Of marriages, second hand cars and being unemployed


Since I started working nearly a decade and a half back, I have quit four jobs. Three out of four times, I quit without having a new job in place. Two out of the three times I was looking for a job, I easily found one.

Nevertheless, if you go by conventional advice this is really not done. And there is solid logic behind it. The economists call it information asymmetry. This is essentially a situation where the seller has more information than the buyer.

When I quit a job and look for a new job, I am a seller of services. The prospective employer is the buyer. I know why I quit my job, the prospective
does not. This is information asymmetry and it creates doubts in the mind of the prospective employer.

The following questions might crop up in the mind of the prospective employer: a) Why did he quit his job? b) Did he really quit, or was he fired? c) Is he too much of a rebel?

The information asymmetry creates problems. As Ray Fisman and Tim Sullivan write in The Inner Lives of Markets: “If a job applicant’s previous employer didn’t want to keep him on the payroll, it’s worth asking why not. You can also imagine that the problem deepens the longer you’ve been out of work: Why on earth hasn’t she found someone willing to give her job and what are other prospective employers seeing that I don’t.”

And this is why quitting a job without having a new one, is something really not done, unless you are thinking of doing something else. Information asymmetry spoils the job market for everyone who quits a job, without having a new one. This, despite the fact that the individual quitting the job might simply be bored or not have gotten along with a nasty boss.

The situation is similar to those who resist marriage for a long time and then want to get married, a little late in life.

As Fisman and Sullivan write: “If you’re still single by the time you reach a certain age, it becomes harder and harder to convince a potential mate, that there isn’t something wrong with you.” In the Indian context, this means regular questions and comments from relatives, as well. I remember a few years back, my maternal grandfather, asked my sister: “If I didn’t like women”. I was 32-33, at that point of time and single. Information asymmetry got to my grandfather as well.

And what is true about jobs, single individuals, is also true about second hand cars. Economist George Akerlof wrote a rather unusual research paper The Market for “Lemons”: Quality Uncertainty and the Market Mechanism, which was published in 1970.

In this paper Akerlof talks about the second hand car market in the United States. He pointed out that there are essentially four types of cars. “There are new cars and used cars. There are good cars and bad cars. A new car may be a good car or a lemon, and of course the same is true of used cars.” Bad cars are referred to as lemons in the United States.

An owner of a car has a good idea about whether his car is a good car or a lemon. As Akerlof put it in his research paper: “After owning a specific car, however, for a length of time, the car owner can form a good idea of the quality of this machine…An asymmetry in available information has developed: for the sellers now have more knowledge about the quality of a car than the buyers.”

This leads to a problem where the buyer of the car has no idea as to how good or bad the car is. Hence, as Akerlof put it: “The bad cars sell at the same price as good cars since it is impossible for a buyer to tell the difference between a good and a bad car; only the seller knows.”

Information asymmetry essentially stops the job market, the marriage market as well as the second hand car market, from working properly.

The column originally appeared in the Bangalore Mirror on July 27, 2016

Why everybody loves credit cards

credit cardRecently I went looking for a new Wi-Fi data card. I quickly decided on what I wanted, and put up the necessary papers required. When I was ready to pay using a debit card, I was told that there would be a 2% charge if I decided to pay using either a credit or a debit card.

This came as a surprise. The merchant clearly was still living in the 1990s.

The merchants used to charge extra on a card payment when credit and debit cards were just getting started in India in the late nineties. This continued in the early noughties as well. This was because banks charged the merchants every time a card holder used a credit or a debit card to make a payment. And merchants did not want to pay that money out of their own pockets.

Over a period of time as cards became popular this changed and no extra payments needed to be made if one decided to pay using a credit or a debit card. What brought about this change? Other than the fact that cards became ubiquitous, with people not wanting to carry cash around everywhere, merchants also realised something else.

And what was that? People end up spending more when they use cards.

This is primarily because cards take out the pain one feels while spending paper money, totally out of the equation. As Nobel Prize winning economists George Akerlof and Robert Shiller write in their book Phishing for Phools—The Economics of Manipulation and Deception: “One of the bases of credit card’s magic is that most of us think that we buy only what we need(or want).” Nevertheless “there is circumstantial evidence that people with credit cards spend more.”

In fact, psychologist Richard Feinberg carried out a series of very interesting experiments to show that just the presence of a credit card as a cue, leads to people spending more. In one of these experiments, people were shown various items on a screen, one at a time, and were asked how much would they pay for each one of them.

