MacroStrategy

Today's Reads

2012-01-26T06:36:00.001-08:00

Today's Reads
Interesting readings from today

The Fed surprised the market by promising to keep the rates low "at least through late 2014". Chairman Bernanke gave subtle hint that it may initiate QE3 at the post-FOMC press conference although there is disagreement among economists on whether the Fed will actually go for it. The reason for the Fed becoming more dovish was a reduction in their outlook for growth and inflation (but no unemployment rate) for 2012-13.

The painstaking negotiation between Greece and the bondholders continues. It was supposed to be over before last weekend ahead of the EuroFin meeting but that didn't happen (surprise?). Looks like there is broad agreement on the outline but disagreement over the details particularly how much "average" interest should be paid on the new debt - Greece wants 3.50% while bondholders want 4% but they might split the difference at 3.75%. It will be interesting to find out the final outcome, hopefully in the next few days. There pretty cool references on this top including,
(1) From BBC, Pretty nifty graphics on debt by major countries
(2) From FT, An Interative Timeline of Greek debt crisis
(3) From HSBC Global Research, "FAQ on Greek Debt Swap" published back in August 2011.

In his, State of the Union address, President Obama proposed relief to homeowners through mortgage refinancing but the likelihood this proposal becoming a law is minimal. This looks errily like HARP, which allows homeowners with negative equity to refinance without paying mortgage insurance but goes one step further, which is that it allows Non-Agency mortagage borrowers to refinance also without penalty. This could be bad for mortgage REITs but it is offset by the Fed's commitment to keep the rates low and possibly initiate QE3, which will likely focus on Agency MBS securities. The President's proposal could also bring relief on loan-level price adjustment (LLPAs) that Fannie Mae charges.

Notwithstanding today's worse than expected weekly jobless claims, the trend has been heading south. But it has not improved fast enough to dent the poverty rate in the country. According to the USDA that administers the Supplemental Nutrition Assistance Program (SNAP) aka Food Stamp, 44 million American receive that aid amounting to $134/month on average. Companies like SBUX, SVU, FDO and of course WMT are positioning themselves to get the most of $71.8 billion Food Stamp money - they already get 85% share.

McKinsey Global Institute: Debt and Deleveraging

2012-01-19T06:24:00.000-08:00

Debt and Deleveraging: Uneven progress on the path to growth
McKinsey Global Institute, Jan 2012
[Full Link]
[Full Report in PDF]

Safely reducing debt and clearing the way for economic growth in the aftermath of the global credit bubble will take many years and involve difficult choices, as MGI’s 2010 report showed.

Two years later, major economies have only just begun deleveraging. In only three of the largest mature economies—the United States, Australia, and South Korea—has the ratio of total debt relative to GDP fallen. The private sector leads in debt reduction, and government debt has continued to rise, due to recession. However, history shows that, under the right conditions, private-sector deleveraging leads to renewed economic growth and then public-sector debt reduction.

These are the principal findings of MGI’s latest perspective on deleveraging, which revisits the world’s ten largest mature economies to see where they stand in the process of reducing debt ratios (United States, Japan, Germany, France, United Kingdom, Italy, Canada, Spain, Australia, and South Korea). It focuses in particular on the experience and outlook for the United States, United Kingdom, and Spain—three countries covering a range of deleveraging and growth challenges. It also examines the relevant lessons from history about how governments can support economic recovery amid deleveraging, and identifies six key markers business leaders can look for to monitor progress of specific countries.

Highlights of the research include:

* The deleveraging process has only just begun in most countries. Based on data up to Q2 2011, total debt has actually grown across the world’s ten largest mature economies since the 2008–09 financial crisis, due mainly to rising government debt. Only three countries in the sample—the United States, Australia, and South Korea—have seen the ratio of total debt to GDP decline.

* The deleveraging processes in Sweden and Finland in the 1990s offer relevant lessons today. Both endured credit bubbles and collapses, followed by recession, debt reduction, and eventually a return to robust economic growth. Their experiences and other historical examples show two distinct phases of deleveraging. In the first phase, lasting several years, households, corporations, and financial institutions reduce debt significantly. While this happens, economic growth is negative or minimal and government debt rises. In the second phase of deleveraging, GDP growth rebounds and then government debt is gradually reduced over many years.

* The historic deleveraging episodes reveal six critical markers of progress: the financial sector is stabilized and lending is rising; structural reforms unleash private-sector growth; credible medium-term public deficit reduction plans are in place; exports are growing; private investment has resumed; and the housing market is stabilized and residential construction revives.

* As of January 2012, the United States is most closely following the Nordic path towards deleveraging. Debt in the financial sector has fallen back to levels last seen in 2000, before the credit bubble, and the ratio of corporate debt relative to GDP has also fallen. US households have made more progress in debt reduction than other countries, and may have roughly two more years before returning to sustainable levels of debt. Deleveraging in the United Kingdom and Spain is proceeding more slowly, and these countries could face many years of gradual debt reduction ahead.

* Understanding the course of deleveraging will be of critical importance both to business leaders, who will need to take a granular approach to strategy, and to governments. The report examines implications for business strategy and suggests that current macroeconomic models do not fully capture the impact of deleveraging on demand—so companies must develop their own views of how deleveraging is proceeding to find pockets of opportunity in the near term. Overall growth in the time of deleveraging is likely to be restrained, but the pace of debt reduction varies across nations and sectors and from place to place within nations. No single country has all the conditions in place to revive growth.

