs are going to fall and how this is going to revive the economy. And how acche din are almost here. Now only if it was as simple as that.

A cut in the repo rate is not translated into exact cuts in bank lending rates. After any repo rate cut, banks quickly cut their deposit rates. They cut their lending rates as well, but not by the same quantum.

As a recent study carried out by India Ratings and Research points out: “In the recent policy cycle, RBI has cut policy rates since January 2015 by a cumulative 125 basis points, banks have cut one year deposit rates by an average 130 basis points and lending by 50 basis points, which includes the base rate cuts in the last one week. Base rate is the rate below which a bank cannot lend. In the last 18 months three-month commercial paper and certificate of deposit rates have fallen by 150 basis points. Thus transmission of policy rates has been more through market rates and banks deposit rates in the last one year.” One basis point is one hundredth of a percentage.

In an ideal world, a 125 basis points cut in the repo rate by the RBI should have led to a 125 basis points cut in the lending as well as deposit rates. But that doesn’t seem to have happened. While the one-year deposit rates have been cut by 130 basis points, the lending rates have gone down by just 50 basis points.

And this is a trend which is not just limited to the current spate of rate cuts by the RBI. This is how things have played out in the past as well. As Crisil Research had pointed out in a report released in February 2015: “Lending rates show upward flexibility during monetary tightening but downward rigidity during easing. Between 2002 and 2004, while the policy rate declined by 200 basis points, lending rates dropped by just 90-100 basis points. Conversely, in 2011-12, when the policy rate rose by 170 basis points, lending rates surged 150 basis points.”

So, the point being that when the RBI starts to raise the repo rate, banks are quick to pass on the rate increase to their borrowers, but the vice-versa is not true.

As India Ratings and Research points out: “The policy cycle is being used by banks to their advantage. A study of the last 10 years shows, that in most cases when policy rates have reduced, deposit rates have comedown faster and the quantum has also been higher compared to lending rates. The same was also true when policy rates were hiked, where lending rates went up and the quantum was also higher compared to deposit rates.”

Also, this time around banks have been quick to cut their base rates, the minimum interest rate a bank charges its customers, after the RBI cut the repo rate by 50 basis points to 6.75%, in September. Having cut their base rates, banks have increased their spreads, and negated the cut in base rate to some extent.
Take the case of the State bank of India. The country’s largest bank cut its base rate by 40 basis points to 9.3%, in response to RBI cutting the repo rate by 40 basis points.

This meant that the interest rate on home loans should have fallen by 40 basis points as well. Nevertheless, the interest rate on an SBI home loan will fall by only 20 basis points. Why is that? Earlier, the bank gave out home loans to men at five basis points above its base rate (or what is known as the spread). To women, the bank gave out home loans at the base rate. Now it has decided to give out home loans to men at 25 basis points above the base rate. In case of women it is 20 basis points.

Hence, interest rate on a SBI home loan taken by a man will be now be 9.55% (9.3% base rate plus 25 basis points). Earlier, the interest rate was 9.75%. This means a fall in interest rate of 20 basis points only and not 40 basis points, as should have been the case.
ICICI Bank has done something along similar lines as well. And this step has essentially negated the cut in the base rate to some extent.

Further, the public sector banks have a problem of huge bad loans, which are piling on. Given this, they are using this opportunity to ensure that they are able to increase the spread between the interest they charge on their loans and the interest they pay on their deposits. This extra spread will translate into extra profit which can hopefully take care of the bad loans that are piling up.

The bad loans will also limit the ability of banks to cut their lending rates. As Crisil Research points out: “High non-performing assets [NPAs] curb the pace at which benefits of lower policy rate are passed on to borrowers. Data shows periods of high NPAs – such as between 2002 and 2004 (when NPAs were at 8.8% of gross advances) – are accompanied by weaker transmission of policy rate cuts. This time around, NPA levels are not as high as witnessed back then, but still remain in the zone of discomfort.”

Another reason banks often give for not cutting interest rates is the presence of small savings scheme which continue to give high interest when banks are expected to cut interest rates. As India Research and Ratings points out: “In the last decade small saving deposit schemes have offered rates between 8-9.3% unrelated to the up-cycle or down-cycle in policy rates. These rates are also politically sensitive since a bulk of this saving is made by elders, farmers and low income groups. In fact in 2009 when repo rates were at a low of 4.75%, PPF and NSC both continued to offer 8% return and in 2012 when the repo rate moved up to 8.5%, PPF offered 8.8% and NSC offered 8.6% return.”

Nevertheless, this time around banks have cut interest rates on their one year deposits by 130 basis points. This is more than the 125 basis points repo rate cut carried out by the RBI during the course of this year.

A more informed conclusion could have been drawn here if there was data available on the kind of interest rate cuts that banks have carried out on their fixed deposits of five years or more. This would have allowed us to carry out a comparison with small savings scheme which typically tend to attract long term savings.

Long story short—EMIs and interest rates fall more on the front pages of business newspapers than they do in real life.