As Akerlof and Shiller write about the experiment: “In the presence of a credit card in the corner on the screen…subjects were willing to spend more.”  For a toaster, they were willing to pay $67.33, in the presence of a credit card cue. When there was no credit card in the corner of the screen, they were willing to pay only $21.50. The numbers for a tent were $28.42 in the presence of a credit card and $7.58 in the absence of one.

In fact, this discrepancy was seen in case for all the items that were flashed on the screen. Further, in the presence of a credit card, the decision to buy at a higher price was made much faster.

Given these reasons, it is hardly surprising that merchants have taken to cards, like a fish takes to water. And they are happy to accept cards these days, even if that means paying a fee to the bank, every time they accept a card payment. They have realised that people spend more when they use cards, and this benefits them.

This brings me to another question. Why don’t merchants offer discounts to those paying cash, given that there are no extra costs that they need to pay? As Akerlof and Shiller write: “If people are unknowingly spending more because they are paying by credit card, it would be ill-advised for…the local supermarket to remind their customers that they might, well, get a discount for paying by cash.” What is true for a local supermarket is true for other merchants as well.

This explains why everyone loves credit cards. The customer can spend more money than he has. The merchants can sell more, which is something that the merchant I mention at the beginning of this column, needs to realise. And the bank can collect exorbitant interest on the money that is spent.

The column originally appeared in the Bangalore Mirror on October 28, 2015

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)


What bankrupt Indian business groups can learn from Genghis Khan

genghis khan
Over the last few years, Credit Suisse has brought out an interesting series of reports titled the “House of Debt”. The latest version of the report was released last week.

The report tracks the total debt of 10 Indian business groups which have taken on around 12% of total loans of the Indian banking system. These groups are Adani Group, Essar Group, GVK Group, GMR Group, Lanco Group, Vedanta Group, Reliance ADAG Group, JSW Group, Videocon Group and Jaypee Group.
Analysts Ashish Gupta, Kush Shah and Prashant Kumar make several important points in this report. Here are a few of them:

a) The loans given to these business groups amount to 12% of total bank loans. Further, they amount to 27% of the corporate loans made by banks. In the last eight years the loans of these 10 business groups have gone up seven times. This pace of rise has slowed down in the last couple of years and in 2014-2015, the increase was 5%.

b) The interest coverage ratio of these business groups was at 0.8 in 2014-2015, down from 0.9 in 2013-2014. The interest coverage ratio essentially points to the ability of a company to keep servicing its debt by paying interest on it. The ratio is calculated by dividing a company’s earnings before interest and taxes (or operating profit) during a given period by the total interest it has to pay on its outstanding debt, during the same period.

Typically, companies need to have an interest coverage ratio of at least 1.5, to be considered in healthy financial territory. In this case the ratio is just 0.8. An interest coverage ratio of less than one means that the company is not earning enough to keep paying interest on its outstanding debt. Hence, on the whole, these groups are not earning enough to pay the interest on their debt.

The trouble with any average number is that it does not give us the complete picture. The interest coverage ratios of several groups are well below the average.

The GMR group is at 0.2. The GVK group is at 0. The Lanco Group is at 0.2. The Videocon group is at minus 0.3. And the Jaypee Group is at 0.6.

These business groups are in a very bad situation when it comes to the ability to keep servicing their debt.

c) The interest coverage ratio is at abysmal levels despite a large amount of interest being capitalised, as can be seen from the accompanying table.

As the Credit Suisse analysts point out: “while interest coverage is less than 1, a large amount of interest (15-170% of P&L interest) is being capitalised.”
The Accounting Standard 16 states thatborrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset should be capitalised as part of the cost of that asset.” It further defines a qualifying asset as “an asset that necessarily takes a substantial period of time to get ready for its intended use or sale.”

What this tells us is that the real interest coverage ratios of these business groups are worse than they seem.

d) Given that the interest coverage ratios of these firms are in such a mess, it is not surprising that they are already defaulting on their debts. As the Credit Suisse analysts point out: “Rating agencies have now assigned the default “D” rating to ~5-65% of debt for these groups. For Jaypee Group, almost two-thirds of the group debt is now in the default category including standalone parent company debt. Other groups have also seen multiple defaults at the SPV level for power and road projects.” (As can be seen from the accompanying table)

In fact, the auditors have also highlighted these defaults in the annual reports of these companies. As the Credit Suisse analysts point out: “According to their auditors report, eight of the ten ‘House of Debt’ groups were in default last year. Total debt with these companies in default was at US$53 bn (~48% of total debt with the groups) of which US$37 bn were reported to be in default for 0-90 days by the auditors.” These are not small numbers by any stretch of imagination.

e) Over the last few years, the business groups have tried to repair their balance sheets by selling assets in order to repay their debts. This hasn’t helped much given that in certain cases, the assets that they have had to sell, essentially brought in the money.

