In a little street called Narayana Pillai Street, off Commercial Street in the Shivajinagar area of Bangalore there stands a building called “Ganesh complex” which can be called a tailoring hub. There are some ten to twelve shops (forgive my arithmetic if I’ve counted too low) all of which are occupied by tailors who stitch women’s clothes, primarily salwar kameez and its derivatives. I don’t know if there’s much to choose between the stores, and I think it’s a question of “tailor loyalty” the way it’s practiced among beach shacks at Baga beach in North Goa.

The wife is friends with a tailor called Ahmed, who runs a shop called HKGN tailors in this complex. Till recently (when he took two weeks with a consignment) his USP was “one hour tailoring”, where upon receiving cloth and measurements, he would stitch your dress in about an hour. I hear that there are a large number of tailors in the vicinity (though not sure if they’re in Ganesh complex) who offer the same terms. In fact, I know a lot of women who travel to that area to get their clothes stitched both for the quick delivery and also for the network of tailors that is present there.

While waiting for Ahmed to deliver the wife’s latest consignment yesterday (the one he took two weeks with), I was watching tailors in neighbouring shops working. The thing that struck me was that there isn’t much economies of scale in bespoke tailoring. Each piece  of cloth needs to be cut separately, in its own size, and there’s nothing that can be “batch processed” across different samples. Of course, there is tremendous scope for specialization and division of labour, so you see “masters” who measure, mark out and cut cloth, and “stitchers” who stitch up the stuff together.

However, across the city, except for the handful of tailors in the Shivajinagar area, the standard turnaround time for stitching seems to be about two weeks. And given the wife’s experiences (I usually buy readymade garments so not much insight there) it is a fairly disorganized industry and requires several rounds of follow-ups and waiting at the tailor’s shop in order to get the goods.

The economics of the industry (that there are no economies of scale) makes me wonder why the two-week-turnaround time has become standard in this industry. Isn’t the turnaround time solely because of inventory piled up at the tailor’s? Can the tailor not manage his inventory better (like say going a few days without fresh orders or hiring a few extra hands temporarily or working a weekend) and thus lead to much shorter turnaround time? Given the individual nature of the job, what prevents tailors from offering instant turn-around like the handful of people in Shivajinagar do? Or is it that bulk orders (one person coming with a bunch of clothes to stitch) mess up any “quick turnaround model” the tailors could offer?

There is only one explanation I can think of. “Sales” and “production”, for the tailors happens at the same spot (their storefronts). For “sales” purposes they need to be there all the time, though they don’t need to be actively doing anything. Hence, it suits them if production is also a continuous full-time process, so that the time they spend at the storefront isn’t all “wasted”. By piling up an inventory of orders, tailors are always assured of having something to do even if no fresh customers are forthcoming.

So as the wife’s experience with Ahmed has shown, the “quick turnaround” hasn’t been sustainable at all.

Ratings and Regulations

So the S&P has finally bitten the bullet and downgraded US federal debt to AA+ from its forever rating as AAA. While this signals that according to the S&P US Treasuries are no longer the least-risky investments, what surprises me is the reaction of the markets.

So far, since the rating change was announced after US market hours on Friday evening, only one stock exchange has traded – the one in Saudi Arabia, and that has lost about 5%. While it can be argued that it is an extension of severe drops in the markets elsewhere in the second half of last week, at least a part of the drop can be explained by the US debt downgrade. Now, when markets elsewhere open tomorrow after the weekend, we can expect a similar bloodbath, with the biggest drop to be expected in the US markets.

Now, the whole purpose of ratings was supposed to be a quick indicator to lenders about credit risk of lending to a particular entity, and help them with marking up their loan rates appropriately. It was basically outsourcing and centralization of the creditworthiness process, so that each lender need not do the whole due diligence himself. You can argue in favour of ratings as a logical extension of Division of Labour. If lending is akin to making shoes, you can think of rating agencies analogous to leather tanners, to save each shoe maker the job of tanning the leather himself.

However, over the course of time, there have been two consequences. The first was dealt with sufficiently during the global crisis of 2008. That it is the debt issuer who pays for the ratings. It clearly points out to an agency problem, especially when the “debt issuers” were dodgy SPVs set up to create CDOs. The second is about ratings being brought into the regulatory ambit. The biggest culprit, if I’ve done my homework right, in this regard was the much-acclaimed Basel II norms for capital requirements in banking, which tied up capital requirements to the ratings of the loans that the banks had given out. This had disastrous consequences with respect to the mortgage crisis, but I’ll not touch upon that here.

What this rating-based regulation has done is to take away the wisdom of crowds in pricing the debt issued by a particular issuer. Normally, the way stock and bond prices work is by way of wisdom of crowds, since they represent the aggregate information possessed by all market participants. Different participants have different assumptions, and at each instant (or tick), they all come together in the form of one “market clearing price”.

In the absence of ratings, the cost of debt would be decided by the markets, with (figuratively) each participant doing his own analysis on the issuer’s creditworthiness and then deciding upon an interest yield that he is willing to accept to lend out to this issuer. Now, however, with ratings linked to capital requirements, the equation completely changes. If the rating of the debt increases, for the same amount of capital, the cap on the amount the banker can lend to this particular issuer jumps. And that means he is willing to accept a lower yield on the debt itself (think about it in terms of leverage).

Whereas in the absence of ratings, the full information known to all market participants would go into the price of debt, the presence of ratings and their role in regulation prevents all this information flowing out to the market in terms of the price of debt. And thus the actual health of the issuer cannot be logically determined by its bond price alone – which is a measure that is continuously updated (every tick, as we say it). And that prevents free flow of information, which results in gross mispricing, and large losses when mistakes are discovered.

I don’t have anything against ratings per se. I think they are a good mechanism for a lay investor to get an estimate of  the credit risk of lending to a particular issuer. What has made ratings dangerous, though, is its link to banking regulation. The sooner that gets dismantled the better it is to prevent future crises.

Division of Labour

Some six of us have planned for a vacation for next month. And so far, the “labour” of planning the vacation has been divided unevenly. So far, it has been three of us who have been doing a lot of the work – talking with tour operators, drawing up schedules, planning transport and accommodation, booking tickets, etc.

Now with a large part of the work having been done, the three of us who have been doing the work have decided to put NED and have left it to the other three “freeriders” to complete the rest of the work. As you might expect, the other three continue putting NED and in the last few days not much work has been done.

The question is this – what is the optimal strategy for the three of us who have been so far doing work? We think we’ve done more than enough of our share and so the others should take over now. On the other hand, the more we leave it to the other three, the more procrastination that will happen which might come back to hit all of us in terms of higher rates, etc.

It is dilemmas like this that allow freeriders to freeride – they know that by freeriding, they are not the only ones who are losing out, and that there are people who are more driven than them who will also end up losing out if these guys freeride. And the freeriders know that the driven guys won’t let things drift and will positively do something about it, and that encourages them to freeride further. And so forth.

Is there a solution to this problem? When there is a common objective, how should incentives be structured in order to make the freeriders work, while also not making it obvious that these are artificially tailored incentives?