Today's Reads

2012-01-18T07:34:00.000-08:00

Today's Reads
Interesting readings from today

The World Bank lowered its 2012 growth forecast to 2.5% (down from 3.6% forecast in June). Developing countries should expect 5.4% growth (from 6.2%) and developed countries 1.4% (from 2.7%). Euro Area will be in a recession with -0.3% (from +1.8%) growth and China's growth will be at a "dismal" 8.4%.

The IEA is also lowering its global demand forecast for oil for 2012 to 1.1 MBD (from 1.3 MBD). Growth in emerging markets (+3.2%) will offset decline (-0.7%) in developed countries bringing the aggregate growth to 1.2%. China's growth is cut to 4.3% (from 5.2%) but still accounts for 40% global increase.

The FDIC now requires 37 banks with more than $50 billion assets (total $4.14 trillion) to provide "living will" for dismantling them if they collapse. Banks with excess of $10 billion are required to conduct regular "stress test".

The National Science Board released a new report where it outlines trends in U.S. global competitiveness in Science and Technology (S&T). The interesting takeaway is that between 1999 and 2009, the U.S. share of global R&D dropped to 31% (from 38%), whereas Asian share grew to 35% (from 24%). China's R&A grew 28% just in one yar (2008 to 2009) to propell it to the 2nd position behind the US.

Among the bizarre news, imagine travelling on BA Flight 206 from Miami to London, and 3 hours into the flight, you hear the announcement, "This is an emergency. We will shortly be making an emergency landing on water". The good news was that it was a pre-recorded message that activated in error.

Today's Reads

2012-01-17T08:28:00.000-08:00

Today's Reads
Interesting readings from today

US markets ripped higher in the morning on reports of better than expected China GDP growth, up 8.9% vs 89.7% consensus. The funny thing is that I have not been able to get hold of the expenditure breakdown of the Chinese GDP i.e. C+I+X-M+G. And there is plenty of skepticism about the trustworthiness or the quality of Chinese economic figures. In any case, the market seems to be shrugging off bad news, and the FT tries to make a point that it could just be short covering.

In "Time to stop fearing the Greek CDS bogeyman" Sober Look gives 4 reasons why a trigger of the Greeck CDS is not as big a deal as the ECB is making it to be, (1) they're already marked to market (2) protections are written long time ago (3) worst case scenario priced in because CDS spreads have narrowed vs 1 month ago, and (4) CDS is already pricing in a 70% probability of a default.

CNBC has an interesting explanation of "Credit Event for CDS and Bond Payouts".

An interesting interview with the CEO of Athenahealth (ATHN), a Healthcare Tech Company, by Fortune Magazine. Couple of interesting tidbits (1) 1/3 of healthcare is consumed by 5% of population that dies each year, another 1/3 by 5% with chronic diseases, and the rest by 90%, (2) VC invested $410 million in Healthcare IT in 2011 vs $30 billion in tech including social media, and (3) only ~1% of doctors are using closed loop Healthcare IT system because it is illegal for a pharmacy or a testing lab to pay a doctor for sending information electronically - it's considered a kickback.

An interesting chart of oil price going back to 1861 from page# 15 of BP Statistical Review of World Energy (June 2011)

Raising the Ante on Last Year’s Big Global Macro Bets

2012-01-05T13:27:00.000-08:00

Raising the Ante on Last Year’s Big Global Macro Bets
Institutional Investor, 5-Jan-12
James Shinn

Some traders ruefully describe 2011 as “shockingly volatile,” even as others are pricing new Ferraris in sleek showrooms on Park Avenue and in Mayfair. What combination of asset volatility and fast-car returns is in store for 2012?

In the June 2011 issue of Institutional Investor, I described a reference scenario of the events that global macro traders believed to be moving markets last year, based on a two-day conference at Ditchley Park in Oxfordshire, England. According to this scenario, global macro hedge funds were focused, laserlike, on just four key events: the Federal Reserve Board’s monetary stance, a Chinese hard or soft landing in terms of GDP growth, euro zone stresses and that perennial favorite, oil prices. As I explained in my previous article, “with four big events, there are 16 possible outcomes (two to the fourth power) in the reference scenario ‘decision tree.’?”

With the benefit of hindsight, how did these scenario events actually play out, and how skillfully did our traders predict the four outcomes? Are the same cyclical and secular drivers of these events still at work? Looking forward, will these be the four key variables in 2012? And as the accountants tally up hedge funds’ year-end winners and losers, what is the reference scenario for 2012 — and with what odds?

The Fed’s Stance: Loose or Looser

The Federal Reserve’s monetary stance is the first big event under traders’ scrutiny, as the Federal Reserve Open Market Committee’s decisions will drive asset markets around the world, for good or for ill.

One branch leading from this decision is moderate economic recovery, reflation of price levels, sustained U.S. government deficits, a slightly tighter Fed stance (and no more quantitative easing), gradual improvement in job creation, gradual repair of household and bank balance sheets, and a sideways movement of the trade deficit. In this branch continued dis-saving by Washington is matched by household savings and the purchase of Treasury debt by foreigners and Ben Bernanke’s Fed, and this is what powers GDP recovery — at least for a while.

The other branch of this part of the decision tree says this party can’t go on for much longer and leads to slower economic recovery, flat employment and selective deflation (or the dreaded “stagflation”), some nominal reduction of the federal deficit, a continued expansive Fed stance and gradual shrinkage of the trade deficit. The former branch might be described as “business as usual,” the latter as “malaise” or “painful adjustment.” At the end of the day, the latter scenario writes off QE2 as a dangerous illusion.

