The Second Parchment

On Economics, Finance, Politics and Music

4 Reasons Why The Market Wasn’t That Perfect

new-york-13-exterior-night-04Before the 2008 subprime mortgage crisis happened, economic policymakers of developed countries thought they had reached a complete integration of economic theory and practice. The United States—and most of the world’s developed, mature economies, was believed to have reached its ideal state of market efficiency. The panacea for short-term fluctuations in the business cycle of developed countries was believed to have been found: it is a balanced mixture of monetary policy independence, rule-based stabilization policies, financial deregulation, and trade liberalization. Prof. Taylor prided himself in the robustness of his Taylor rule—the espousal of which had reduced macroeconomic volatility—Prof. Bernanke coined the term ‘the great moderation’ in his 2004 speech, Prof. Lucas declared that technical problems regarding recession-prevention have been resolved. ‘Bubbles’ was a misnomer. Valuation and pricing of every asset was believed to be grounded on concrete, measurable, logical economic drivers.

This belief stemmed from the idea that as an economy matures and financially modernizes, it becomes more efficient. Such was the case of the United States, as most economists and policy makers believed. Here, ‘efficiency’ was referred to as a concept whereby barriers to competition were minimal, economic agents acted on high level of rationality, information asymmetry no longer predominated, and regulation had ensured the deconstruction of unfair monopolies to allow non-coercive exchanges among members of the economy. Efficiency had also defined by how governments of developed countries had sufficiently learned from monetary, fiscal, and trade policy mishaps their counterparts made in the past. These attributes, coupled with the flawed belief that legal financial/non-financial loopholes had been addressed, justified the correctness of a strong form of an efficient market hypothesis. The term ‘bubble’ was an inaccurate designation—most economists and policy makers believed that the market knows how, why, and what it prices given the complete information available. An asset could not in a bubble. Rather, it could experience a strong upward appreciation of value owing to improving fundamentals.

Regulations of financial institutions were perceived as costly and highly unnecessary. Under the assumptions described in the aforementioned paragraph, financial institutions would thus act cautiously in making investment decisions that expose themselves to risk. Through strategic decision-making processes, they would decide on which risk-to-reward ratio to choose. Take the market of leveraged loans for private equity buyouts, for example. A group of banks deciding to syndicate loans in a highly-levered transaction simply mean that they are willing to take more risk for a higher expected return. Another example lies on the repo-to-CDO market. Intensive involvement in issuing low-yield, short-maturity debt—repo—for it to be used for financing investments in assets of high returns, longer maturity—CDOs—simply means that banks are willing to bear the risk of loss for the action they take. In a perfect market, ‘good’ corporate decisions are reciprocated with rewards, and bad ones are rewarded with losses. Policy makers, with this in mind, thus deemed financial regulation as costly. Some also believed that it would further stymie any form of financial innovation or hinder investments in profitable corporate-level projects. Prior to the crisis, they would feel that the repeal of the Glass-Steagall act of 1933 was justified.

The 2008 financial crisis proved that the belief was somewhat incorrect. The free market wasn’t free, nor was it perfect, and either coincidentally or not, some economists sensed that the perfect state of the efficiency of the financial market seems to be too utopian to be true. Prof. Roubini, Prof. Rajan, and Prof. Blinder attempted to investigate the validity of the assumptions of what makes a free market free of defects, within the context of the U.S. and other developed countries. Despite differences in the way their opinions were conveyed, they were unanimous in their belief on that bubbles are inevitable possibility in every market. In the context of the U.S. financial market, they believed that pricing of assets—particularly real estate and securitized debt obligations—were not necessarily backed by strong fundamentals. The appreciation of asset prices arose not because the market is perfect, but because it is imperfect, a case that is highly probable with transactions involving bank lending.

Sidenote: More background from a politician perspective can be found here, an article I wrote 2 years ago.

Why wasn’t it perfect?

Inspired from the explanation of these economists, I argue that these imperfections originated from the tenuousness of at least four (4) assumptions supporting the notion of a perfectly competitive market.