Take the case of Jaypee Group. The group has sold assets and these sales are expected to   bring in Rs 22,000 crore. The trouble is that these assets contributed 59% of its operating profit (earnings before interest and taxes) during 2014-2015.

Further, “a large number of projects especially from power and road sectors have seen delays in completion which has led to cost overruns. Some of the projects now have reported cost overruns of 20-70%.

What makes the situation trickier is the fact that “some of the companies have 5-50% of long-term debt (~US$15 bn) maturing within the next year and would need refinancing. Also, 5-37% of their debt is short term (~US$20 bn) that needs to be rolled over.”

What this tells us very clearly that all this talk about general corporate revival needs to be taken with a pinch of salt. A major section of the corporates the infrastructure sector continues to battle the high debt that they had taken on during the go-go years between 2004 and 2011 and are now not in a position to even pay interest on this debt.

Also, it is worth mentioning here that owners of a bankrupt company have no real incentive in acting in the best interests of the company. This is a point that Nobel Prize winning economists George Akerlof and Robert Shiller make in their book Phishing for Phools – The Economics of Manipulation and Deception.

As they write: “If the owners of a solvent firm pay themselves a dollar out of the firm, they diminish the amount they can distribute to themselves tomorrow by that dollar plus its earnings.” Hence, owners of a solvent firm have some incentive to not take out money from it. But that is not the case with the owners of an insolvent or a bankrupt firm.

As the economists write: “In contrast, if the owners of a bankrupt firm take an extra dollar out of their firm, they will sacrifice literally nothing tomorrow.”

And why is that? “Because the bankrupt firm is already exhausting all of its assets, paying all those Peters and Pauls [read banks in the Indian case]. Since there will be nothing left over for the owners, they have the same economic incentives as Genghis Khan’s army, as it marched across Asia: what they do not take today, they will never see tomorrow. Their incentive is to loot.”

Look at what happened to the banks in case of Vijay Mallya and all the money he had borrowed. This also explains why many Indian firms become sick but no Indian industrialist ever becomes bankrupt.

Long story short – banks will continue to have a tough time ahead.

The column originally appeared on The Daily Reckoning on Oct 27, 2015

Looking back: Real estate crash of 1997 reminds us prices can fall by 50%

Vivek Kaul

In response to a column I wrote yesterday many people wrote in saying that real estate prices never fall. Some others said that real estate prices cannot fall in India because India has a huge population, there is scarcity of land, and there is inflation and a lot of black money.

Fair enough.

Another logic that was offered was that real estate prices will not fall because they have only gone up in the past. Alan S Blinder explains this logic in his book After the Music Stopped:  “A survey of San Francisco homebuyers[sometime in the mid 2000s]… found that the average price increase expected over the next decade was 14 percent per annum…The Economist reported a survey of Los Angeles homebuyers who expected gains of 22 percent per annum over the same time span.” At an average price increase of 14% per year, a home that cost $500,000 in 2005 would have cost $1.85 million by 2015. At 22% it would have cost $3.65 million.

Now replace San Francisco with Mumbai or Delhi or Bangalore, and you get the drift of how people who believe that real estate prices can never fall, tend to think. This, if anything is a classic sign of a bubble. We all know what happened to American real estate starting in 2007-2008.
The naysayers might turn around and tell me, but this happened in the United States and not in India, and given that something like this is not possible in India.

So, let me tackle this by offering evidence from the real estate bubble of the 1990s, which started to run out of air sometime in the mid 1990s. As Manish Bhandari of Vallum Capital wrote in a report titled The End game of speculation in Indian Real Estate has begun: “The previous deleveraging cycle in year 1997-2003 witnessed price correction by more than 50% in Mumbai Metro Region (MMR) property.”

Yes, you read it right. Prices fell by 50% in Mumbai, where the population is huge and there is huge land scarcity. And the city had a lot of black money then. It has a lot of black money now.