Original Prediction: Painful Adjustment

Traders in our poll overwhelmingly bet on the “malaise/painful adjustment” outcome, 68 percent to 32 percent (with a standard deviation of 17 percent). The individual arguments supporting this view reflected global macro traders’ conviction that long-term adjustment is crucial — “This party just can’t go on forever,” one trader explained. The traders were also confident, in some cases adamant, that financial markets would force a fiscal deficit reduction in Washington: “If Moody’s gives the Treasury a downgrade, even Congress will have to pay attention,” was a popular comment. Most traders have a visceral dislike of quantitative expansion in any form — “QE is just a central bank’s monetization of government debt, any way you look at it,” observed one trader.

I should add that all quotes in this article are guaranteed genuine, but some of our traders’ firms have blanket policies forbidding their employees from being quoted in the financial press.

Actual Outcome: Business as Usual, Plus ‘Twist and Shout’

Contrary to the traders’ average prediction, we are still heading up the “business as usual” branch at the start of 2012, with no real deal on the U.S. fiscal deficit and with another shot of QE via September’s Operation Twist, although, unlike QE1, the Twist was balance-sheet neutral for the Fed.

The U.S. federal deficit in fiscal 2011 was -8.6 percent of GDP, barely down from 2010’s -9 percent. According to International Monetary Fund forecasts, the U.S. fiscal deficit will shrink only slowly, stubbornly sticking above 6 percent five years out. Consensus forecasts for U.S. economic growth are 1.8 percent for 2011 and 2 percent for 2012, with unemployment running at 9 percent and 8.7 percent, respectively. Even as government debt continues to climb, households will deleverage very slowly, and the external trade deficit will keep running at the 3 percent–of-GDP level more or less indefinitely.

The benefits of QE may still be a dangerous illusion in the minds of many financial professionals and has encountered a groundswell of political opposition in the Republican Party. But all indications are that the dominant dove faction on the Federal Reserve Board is keeping this option open. “Public political criticism of the Fed is nothing new and won’t have more than a marginal impact on its policy actions — maybe just on how it communicates them,” says Thomas McGlade, a Greenwich, Connecticut–based portfolio manager and director of U.S. operations for London-based hedge fund firm Prologue Capital.

Drivers: Deflation and Unemployment Fears Trump Deleveraging

As an example of the communication style described by McGlade, in a November 15, 2011, speech at the Council on Foreign Relations in New York City, Chicago Fed president Charles Evans made the case that inflation was essentially under control, displaying slides showing that the FOMC “central tendency” forecasts have core inflation running well under 2 percent for several years while unemployment slowly creeps down from the 9 percent level, still hovering in the 8 to 9 percent range a year hence and not going below 7 percent until 2014. If Evans’s view indeed reflects the central tendency of the Fed, the cyclic driver of slow U.S. recovery and sideways unemployment will wash the urgency out of deleveraging.

The persistence of secular leveraging was called rather rudely to the Fed’s attention by the now-famous paper on “the real effects of debt” by Brandeis University finance professor Stephen Cecchetti and his colleagues, presented at the Fed’s August 2011 Jackson Hole meeting; it later appeared as the Bank for International Settlements’ BIS Working Papers 352. I have seen copies of the graphs from this paper (see graph below, left) taped to traders’ screens and pinned to the corkboard over a trading floor’s espresso machine.

According to the BIS team’s calculations, total nonfinancial debt in 18 OECD countries grew from 167 percent of GDP to 314 percent between 1980 and 2010, an increase of almost 5 percent of GDP per year for three decades, as shown in the graphs. This trend has brought us to the point in many of these countries where debt levels are stifling GDP growth, according to economists Carmen Reinhart and Kenneth Rogoff. This implies that households and then governments must go through a sustained and painful deleveraging process.

Says Paul Brodsky, co–managing member of New York–based hedge fund firm QB Asset Management: “The issue across the board in developed economies is solvency — not discrete liquidity flare-ups among sovereigns, banks or households. Nor is a lack of confidence among consumers the issue. It all comes down to the extraordinary gap separating systemic debt from existing base money. The world needs to deleverage.”

The FOMC may think that deleveraging and adjustment are necessary someday, but putting more of the 25 million unemployed or involuntarily part-time employed Americans back to work appears to be more pressing — the central banker’s version of Saint Augustine of Hippo’s famous prayer, “O Lord, grant me chastity and continence, but not yet.”

Prediction for 2012: The Fed Will Make It Too Dangerous to Hold Bonds

Looking forward into 2012, our sample of traders believes the important choice is no longer between business as usual and adjustment, but between more quantitative easing or not, and the vast majority believe the Fed will engage in QE3. The average bet is 70-30 in favor of QE3, with a standard deviation of 22 percent.

There is broad consensus among traders that U.S. growth and employment are sliding sideways in an L-shaped, “slow and fragile” recovery through 2012, and the real question at this point is when and how much the doves at the Fed will resort to QE3. “How many bullets does the Fed really have left in its gun at this point?” asks Prologue’s McGlade. “From now on, the only remaining impactful policy option is additional QE, which could be balance-sheet neutral or expansive. And sometime in the first half of 2012, provided that the data continues to undershoot the hurdles of the dual mandate, I think we will see additional QE involving balance-sheet expansion rather than another balance-sheet-neutral move like Twist, and most likely involving mortgages this time.”

There is disagreement over what the transmission mechanisms from QE3 back into the real economy are — if any. “By pressing rates so low, the Fed is just making it too dangerous to hold cash and bonds,” concludes a skeptical global macro trader. “If you need yield, you are being forced up into equities and other real assets — not a comfortable position to be in.”

China: Hard or Soft Landing?

Will Beijing keep real Chinese GNP growing somewhere around its current target of 7.5 percent for the next year? Or will inflation fears cause the leadership to dampen demand levels back down toward 5 percent? There is a history of Beijing throttling the economy back and forth rather radically. As Arvind Sanger, founder of New York–based hedge fund firm GeoSphere Capital Management, says, “The Chinese authorities have only two economic management tools at their disposal — one is a flamethrower, and the other is a fire extinguisher.”