The first assumption relates to the incorrect notion that information asymmetry among economic agents no longer exist in developed capital markets. In a market with no information asymmetry, prices are determined based on the considerations of the seller and the buyer with equal access to information integral to asset pricing. However, prior to the 2008 calamity, banks had possessed more information regarding the actual components of the CDOs they securitized with complex financial engineering. Indeed, investors received investment prospectuses, but the triple-A stamp on the tranches they purchased made the idea of re-valuing the product for crosschecking purposes unnecessary. Furthermore, investors were unaware that banks had the right to purchase CDSs on the CDOs they purchased—another naked form of information asymmetry.

The second assumption is associated with the wrong belief that developed countries would have capital markets free of conflict of interest among economic agents. Prior to the crisis, credit rating agencies and banks performed business through an issuer-pay business model. The model arguable generated conflict of interest, as the incentive to maintain a neutral evaluation of credit quality of debt products securitized by their own clients would dissolve. The agencies were funded by their clients—mostly investment banks with securitization capabilities—to assess the credit quality of all tranches (as well as financially engineered sub-tranches) of collateralized debt obligations (CDOs) their clients intend to sell to willing institutional investors. Given the risky nature of the CDOs stemming from the subprime creditworthiness of the borrowers as well as mortgages being a majority portion constituting them, the banks arguably prefer to dispossess of them as soon as possible from their balance sheet. The agencies were aware of this, yet economists argued that they were incentivized them to improve their ratings of the CDOs they were paid to rate, under the spirit of client satisfaction and retention. According to policy makers, investors and CDS issuers were endangered by this practice as the issuer-pays model leads to the collateralized debt being over-rated—the asset value does not reflect its true risk levels.

The third assumption is connected to the erroneous view that moral hazard within the financial markets was an old cliché, as it has been successfully mitigated with existing financial regulation. In this case, moral hazard stemmed from the fact that agents lost their incentives to perform based on a risk-reward standpoint as they were allowed to shift risks to other parties without bearing any risks themselves. Before Dodd-Frank was introduced, banks need not have their risky, self-securitized risky debt in their balance sheet, before selling them to their clients or potential investors. This created moral hazard as expected profit/reward was no longer from the risk to which they were exposed; it was gained from speed: the faster risky securitized debt obligations can be sold, the more they gained.

The fourth assumption, arguably the most classic of all, derives from the inaccurate idea that economic agents are rational. Rational economic agents would evaluate their potential investments carefully and would invest in products that bring benefits both in the short-term and the long-term. In the years prior to the crisis, a large portion of investors subjected themselves to the trend of the herd, relished themselves in their own irrational exuberance, and sought for industries with short-term gains, such as the real estate market. Potential homeowners did not carefully evaluate the mechanics behind their cheap mortgages, and whether or not they were creditworthy enough to acquire the house they intended to buy. Before the crisis, there were tons amazing ads in televisions that getting a home is of utmost importance, irrespective of the need to understand that the debt they borrow were actually priced in a ‘teaser’ rate.

Perfecting the market

Regulators have taken steps toward eliminating the four issues I outlined previously. Lets dissect these steps one-by-one.

The first assumption—existence of information assymmetry—has been approached even within the international arena. G20 leaders have convened to emphasize on the importance of post-trade transparency in the trading of CDSs. In other words, second/third parties purchasing CDSs to hedge/speculate against a potential default of a particular debtor have been mandated to disclose their positions.

The second assumption—conflict of interest among economic agents—has been thought about, too. The Securities Exchange Commission (SEC) formulated new policies entitled “Amendments to Rules for Nationally Recognized Statistical Rating Organizations (NRSROs)”. The SEC has considered the following laws to enact:

  • Agencies/NRSROs are prohibited from rating debt instruments they have assisted with structuring;
  • Credit analysts of agencies/NRSROs are forbidden in fee negotiations with their clients (the CDO securitizors);
  • Agencies/NRSROs have limits on gifts they can receive from their clients;
  • Agencies/NRSROs are required to disclose the methodologies, assumptions, and criteria with which they rate the debt instruments to the SEC and/or third-party investors.

The implementation of these rules would reduce mismatched incentives arising from the issuer-pays model.