The column originally appeared on The Daily Reckoning on October 8, 2015

7 October, 2015

Experts are bad at forecasting: Remember this, next time you see a forecast

If I ever have the time, the money and the resources, I would like to carry out an experiment. Every day on business TV channels, experts offer their forecasts on stock prices, commodity prices, the direction of the economy, politics of the nation and so on.

There are other experts making forecasts through research reports. As the British economist John Kay writes in Other People’s Money: “Most of what is called ‘research’ in financial sector would not be recognised as research by anyone who has completed an undergraduate thesis.”

Getting back to the topic at hand, I would like to figure out how many of these forecasts eventually turned out to be correct. So, if an analyst says that he expects the price of HDFC Bank to cross Rs 1300 per share in a year’s time, did he eventually get it right.

Also, I would like to figure out whether the “so-called” forecasts were forecasts at all, in the first place? Saying that the HDFC Bank stock price will cross Rs 1300 per share, but not saying when, is not a forecast. As Philip Tetlock and Dan Gardner write in their new book Superforecasting—The Art and Science of Prediction: “Obviously, a forecast without a time frame is absurd. And yet, forecasters routinely make them.”

When it comes to the stock market, there are two kinds of experts who come under this category of making a forecast without a time-frame attached to it. One category is of those who keep saying that the bull market will continue, without really telling us, until when. “Predicting the continuation of a long bull market in stocks can prove profitable for many years—until it suddenly proves to be your undoing,” write Tetlock and Gardner.

The second category is of those who keep saying that the bear market is on its way, without saying when. “Anyone can easily “predict” the next stock market crash by incessantly warning that the stock market is about to crash,” write Tetlock and Gardner.

The broader point is that no one goes back to check whether the forecast eventually turned out to be correct. There is no measurement of how good or bad a particular expert is at making forecasts. I mean, if an expert is constantly getting his forecasts wrong, should you be listening to him in the first place.

But no one is keeping track of this, not even the TV channel.

As Tetlock and Gardner write: “Accuracy is seldom even mentioned. Old forecasts are like old news—soon forgotten—and pundits are almost never asked to reconcile what they said with what actually happened.” And since no one is keeping a record, it allows experts to keep peddling their stories over and over again, without the viewers knowing how good or bad their previous forecasts were.

“The one undeniable talent that talking heads have is their skill at telling a compelling story with conviction, and that is enough. Many have become wealthy peddling forecasting of untested value to corporates executives, government officials, and ordinary people who never think of swallowing medicine of unknown efficacy and safety,” write Tetlock and Gardner.

In fact, in the recent past, many stock market experts were recommending midcap stocks. After the Sensex started crashing the same set of experts asked investors to stay away from midcap stocks as far as possible.

There is a great story I was told about an expert, who was the head of the commodities desk at one of the big brokerages. He was also a regular on one of the television channels as well. This gentlemen kept telling the viewers to keep shorting oil for as long as prices were going up and then when the prices started to fall, he asked them to start buying. This was exactly opposite of what he should have been recommending. Obviously anyone who followed this forecast would have lost a lot of money.

I can say from personal experience that predicting the price of oil is very difficult, given that there are so many factors that are at work. As Tetlock and Gardner write: “Take the price of oil, long a graveyard topic for forecasting reputations. The number of factors that can drive the price up or down is huge—from frackers in the United States to jihadists in Libya to battery designers in Silicon Valley—and the number of factors that can influence those factors is even bigger.”

Nevertheless, the television appearances of the commodity expert I talked about a little earlier, continue. And why is that the case? Tetlock and Gardner provide the answer: “Accuracy is seldom determined after the fact and is almost never done with sufficient regularity and rigor that conclusions can be drawn. The reason? Mostly it’s a demand-side problem: The consumers of forecasting—governments, businesses, and the public don’t demand evidence of accuracy. So there is no measurement. Which means no revision. And without revision, there can be no improvement.” And so the story continues.

One would like to believe that forecasts are made so that people can look into the future with greater clarity. But that is not always the case. Some forecasts are made for fun. Some other forecasts are made to fulfil the human need to know what is coming. Some other forecasts are made to advance political agendas.

And still some other forecasts are made to comfort people “by assuring [them] that their beliefs are correct and the future will unfold as expected,” Tetlock and Gardner, point out. Now only if it were as simple as that.

In fact, Tetlock spent close to two decades following experts and their forecasts. In the experiment, Tetlock chose 284 people, who made a living by predicting political and economic trends. Over the next 20 years, he asked them to make nearly 100 predictions each, on a variety of likely future events. Would apartheid end in South Africa? Would Michael Gorbachev, the leader of USSR, be ousted in a coup? Would the US go to war in the Persian Gulf? Would the dotcom bubble burst?

By the end of the study in 2003, Tetlock had 82,361 forecasts. What he found was that there was very little agreement among these experts. It didn’t matter which field they were in or what their academic discipline was; they were all bad at forecasting. Interestingly, these experts did slightly better at predicting the future when they were operating outside the area of their so-called expertise.

It is well-worth remembering these lessons the next time you come across a forecast. And that includes the forecasts made in The Daily Reckoning as well.

The column originally appeared on The Daily Reckoning on October 7, 2015