One possible outcome from the China event is real growth in the 8 to 10 percent range, with increasing inflation above 5 percent, sustained feverish levels of capital and infrastructure investment, and some reduction in net exports (which together add to 70 percent of GDP) — not quite the flamethrower mode but still pretty hot, and consistent with a “business as usual” view of the world. The other possible outcome is a hard landing: growth around 5 percent, with persistent inflation and expansion of net exports.

Original Prediction: Soft Landing

On average, the traders assigned a 57 percent probability to the soft-landing path and 43 percent to a hard landing, with a standard deviation of 19 percent. The dominant view argued that the leaders in Beijing had a lot of tools at their disposal to drive the economy in the direction they wanted it to land, including ownership of the banking system and a cushion of several trillion dollars in foreign exchange reserves.

Actual Outcome: Headed for Hard Landing but Changed Course

The traders were on the money, on average. We are still in soft-landing territory, with Chinese real growth expected to hit 9.2 percent on an annual basis in 2011, according to Xinhua News Agency. This growth was achieved by sustained high levels of domestic investment and by net exports, although the ratio of net exports to GDP declined from 3.1 percent in 2010 to 2.4 percent in 2011.

“They [Beijing] were tightening at the beginning of 2011, tightening real estate lending and raising some tax rates, but then they changed in October, with a minor monetary ease, some tax cuts for business and a shift toward easier monetary and fiscal policy, suggesting that the Chinese leadership is more concerned about the risk of a “hard landing,” says Laurence Zuriff, managing partner of Granite Capital International Group, a New York–based investment firm.

There is considerable uncertainty about the real rate of inflation, given doubts about the accuracy of reported consumer price index figures: Official 2011 inflation is running at somewhere between 5 and 6 percent (6.1 percent in September and 5.5 percent in October). Some believe this number has been engineered by the government statistics office — for example, by lowering the weights of food in the CPI basket.

Drivers: Rebalance, but Not Yet

Cyclically, the Chinese face the same trade-offs noted in my last article. The Politburo, which charts the basic guidelines for macro policy, fears the twin miseries of unemployment and inflation. If real growth falls below 7 percent or so, China cannot absorb annual increases in the workforce; if inflation rises much above 5 percent, the population gets restive.

Secularly, the members of the Politburo know they need to rebalance the components of GNP sooner or later — probably sooner — because the large weight and high growth rates of fixed investment and net exports can’t continue indefinitely and will have to be replaced with high personal consumption. All the official speeches acknowledge this. But no one in Beijing appears to be in any hurry to accelerate adjustment at the risk of domestic instability.

According to Ben Simpfendorfer, a Hong Kong–based economist for New York–based financial advisory boutique Global Strategic Associates and editor of the “China Insider” newsletter: “China has some of the world’s best economic planners, but the scale of the challenges are daunting, especially in the midst of a political transition. Beijing’s biggest challenge is weaning itself off state-owned heavy industry and revitalizing the private sector. The economy was, ironically, better balanced in 2008, or shortly before the crisis.”

Chinese officials think the shrinkage of net exports will continue, although some in Beijing are already raising alarms about a possible sharp swing down. According to Zhang Yansheng, director of the Beijing-based Institute for International Economics Research, under the National Development and Reform Commission, “What we’re facing now is a grave situation for exports, and slowdown is inevitable in the third and fourth quarters.”

So a soft landing is still the target, though what constitutes “soft” appears to be somewhat slower nominal growth — say, 8 percent rather than 9 percent — and the danger zone of hard-landing growth is a bit higher: say, 6 percent rather than 5 percent.

Prediction for 2012: China Needs Reform, Not More Easing

Looking forward, the traders believe that China’s glide path toward lower growth is still one of the big four events that will move financial markets in 2012. The average prediction continues to see a soft landing, but the odds fell from 57 percent in June to 53 percent looking forward into 2012.

“China has the firepower to prevent a hard landing in 2012, but the economy needs more reform, not more policy easing,” says Simpfendorfer. “Flushing the system with more credit will only worsen imbalances. China’s middle-income trap is approaching fast unless productivity gains start replacing labor and capital as the main drivers of growth. Policy easing can only delay, not avert, the challenges.”

Granite’s Zuriff agrees that 2012 will be a tougher growth environment for Beijing’s leaders. “Global demand will likely be lower, and their wage inflation is reducing their competitive advantage in a lot of export sectors,” he says. “And there have been a series of frauds and corporate governance issues, like Sino-Forest and Alipay, that are undermining inward foreign investment. The housing sector is overbuilt and vulnerable to a big price correction, and the Communist Party leadership itself is going through a big transition in the second half of the year. When trying to determine if we will see a hard landing in 2012, we have to ask if the party leaders will try to buy growth to buy stability in front of the leadership transition — and if they’ll succeed.”

Of course, the 53-47 split of our poll indicates average confusion more than anything else, as the standard deviation of the forecast widened from 20 percent to 23 percent. “We can’t understand economic policymaking in Brussels or Washington anymore, much less in Beijing,” complains one trader. “Plus, if the Chinese don’t make their growth or inflation targets, they can just make it up. But at the end of the day, the Chinese can have a soft landing because they can afford it — they have the resources needed to carry them through a transition period.”

Euro Zone: Extend or Breakup?

Will the EU peripheral states force bondholders to take a haircut on their debt? Or will the EU, the European Central Bank and Germany somehow manage to bail them all out in a way that doesn’t force big write-downs?