The third assumption—moral hazard/risk-shifting—has been addressed by mandating banks to have a higher minimum balance of their securitized products sellable to investors. True, the CDO market is back, but I am optimistic that this new regulation, coupled investors being more cautious in their investments, would slowly remove the issue related to the third assumption. The purpose of securitizing CDOs in the first place—risk diversification, not risk amplification—can thus be reached.

The fourth assumption—irrationality of economic agents. How do we make people more rational? Honestly…lets just ask him.


The Small Handbook of Short-run Macroeconomics

All students of macroeconomics should definitely refer to this PDF document written by Professor David Romer to relearn/refresh the basic framework behind how monetary & fiscal policies interact in the short run.


If you were a High Net Worth Individual seeking to invest in alternative assets, specifically in private equity or venture capitalist funds, is it worthwhile to do it via a fund-of-funds? A graph I took from a book I recently read suggests a yes to the question posed:

In line with the fundamental portfolio theory, it provides you, as the investor, with diversification benefits that may lead to higher investment returns or exit multiples. The only looming problem is the aggregate fee associated with hiring a fund-of-funds manager to help you invest in funds you’d like to invest in. I’m not sure about how a PE/VC fund-of-funds fee structure looks like, but research by Columbia University found that fees for funds-of-funds focusing on hedge fund investments to be arguably overcompensated.

A fund-of- funds passes onto investors all fees charged by the underlying hedge funds in the fund-of- funds’ portfolio. In addition, investors in funds-of-funds must also pay an extra set of fees to compensate the funds-of-funds’ managers. These fees-on-fees are not negligible. In the TASS database, the average management fee levied by funds-of-funds is 1.5% and the average fund- of-funds’ incentive fee is over 9.2%. These fees are on top of an average management fee of 1.4% and an average incentive fee of 18.4% for hedge funds.


Sovereign Credit Rating Service: A Public Good?


It is inevitable that credit rating agencies partially catalyzed the credit crunch the financial system experienced in 2008. Some have attributed the recession to the way Moody’s, S&P, and Fitch Ratings rated fixed income products; one of whom is Annette Heuser of the Bertelsman Foundation. I recently stumbled on her TED talk, and got interested. In her talk, she made a bold statement: “credit rating services, especially sovereign credit ratings, should be a public good.” Watch her TED talk here.

In other words, she wants sovereign credit rating services to be free and transparent for everybody: clients, investors, non-clients, and non-investors. As an effort to realize this, she and her team have been working on a “forward-looking” credit-rating model that they name INCRA. She doesn’t want it to be a business, so operations under the project have been done under the non-profit umbrella and financing of the project has been based on endowments made voluntarily by outside contributors. Read her latest update on INCRA here.

During the talk, she justifies her decision to develop a free sovereign credit-rating model on several fundamental beliefs: i. The downgrading of sovereign credit ratings increases the cost of borrowing for governments–usually emerging countries–that are dependent on the international credit market for their infrastructure financing; ii. The market of credit rating is imperfect–it is an oligopoly–with three key players in it (Moody’s, S&P, Fitch ratings); iii. There is a ‘moral hazard’ in the credit rating business: she believes that credit rating agencies tend to deliberately overestimate the creditworthiness of a particular institution, because that institution is the one paying for the credit rating service. Since fixed-income investors might not know about this, they would trust whatever the credit rating agencies publish on their reports.

I find some of her reasons a little bit too bold. One has something to do with the assumption Ms. Heuser is making on how credit rating agencies always rate in their clients’ favor–the institutions/countries hiring them to rate their institutions/countries (refer to point iv). This might be true in the context of what happened in the 2008 mortgage-backed securities fiasco, but I don’t think the case can be extrapolated to sovereign credit ratings. I still couldn’t find any relevant studies, so here’s a question: do governments pay credit-rating agencies annually, thus making them having a voice when upgrades/downgrades of their countries ratings are being discussed? I know governments hire sell-side/buy-side financial analysts for capital restructuring reasons (i.e. Greece hired BlackRock), but do they also hire credit rating agencies?