Real estate prices also fell in other parts of the country. As an August 1997 newsreport in the India Today magazine points out: “Be it Mumbai’s ‘golden mile’, Nariman Point – the most expensive stretch of real estate in the world – or Somajiguda in Hyderabad; Delhi’s commercial hub Connaught Place or Koregaon Park in Pune; Bangalore’s pulsing heart M.G. Road or the sedate T. Nagar in Chennai. Each of these upmarket addresses, the most sought – after in their respective cities, are now dotted with unoccupied apartment blocks, unwanted commercial complexes and office space purchased at rates too hot to handle today.”

The point being that home prices had fallen by a huge amount across the country. “For the country’s over Rs 1,00,000 crore real estate business-one-twelfth the size of the GDP – it has been a crash without precedent. Between mid-1995, when the real estate boom peaked, and mid-1997, prices have fallen a bruising 40 per cent,” the India Today report newsreport further pointed out.

So what is the learning here? That real estate prices fall. And that they may not fall as quickly as stock markets do, but they do fall. Further, the fall can pretty much be all across the country, instead of only certain pockets. This despite, all the reasons offered in favour of “real estate prices can never fall” argument.
What this also tells us is that people have very weak memories and they tend to remember only things that have happened over the last few years. I guess up until late 2013, the real estate sector did reasonably well. And that is what people remember.

Actually, this is like information technology is the best sector to work in, argument (and Infosys is the best company). It may have been true a decade back, but clearly is not true today. Nevertheless, a whole new crop of parents forcing their children to become engineers continue to believe in it.

Getting back to the point, what those who still believe in the real estate story have not yet started to realise is that over the last one year, real estate prices have more or less been flat. And this as per data provided by real estate consultants, who have an incentive in ensuring that real estate prices continue to go up. There is enough anecdotal evidence to suggest that real estate prices have been falling at double digit rates in large parts of the country. It is just that no independent agency or organisation collates such data real time to give us a true state of the real estate prices in the country.

Also, from data that is available it can clearly be seen that real estate builders are sitting on a huge number of unsold homes. The bank funding to the sector has slowed down considerably over the last one year. The number of new launches, another source of funding for real estate companies, has collapsed, as real estate companies have not been able to deliver on their earlier projects. And investors are getting restless.

Further, those who believe in still buying real estate have no memory of the real estate crash of the late 1990s and the early 2000s. Hence, for them real estate prices can never fall. But that as I have shown is a stupid argument to make.

Also, the land-population argument is not a new one. It has been made over a very long period of time and despite that many real estate busts have happened all over the world. As Noble Prize winning economists George A. Akerlof and Robert J Shiller point out in Animal Spirits: “In a computer search of old newspapers, we found a newspaper articles from 1887-published during the real estate boom in some U.S. cities including New York-which used the idea to justify the boom amid a rising chorus of skeptics: “With the increase in population, the demand for land increases. As land cannot be stretched within a given area, only two ways remain to meet demands. One way is to build high in the air; the other is to raise price of land…Because it is perfectly plain to everyone that land must always be valuable, this form of investment has become permanently strong and popular.”

So, the land-population argument has always been offered by those who want you to buy real estate all the time. For those who are still not convinced, I suggest that you read the India Today story that I have mentioned earlier in the column. If you continue to remain a believer even after that, then best of luck from my side.

To conclude, let me reproduce an example from the India Today article: “At Himgiri, a typical multi-storeyed residential block on Mumbai’s arterial Peddar Road, the IT Department acquired a 624 sq ft flat for Rs 72 lakh in 1994. A year later, a similar flat went for Rs 60 lakh. And in June this year, a 622 sq ft flat was bought at a little under Rs 50 lakh. The list is endless.”

Pedder Road, as you would know is where Lata Mangeshkar lives and it is located in South Mumbai. And if real estate prices can crash in South Mumbai, they can crash anywhere else. Meanwhile, let me hear a few more arguments in favour of investing in real estate. Bring it on! But do remember that the one investment lesson that people learn over and over again is that, this time is not different.  

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Firstpost on July 22, 2015

India’s real estate market is being run by crooks

Vivek Kaul

The real estate sector remains down in the dumps. Nevertheless, insiders(the builders, the real estate consultants, the housing finance companies etc.) would like us to believe that “acche din” will be here for the sector pretty soon and hence, we should be investing in it.

In a recent report JLL India, a real estate consultant, pointed out that: “Many home buyers as well as investors have been speculating about the movement of residential property prices in Mumbai…The market’s readings indicate that that it will start moving up later this year. An average price appreciation of around 6% is expected by the end of Q4 2015. Mumbai’s residential property market will start seeing a lot of buying activity in around six months, with buyers taking advantage of prevailing market conditions to get good deals. The increased market activity is expected to continue next year too.”