All macro traders believe the question isn’t whether the periphery writes down its sovereign debt, but rather how it does so. One branch of the European debt limb of the decision tree is what one trader describes as “extend and pretend,” with some kind of government bailout that keeps holders of Irish, Greek and Portuguese sovereign debt from taking big write-offs, thereby averting contagion to the European banking system. This is business as usual in the euro zone. The other branch is an ugly adjustment that reveals the scale of the exposure of French and German banks to peripheral sovereign debt and threatens to spread to Italy and Spain.

Original Prediction: Extend and Pretend

The average probability estimate for “extend and pretend” was 53 percent, versus a 47 percent prediction of an ugly default, with a standard deviation of 25 percent, a wide distribution around the mean.

The average prediction gave the euro authorities almost even odds between going up the “extend and pretend” path with a bailout that didn’t result in a haircut for the holders of euro zone periphery sovereign debt and an ugly default on the periphery, which would rapidly spread to Italy and Spain as well as threaten the credibility of the European banking system, including the core French and German banks. The big standard deviation suggests a fairly wide dispersion around the mean by individual traders. Some believed the Europeans could trudge toward a solution and eventually muddle through. Others insisted that markets wouldn’t wait that long.

Actual Outcome: Ugly Adjustment

The funding crisis of European banks and sovereigns alike is driving them both pell-mell into the reluctant embrace of the ECB. This surely constitutes evidence that we are going down the ugly-adjustment pathway.

In the last half of 2011, French banks’ dependency on the ECB for liquidity exploded, from €10 billion to €100 billion ($13 billion to $130 billion). The FTSE index of French and German banks dropped from 100 to 60. Moody’s Investors Service downgraded the credit ratings for BNP Paribas, Crédit Agricole and Société Générale, while Fitch Ratings downgraded the long-term ratings of Barclays, Credit Suisse and Deutsche Bank.

Euro zone authorities are still pretending that the monetary union part of the “European project” is on track, but this could fall apart any day now. They are also pretending that there has been no default event for the holders of European sovereign debt, even while twisting their collective arm to take a big haircut — a truly surreal juxtaposition. In the meantime, Greek debt is trading at a deep discount to par, which is surely a write-down in the real world. Beyond the Continent everyone is watching the circus of euro negotiations with a combination of anxiety and disbelief. “Demographics have caught up with the European social welfare state, and European governments made promises they can’t keep, so what we’re seeing is the bursting of the entitlements bubble,” says one Connecticut-based global macro trader. “These last weeks have been a fiasco for European authorities. The EFSF [European Financial Stability Facility] is hamstrung, the outlook for the euro is bleak, and any chance of a year-end rally is gone. The banking crisis will deepen, sovereign bond yields will continue to increase, and we traders are facing grindingly volatile markets with a downward trend.”

Drivers: The Sovereign Debt Danger Zone

The cyclic and secular drivers of euro zone survival going into 2012 are the same as in mid-2011. The euro zone is sliding into a second recession, and the long-term problems of center-periphery price adjustment (or lack thereof) and sovereign debt remain unresolved. The sheer scale of the political compromises and subsequent approvals required to alter the euro zone agreement — particularly in Germany — is dragging out the adjustment process and amplifying the cyclical crisis.

The basic math on the sustainability of sovereign debt is still in place: Once sovereign yields climb above the likely GDP growth rate, the debt burden will climb and sooner or later crush the state. By this measure, all of the so-called PIIGS — Portugal, Ireland, Italy, Greece and Spain — are already above the sovereign yield danger zone.

Prediction for 2012: Either Way, It’s Game Over in 2012

Our traders remain almost equally split on the euro zone trajectory — 53 to 47 — with an average forecast that Brussels and the European authorities can somehow pull off an extend-and-pretend bailout of the periphery and the core through 2012, but the standard deviation of the forecasts narrowed from 25 percent to 19 percent. The overall tone, however, is increasingly skeptical as traders and other market participants watch the European authorities dither through endless summits, deadlines and “senior consultations.”

“With some help from other wealthy European states and ECB repo operations, Germany has the money to do a wholesale credit wrap of euro-area bank and sovereign debt,” says Prologue’s McGlade. “But there are stringent conditions from the Germans for that wrap. Plus, the political and nationalist constraints in the other states that have to accept those German conditions are uncertain and volatile. The scale of funding needs in the first quarter at the sovereign, banking and corporate level in Europe is absolutely huge, and that means some sort of climax is imminent.”

From his market soundings, McGlade believes he is not alone in this view. “The ECB is dancing as fast as it can to preserve the European banking system, and the market is sniffing this,” he explains. “[ECB president Mario] Draghi’s hawkish refusal to allow the ECB to expand the bond purchase program has begun a new, dangerous chapter in the euro crisis. The global pool of capital will not fund those debt rollovers unless it is at a steep discount, and at such a discount the debt-service load becomes untenable and the government business models unsustainable.”

Another Greenwich-based macro trader is equally pessimistic. “The euro is destined to be a weak currency in 2012,” he says. “Rates are going to zero or just 25 basis points, Brussels’ interventions will remain haphazard, and the ECB will continue to disappoint those calling for full-force monetization of struggling sovereign debt. Greece and Italy will both default in 2012, and the ‘core’ European banks are going to have to get recapitalized. We are on the precipice of a nasty election cycle globally, and there is going to be a lot of tearing of social fabric.”

Not all observers are so bleak about the euro zone’s prospects, though they agree that 2012 is a year of decision. “The political obligation on the part of the Germans to avoid the disintegration of Europe is so great that ultimately they will choose the lesser of two evils and decide to take the hit and guarantee debt. The Greeks and Italians will write rules, and the Germans will sign the checks,” predicts a senior investment banker. “Either way, it’s game over within 2012. Either Germany concedes or the euro zone dies.”