Another point is the following (refer to point i): while it is true that a central bank’s policy to increase a country’s interest rates will directly affect the cost of borrowing, there is insufficient evidence demonstrating that the downgrading of a country’s credit rating would do the same. I cannot intuitively see any direct correlation between credit upgrades/downgrades with the central bank’s choice of interest rates. I haven’t done any research on this yet, but I believe that the argument on the correlation between credit rating upgrades and the increase in interest rates is still a matter of academic debate. In the end, American investors invest in Indonesian bonds based on what Bank Indonesia wants Indonesia’s short-term or long-term treasury bonds to be. Indonesia determines its own cost of borrowing–Moody’s, S&P, and Fitch might (potentially) just contribute to an insignificant premium of the bond rates in secondary capital markets.

Ms. Heuser is probably referring to foreign direct investments (FDIs), which are correlated with sovereign credit ratings. Investors would demand higher equity (not bond?) returns when investing in the emerging markets, or countries with ratings just slightly above the investment grade. If this is the case, it makes sense, but then again, the amount of FDI inflow has little correlation with how much the government should allocate its budget for foreign debt payments. Additionally, the central bank also has power to influence FDI. Again, take the case of Indonesia. Ever since former Federal Reserve Chairman Ben Bernanke announced its tapering off of quantitative easing, investors have been pulling out their investments out of Jakarta (Early August 2013). Weeks and months afterwards, Bank Indonesia, increased interest rates by hundreds of basis points (Late August 2013). Since local currency is used to finance local investments, a good proxy for FDI inflows/outflows would be this year’s $-Rupiah exchange rates, which can be seen here. Also since investments are made in equities, the Jakarta Composite Index serves as a good indicator, which can be viewed here. Look at the significant increase and decrease of the rate/index over August-September. This shows that ratings might alter the the outflows/inflows of direct investments, but not foreign investors’ preferences in purchasing government debt. Unless the ratings are incorporated to the calculation of the probability of sovereign debt defaults.

So far, INCRA has produced a total of 6 reports, which can be downloaded here. Most of them are produced by political scientists and economists within the academic field. While I doubt that INCRA’s presence will change the landscape of the credit-rating business, I’m still interested in where this project is going.

Basel III: An Update

It has been approximately a semester since I left my internship at the Central Bank of Indonesia’s Monetary Policy Group, in which I worked closely with senior economists on developing a proxy for measuring risk levels of Indonesia’s banking system. The discussion on the developments of Basel III was a ritual every morning, and I am pretty sure it is still today. I remember looking at the following table and wondering what will happen as members of the Bank of International Settlements gradually establishes each of the framework’s regulatory points:


As I perused the financial statements I was assigned to, I would ask myself: “How will banks respond to the increasingly ‘restrictive’ regulation proposed by the central banks involved in the formulation of Basel III?” As the year of 2013 ended, some answers have emerged.

In Indonesia, at least an issue arose due to Bank Indonesia’s minimum Capital Adequacy Ratio rule imposed on several domestic banks. Such particular rule, I believe, is highly influenced by Basel III. This has led to an additional capital injection–or colloquially, a bailout–of Bank Mutiara, after its controversial Century days. Read more here. Internationally, investment banks and regulators have constantly revised the terms of the rule to reach a point where profits and risks balance. Quoting a banking professional in an article, the concession has been a ‘win for the [financial services] industry.’ Read more here.

Sinking Strategies


Earlier in class my professor said something that’s been sitting in my mind while I review my notes for my risk management exam tomorrow. He said: “Sometimes, when you’re drowning, keep drowning. Don’t look for ropes and branches to pull you out of water.” He was referring to a strategy once employed by the financial strategists of General Electric (G.E.) prior to and after President Obama’s rescue stimulus given to the firm. In times when the firm suffered from losses (or intentionally sought losses?), G.E. took advantage of the U.S.’ tax credit laws to generate positive cash flows. Although irrelevant to this particular discussion, here’s a representative paragraph on G.E.’ accounting strategies quoted from The New York Times:

Its extraordinary success is based on an aggressive strategy that mixes fierce lobbying for tax breaks and innovative accounting that enables it to concentrate its profits offshore. G.E.’s giant tax department, led by a bow-tied former Treasury official named John Samuels, is often referred to as the world’s best tax law firm. Indeed, the company’s slogan “Imagination at Work” fits this department well. The team includes former officials not just from the Treasury, but also from the I.R.S. and virtually all the tax-writing committees in Congress.