What the report does not point out is the fact that the Mumbai Metropolitan Region has an unsold inventory of homes of close to 46 months or 192.27 million square feet. This data was released by Liases Foras, another real estate consultancy, sometime back. What it means is that if homes continues to sell at the current rate it would take around 46 months for the current stock to sell out. A healthy market maintains an inventory of eight to 12 months.

JLL India may have its own estimates of unsold inventory but they can’t be significantly different from that of Liases Foras. And if there is so much ready supply available, how can real estate prices go up?

This is just one example of research reports that real estate consultants keep coming up with where the conclusion is that “real estate prices will continue to go up”. For them it makes sense to do this simply because they make more money if the real estate sector is doing well, given that there are more deals to execute and more commission to be made in the process. And if the real estate sector is not doing well then they need to tell the world at large that it will start to do well, soon. These positive reports are splashed across the media, given that real estate companies are huge advertisers and a healthy real estate sector is a boon for the media.

The trouble is that the real estate sector in India has a huge information asymmetry, or something that the Nobel Prize winning economist George Akerlof referred to as a “market for lemons”. In a 1970 research paper titled The Market for “Lemons”: Quality Uncertainty and the Market Mechanism, Akerlof talked about four kinds of cars: “There are new cars and used cars. There are good cars and bad cars (which in America are known as “lemons”). A new car may be a good car or a lemon, and of course the same is true of used cars.”

Akerlof then went on to explain why trying to sell a lemon is very difficult. In an essay titled Writing the “The Market for ‘Lemons'”, Akerlof wrote: “I knew that a major reason as to why people preferred to purchase new cars rather than used cars was their suspicion of the motives of the sellers of used cars.” Long story short—a buyer will not buy without proof of the used car being in good shape and the seller did not have the proof.

And this led to the market for second-hand cars not working well. Tim Harford explains this phenomenon very well in his book The Undercover Economist: “Anyone who has ever tried to buy a second-hand car will appreciate that Akerlof was on to something. The market doesn’t work nearly as well as it should; second-hand cards tend to be cheap and of poor quality. Sellers with good cars want to hold out for a good price, but because they cannot prove that a good car is really a peach, they cannot get that price and prefer to keep the car for themselves. You might expect that the sellers would benefit from inside information, but in fact there are no winners: smart buyers simply don’t show up to play a rigged game.”

Hence, the market for second-hand cars has huge information asymmetry—one side has much more information(the seller) than the other(the buyer). And given that the market does not work well.
The real estate market in India is a tad like that. The insiders have all the information and there is no way to verify if the information they are putting out is correct. Take the case of something as simple as the prevailing price trend in a given locality.

There is no publicly available information. All you can do is ask the broker operating in that area and more often than not, he will tell you that “prices are on their way up”. If you are able to figure out a price, there is no way of figuring out whether there are deals happening at that price.

Hence, the system as it currently stands is totally rigged against the buyer. Even when the buyer buys an under-construction property there is no way of figuring out if the builder will deliver everything that he has promised at the time of the sale. There are regular cases of builders promising to build a swimming pool, taking money for it and then not building it. Then there are cases of parking lots being sold even though that is not allowed. In the recent past, builders have disappeared after taking on money and not completing the project.

As Nate Silver writes in The Signal and the Noise –The Art and the Science of Prediction: “In a market plagued by asymmetries of information, the quality of goods will decrease and the market will be dominated by crooked sellers and gullible and desperate buyers.” And that is precisely what is happening in India.

In fact, the real estate market in India currently is like the stock market used to be in the 80s and the 90s. India’s biggest exchange the Bombay Stock Exchange(BSE) was run by and for brokers. Other stock exchanges operating in different cities ran along similar lines. Small investors investing in the market were regularly taken for a ride.

The Securities Exchange Board of India was given statutory powers in 1992. And it took time to crack the whip. The National Stock Exchange started operations in November 1994 and gradually took away business from the broker dominated BSE. The BSE has been trying to play catchup since then.

The real estate business in India needs to be cleaned up along similar lines. The Real Estate (Regulation and Development) Bill, 2013, envisages setting up of a real estate regulator in each state. The builders need to be registered with the regulator and at the same time disclose essential details about the projects. These provisions if and when implemented are likely to reduce the information asymmetry which plagues the sector. But till then “caveat-emptor” will continue to prevail.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)  

The column originally appeared on DailyO on May 25, 2015