Oil: Medium or Expensive?

The final big event is oil prices. Every day since the Arab Spring broke out in December in Tunisia, traders have been running and rerunning the odds that chaos in the dusty streets of Middle Eastern and North African capitals will result in fewer oil tankers passing the Strait of Hormuz. Since it is well established that there is very little swing capacity in the oil market with which Saudi Arabia could maintain stability in oil prices (even if it wanted to), a minor disruption in oil exports from the Gulf could result in big price increases. One possible outcome is expensive oil, $125 or more a barrel; the other is medium to expensive oil at about $100 a barrel.

Original Prediction: Medium Oil

The majority view of the macro traders was the second outcome, toward medium to expensive oil, but only narrowly so, with an average 52 percent probability and a large standard deviation of 21 percent. Traders were more concerned about possible supply shocks caused by the Arab Spring rippling more widely through the oil-supplying countries of the Middle East and less concerned about variations in demand, especially from China and India.

Actual Outcome: Medium Oil as Libya Is Off-Line and Then On-Line

The prediction was right — we are down the path of $100 to $110 oil. “Oil in 2011 was all about Libya,” says one macro trader, who spent a decade as an energy specialist. “Libya went off-line in February and came back on-line in the fall. Before the war they were pumping 1.6 million barrels per day, which then dropped to zero. That’s the chief reason Brent got up to $130 per barrel. But Libya has exceeded expectations recently and is back pumping between 800,000 and 900,000 barrels per day.”

Drivers: Finely Balanced Supply and Demand

The same cyclic and secular drivers are likely to be propelling oil prices in 2012. Emerging-markets demand has absorbed the small incremental pumping capacity that softened developed market demand is freeing up. On the supply side there is still political instability in several major suppliers: Iran, Libya, Nigeria and Venezuela.

In terms of secular drivers, the Arab Spring has resulted in massive injections of funds back into those nations’ societies by nervous sheiks and kings. This puts some pressure on them and OPEC to pump more. On the other hand, it also gives them an incentive to cut back on supply so they can raise prices. For example, because of enhanced fiscal commitments, the price of oil that Saudi Arabia needs to balance its budget — the so-called budget break-even point — went up to $80 a barrel and may climb to $115 a barrel in a year or so at current production rates.

The secular drivers increasing supply or substitutes outside of politically dicey areas in the Middle East and Africa through oil shale, deepwater drilling and fracking are steady but will take time. In the meantime, conventional oil capacity is increasing only about 1 percent per year on a net basis, which, combined with slim marginal capacity, could produce quite a bit of volatility in 2012.

Prediction for 2012: It’s All about Geopolitical Risk

Traders seem to have changed their minds about oil prices more decisively than about the other events. The average forecast is 59 percent that oil will stick at $100 or below throughout 2012, with a standard deviation of 18 percent.

“We are entering 2012 with low oil inventories but with overall demand flat because of recession here and in Europe, and with OPEC pumping at high levels, inventories will build in the early parts of the year, which will knock prices down,” says the energy-specialist-turned-macro-trader. “If Libya holds together, the balances for the second half of 2012 are very bearish. Prices should go flat to down through the year. So we’re really looking at geopolitical risk here. If one more big supplier goes off-line for whatever reason, these prices must go up again to ration demand.”

The Arab Spring continues to reverberate in traders’ minds. “For whatever reason, the capital markets have simply turned a blind eye to the situation or have gotten comfortably numb with all that has transpired in the Mideast, beginning with the immolation of that Tunisian vegetable vendor that sparked the Arab Spring,” says Stevyn Schutzman, chief macro strategist at RBC Capital Markets. “But these situations in the Mideast are all interconnected. The ripple effects that U.S. withdrawal from Iraq may have on the capital markets could be enormous — not just on the oil price but more broadly into energy policy and even defense spending.”

One Extreme or Another?

Some traders insist that oil prices could also move upward in response to higher inflation expectations generated by several central banks engaging in quantitative easing throughout 2012 — a wall of money pumped into the world economy by the Fed, the Bank of England, the Bank of Japan and the ECB. “The financialization of money over the last generation demands the monetization of finance now,” says QB Asset Management’s Brodsky. “The value of goods, services, assets and labor must be reconciled in real terms with our global currencies, both for takers and providers of them. So I expect inflation because of central bank money manufacturing that forces the general price level higher.”

This is an uncomfortable reminder for all forecasters — in academia or trading — that the big events that will move markets in 2012 are not the truly independent variables so prized by the runners of regressions but rather covariant in complex ways.

When smart traders are equally split on the odds while the markets are getting both volatile and increasingly cross-correlated, one strategy is to simply bet on both ends. According to Alen Mattich in his Wall Street Journal blog: “The hope may be for a muddle through when it comes to the euro crisis, but investors are increasingly betting on one extreme or another. Take a look at the oil market . . . [with] very heavy activity in out-of-the-money options on oil prices — at either end of the spectrum. Although prices are currently hovering at around $100 a barrel, investors are betting that prices either collapse by half or surge by 50 percent. But it’s not just oil. Everywhere you look, asset prices seem unstable.”

Concludes Brendan Dornan, principal of New York–based Dornan Capital Management: “The best strategy for this is to sell at-the-money puts and calls, and use the proceeds to fund purchases of many more out-of-the-money puts and calls. This is the ‘barbell strategy’ advocated by Nassim Taleb.”