G.E. generated positive cash flows from the U.S.’ I.R.S. tax credits under circumstances in which profits weren’t in the firm’s favor. The maintenance of positive cash flows for a certain time period, holding other relevant variables constant, increased the firm’s asset values. With G.E.’s impressive business model and human resources, the firm can then switch gears to the conventional profit-seeking strategies whenever it deems optimal.  So when you’re sinking, the most intuitive solution might be getting out of the lake as soon as possible. But it doesn’t imply optimality. Sometimes you just need to hold your breath a little bit longer and simply enjoy the aquatic scenery surrounding you.

On Banda Neira


My favorite music style has always been simple different-gender duets: a male and female singer, harmonizing each other with their melodies, singing while playing their favorite instruments. Typically, the guy plays the guitar while the girl plays the piano. The Swell Season is a perfect example–Hansard (guitar) and Irglova (piano) went famous for their low-budget movie, Once. Another would be The Civil Wars.

I was pessimistic about the existence of such duets in Indonesia, until my friend Afu mentioned Banda Neira, a xylophone-guitar duet formed by Rara Sekar and Ananda Badudu. Not only does the duet write beautifully crafted melodies, they also emphasize the poetic nature of the lyrics in their songs. Rumor has it that Ananda is the grandson of  Jusuf Sjarif Badudu, one of Indonesia’s most esteemed linguists. I don’t doubt this. He definitely inherits his language skills. Listen to ‘Di Beranda‘ and ‘Hujan di Mimpi‘, read the lyrics, and you’ll get what I mean. Afu told me that “Rara’s voice resonates clearly like a flute, while Ananda’s is close to a viola.”

The band’s sense of profundity doesn’t end there; even the word ‘Banda Neira’ has a special meaning. Though I haven’t met either Rara or Ananda, I’m pretty sure that, after doing a quick Google search, they named their duet after a settlement located in the islands of Banda, Malacca, Indonesia. Indonesia was once a colony of the Dutch, and Banda Neira was a portal of global trade. What’s so profound about naming a duet after a port?

Around 1621, Most of its local residents were forced out and exterminated for the purposes of natural resources exploitation. Locals of the Banda Islands were massacred for wealth, some were forced to be slaves to the ruler. Those who don’t know such history of Banda Neira would definitely be deceived by Josias Rappard’s subliminal painting of the port. When he was serving as an infantry unit of Koninklijk Nederlands-Indische Leger (translated: Army of the Kingdom of the Dutch East Indies), Rappard painted Banda Neira with such beauty that people like us would disregard how grim the port was during a certain period of history.

Rara and Ananda can make the argument that this is exactly why they named their duet Banda Neira, a historically dark port, but in the same time wrote their heartfelt songs: to remind us of how peripheral appearance can conceal something whose inner meaning is relatively more dismal. But this is just me over interpreting, because as written in their blog, they chose ‘Banda Neira’ because of the following reason:

During the period of Indonesia’s strive for independence, several national heroes and founding fathers were extradited by the Dutch to Banda Neira. They included Sutan Sjahrir and Muhammad Hatta . . . as Hatta was preoccupied with his books, Sjahrir enjoyed playing with the local kids. He then wrote in June 1936, “this place is heavenly.”*

*Sutan Sjahrir served as Indonesia’s first Prime Minister when Indonesia was a federation. Muhammad Hatta was Indonesia’s first Vice President.

June 1936–hundreds of years after the massacre. Had Sjahrir known what happened on the land he stood, would he still write the line he wrote? Regardless, Banda Neira is a cool duet and they deserve to get famous. Or don’t get famous–just keep writing great songs.


On Indonesian Funds: Hedging A Fall


A few weeks ago I wrote about how the Indonesian government, through its macroprudential laws, prohibits any shorting activities in the Indonesian stock market. Given this restriction, I was wondering what would Indonesian small and second-level investors (like me) do to partake in potential profit-making situations when the market goes bear.

Just hours ago, a friend of mine (Ilya) recommended to long Exchange Traded Funds (ETFs) or Index Funds whose yields negatively correlate with the Jakarta Composite Index: inverse-exposure stocks/portfolios. So when the market goes down, the fund goes up, vice versa. This is one good idea, but unfortunately, such fund is not commercially sold unless an investor directly manages his/her own portfolio by either: i) being an active trader at the Jakarta Stock Exchange, ii) appointing a broker and actively managing the portfolio, ensuring that its beta coefficient is negative, iii) hiring a personal asset manager at an asset management firm.

I went to a mutual fund yesterday to confirm this. (Yes–the day after I visited the mutual fund to talk about the issue and to open a mutual fund account, Ilya messaged me on Facebook about the exact same issue. What a coincidence). After opening my first mutual fund account (an early birthday present!), I talked to one of the marketing officer about the strategy. As expected, those ETFs don’t exist. The investor needs to construct a replicating portfolio by his or herself, accompanied by an asset manager. I then asked about publicly available Indonesian funds out there, and he gave me a broad list:

  • LQ45: An index consisting 45 blue-chip equities, updated every 6 months, based on the companies’ liquidity levels and market capitalization.
  • Sectoral: A portfolio which comprises companies from 10 different sectors in Indonesia: agriculture, mining, consumption goods, properties, infrastructure, etc.
  • Jakarta Islamic: 30 companies whose stocks fulfill the Sharia criteria. Weightings in the portfolio depends on liquidity levels.
  • Bisnis-27: This one is pretty new–a daily newspaper named Bisnis Indonesia partnered with the stock exchange to list 27 top-performing Indonesian companies (based on fundamental analyses).

Curious about their performance, I tried Bloomberg-ing them against the Jakarta Composite Index. Unfortunately only the LQ45 is listed. But I’m pretty sure the others’ annual performance is similar:


Guessing from its general form, the fund moves together with the Jakarta Composite Index. No way that a trader can use this to bet against a dwindling market. Again, this is only LQ45–but I’m very sure that the others are the same. So what should people like me do?

Several options available:

  • Form your own bear portfolio by pooling stocks with negative betas. The thing is, it might be challenging to find a platform to get such list of stocks (not sure, once one have a trading account I think it’s readily available). However, I’m still pessimistic about the liquidity level of these equities considering Indonesia’s top 45 liquid & fundamentally sound stocks have positive betas.
  • Invest in derivatives: buy put options or sell call options. This idea is viable–we do trade options in Indonesia, despite the fact that there’s a policy of automatic exercise. In Indonesia, options will be automatically exercised once prices are below or above the threshold (strike price) by 10%.
  • Work hard and smart and get that first $20,000 to be eligible to short here.
  • Learn Cantonese and go to Hongkong. Alright I’m kidding about this one.

Relevant side note: The efficient market hypothesis doesn’t really apply here in Indonesia. Mutual funds do beat the market, though of course not always. [Paper in Bahasa Indonesia].

Irrelevant side note: In response to a significant Rupiah depreciation and an increasing trend in inflation and capital outflows, our interest rate was raised by 50 basis points just two days ago. My floor at the Central Bank of Indonesia was full of people midnight before the governor announced it. It was amazing to be in the same floor with the economists and central bankers who actually contributed to making the decision. [Article in English].

The Warriors of Tolerance


This is what this country needs. Read this. And this. I feel very happy to have been given the opportunity to join the team. The 10 young Indonesians in this photo will one day lead the movement of cultural, religious, and gender tolerance in Indonesia.

Short Selling in Indonesia


…is allowed but strictly regulated, thanks to the 2008 subprime mortgage crisis. A customer needs to have a minimum of IDR 200,000,000 (approximately USD 20,000) in their stock account to have the privilege of hedging their stock investments when the market plunges. Download the regulation here: Short Selling in Indonesia (in Bahasa Indonesia).

Most active, technical traders I’ve talked to play the one and only strategy to gain profit: capital gains from buying low and selling high. What do they do when the stock declines as Chairman Bernanke recently announced his plan to decelerate the Fed’s quantitative easing program and as the country is in a political turmoil as the price of fuel increases? Simply hope that the market would bounce back again.

Relevant update: Greece is planning on lifting its short-selling ban. [Article].