So what do you need to sleep easily through the new year with your barbell bets? Probably a lot more information than you have. Peter Bernstein, the preeminent academic historian of risk-taking, described the trader’s dilemma, likely to be as true throughout 2012 as it was in 2011:

* The information you have is not the information you want.
* The information you want is not the information you need.
* The information you need is not the information you can obtain.
* The information you can obtain costs more than you want to pay.

James Shinn (jshinn@princeton.edu) is a lecturer at Princeton University’s School of Engineering and Applied Science. After careers on Wall Street and in Silicon Valley, he served as the national intelligence officer for East Asia at the Central Intelligence Agency and then as assistant secretary of Defense for Asia at the Pentagon. He serves on the advisory boards of GSA, Oxford Analytica and CQS, a London-based hedge fund.

CNBC: Byron Wien's 2012 Surprises

2012-01-04T18:35:00.000-08:00

12 Predictions for 2012

2011-12-28T12:39:00.000-08:00

Here is what other market sage are saying
* Byran Wien
* Doug Kass

12 Predictions for 2012
1) Barack Obama will beat Mitt Romney with or without the entry of Ron Paul as a 3rd Party candidate.
2) Republican will take the Senate while the House falls to Democrats.
3) European crisis will persist through year-end but will not spill into the US because European policymakers will react to contain the problem whenever it arises. Greece/Italy stay in the Euro.
4) Iran vs the world drama continues and that'll add volatility to the oil market but there will be no attack against Iran.
5) China's 2012 GDP growth will surprise to the downside i.e. below 8%.
6) US 2012 GDP growth will surprise to the upside - current consensus is ~2.1%.
7) By December, US non-farm payroll growth will reach 250K and the unemployment rate will fall below 7.5%.
8) The Fed will not shrink its balance sheet.
9) Yield on 10-year will end the year above 3%.
10) S&P500 will finish the year above 1,400 i.e. +11%.
11) Financials will be the best performers followed by tech and consumer discretionary.
12) No, the world will not end on 12-12-12.

S&P500 - Fibonacci Levels

2011-11-15T03:47:00.001-08:00

Mutual Fund Underperformance

2011-10-25T17:15:00.000-07:00

[Full Link]

Swiss Franc & Singapore Dollar Swap Spread Turn Negative

2011-08-19T18:01:00.000-07:00

Swiss 2-Year Yields Turn Negative, 10-Year Yield Down the Most Since 1994
Bloomberg, 18-Aug-11
By Keith Jenkins

Swiss two-year note yields stayed negative for a second day after central bankers announced more measures to weaken the franc, showing investors may sacrifice capital for the perceived safety of investment in the currency.

The Swiss two-year note yield fell five basis points to negative 0.06 percent at 4 p.m. in London as stock markets slid around the world. The yield yesterday slid 10 basis points into negative territory, indicating investors will receive less when the bonds mature than the sum they paid for them. Ten-year Swiss yields tumbled 19 basis points today, the most since Bloomberg began collecting the data, to 0.86 percent. (>>>)

Negative swap rate signals Singapore rethink on SGD rise
Reuters, 17-Aug-11
By Kevin Lim

Singapore is attracting an unwelcome flood of U.S. dollars that has caused a key interest rate to turn negative, complicating efforts to dampen inflation and prompting speculation the central bank will tweak its policy to slow the rapid rise in the country's currency.

While Singapore prides itself on having a highly globalised and open economy, the stream of investors seeking refuge from international market turmoil in recent weeks could fuel price pressures on the tiny island, adding to fears of a potential property bubble, even as the economy shows signs of slowing.

That could persuade the city's central bank to reconsider its policy on allowing further appreciation in the local currency. (>>>)

The Missing Link

2011-05-23T17:27:00.000-07:00

The Missing Link
The Economist, 19-May-2011

Economic growth helps investors only if they are clairvoyant

IT MAY seem obvious that faster economic growth should translate into higher equity returns. So it was quite an upset when academics found some years ago that this had not been the case in advanced countries over the 20th century. A subsequent paper discovered that the story was similar for developing economies as well.

These findings are awkward for emerging-market enthusiasts, who usually cite the superior growth prospects of such countries as the reason to invest in them. The counter-attack has duly been led by Jim O’Neill of Goldman Sachs Asset Management, who as a strategist coined the wildly successful BRIC acronym for the big developing economies of Brazil, Russia, India and China. Yet the surprise is not only that the response has been so long in coming but that the case it makes is so limited.

The Goldman paper admits that there is no evidence that equity returns for any given year are correlated with GDP growth in that same year. But it says that “equity markets are a lead indicator of GDP growth and react strongly to expectations about the future.”

This conclusion is hardly new. Stockmarket movements are a standard component of economic lead indicators. But this link is of little use to investors, who are looking instead for a lead indicator for equity performance.

Goldman argues that investors can take advantage of upgrades in economic-growth forecasts, which signal better prospective returns especially in the developing world. But its evidence for this claim is quite limited (just ten years of data for Brazil and Mexico, for example). If one takes the American market over the past 40 years then there is a negative relationship between changes in growth forecasts and equity returns.

This raises another doubt about the Goldman analysis. It is rather dismissive of the long-term stockmarket returns compiled by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School (LBS), who published their findings in 2005. “Averaging over a century fails to account for potentially important structural breaks and changes in the way economies and markets operate,” the report says somewhat sniffily. But the data are the data; it is not scientific to leave out large chunks of evidence.

But what if superior GDP growth showed up in stockmarket returns not immediately but over a prolonged period? The LBS academics tackle this issue in their 2010 work, the “Credit Suisse Global Investment Returns Yearbook”. They take the records of 83 countries from 1972 to 2009 (the most comprehensive set available) and rank them by GDP growth over the previous five years. Investing each year in the countries with the highest economic growth over the preceding five years earned an annual return of 18.4%, but investing in the lowest-growth countries returned 25.1%.

The interesting question is why this phenomenon should occur. One explanation is that investors pile into the stockmarkets of high-growth countries until they become overvalued. That herd-like behaviour makes their subsequent returns disappointing.

Another possibility is that economic growth does not always get captured by the stockmarket. The fastest-growing companies are often unquoted: in emerging markets, for example, many businesses are family-owned or controlled by the state. Even when businesses are quoted, their growth may be financed by additional equity issuance that does not boost the returns of existing shareholders. One paper suggested that this effect could reduce returns by as much as two percentage points a year.

Although analysts often forecast annual profits growth of 10% or more, the LBS academics found that dividends failed to keep pace with GDP growth in every developed country (bar one) they studied between 1900 and 2009. Re-invested dividends are a vital component of long-term equity returns.

If investors could forecast future economic growth, then Goldman would be right: superior returns would be achieved. But there is precious little sign that such clairvoyance exists. And the evidence that past economic growth is of no help remains pretty compelling.

Facebook for Finance

2010-12-22T07:36:00.000-08:00

Facebook for Finance
08-Oct-2010
By Len Costa

Blogs, online networks and other social media web sites are creating new opportunities for investment research. Social media sites are supplementing, and in some cases supplanting, the traditional Wall Street information ecosystem that transmits sell-side investment research and stock calls to the buy side.

If information "wants to be free," as one half of the famous aphorism goes, somebody forgot to tell Wall Street. This fall a federal appeals court in New York will weigh in on a long-running and widely watched legal dispute pitting Barclays Capital, Bank of America Merrill Lynch and Morgan Stanley against Theflyonthewall.com, a New Jersey–based web site that publishes sell-side analyst recommendations before the market opens — and often before the firms can distribute their own research to clients. The firms contend this hurts their commission revenue. This past spring a lower court judge ordered Theflyonthewall.com to delay publication of the firms’ stock calls until one half hour after the opening of the New York Stock Exchange, among other restrictions. The web site countered with an appeal and won a temporary stay.

Even if the brokerage firms prevail in their battle against Theflyonthewall.com, winning the war to preserve the primacy of their investment research won’t be easy. Bolstered by the low cost of online publishing and the rising popularity of blogs, discussion forums and commenting, a growing number of niche web sites are creating opportunities for new forms of investment analysis to emerge — and for buy-side professionals, even those at rival firms, to collaborate and learn directly from one another. These social media web sites are supplementing, and in some cases supplanting, the traditional Wall Street information ecosystem that transmits sell-side investment research and stock calls to the buy side. The sites’ popularity has been fueled by the limitations and shrinking coverage universe of sell-side research and the failure of establishment experts — from Wall Street analysts and strategists to the credit ratings agencies to the financial news media — to call the credit crisis.

“The sell side can often be slow to twist and turn with where the market is going,” says David Jackson, a former Morgan Stanley technology analyst and the founder and CEO of Seeking Alpha, a leading investment blog backed by blue-chip venture capital firms Accel Partners, Benchmark Capital and DAG Ventures. But crowd-sourcing investment ideas, he says, has its benefits: Throughout the rise and crash in the price of oil in 2007 and 2008, the unraveling of the housing market and the implosion of Bear Stearns Cos. and Lehman Brothers Holdings, Jackson’s more than 3,000 handpicked contributors and vocal readers were “uncannily on topic in terms of what was driving the market — at a macro level and an individual stock level.”

In mid-August, as part of the U.S. Treasury Department’s ongoing outreach to the financial blogosphere, seven bloggers were invited to a private meeting with a small group of senior officials, including Treasury Secretary Timothy Geithner, to discuss financial reform. As four of the seven bloggers regularly contribute to Seeking Alpha, the meeting was a nod to the site’s growing influence.

Finance pros have taken notice. According to audience tracker Nielsen Co., Seeking Alpha, which launched in 2004, now attracts more financial professionals than any other major financial web site. The site recently hit 540,000 registered users, and its opinion and analysis pieces, which are free, are read by more than 2.8 million people a month. Nielsen data suggest that more than 385,000 of these individuals are professionals: money managers, sell-side analysts, investment bankers, financial advisers, business leaders, entrepreneurs and sophisticated retail investors. Morgan Stanley’s sell-side research, by comparison, goes out to roughly 250,000 institutional investors, though the firm’s reach is much broader when you factor in its retail network of 18,000 financial advisers and their clients.

“Blogging is absolutely democratizing the investment business,” says Barry Ritholtz, who is CEO and director of equity research at independent quant research firm FusionIQ, and who writes The Big Picture, a well-regarded blog about macro investing themes. A Wall Street veteran and the former chief market strategist at New York boutique investment bank Maxim Group, Ritholtz says that 20 years ago the typical Wall Street strategist had an economics degree, went to one of a half dozen leading MBA programs and came up through the ranks at a big firm: “You’re talking about members of the same club — similar schools, similar background, working at the big Wall Street firms, quoted in the major media.” But these days, he contends, “that model is totally broken.”

For every form of investing, to tweak Apple’s catchphrase, “there’s a blog for that.” Naked Capitalism, which specializes in financial and economic commentary, is overseen by Yves Smith, the nom de plume of a former Goldman, Sachs & Co. and McKinsey & Co. executive, and is widely read by hedge funds. Footnoted.org, launched by journalist Michelle Leder, reports on the things that companies try to bury in their Securities and Exchange Commission filings and was recently acquired by Morningstar. And Jeff Matthews Is Not Making This Up, written by te founder of Greenwich, Connecticut–based hedge fund RAM Partners, delivers blunt analysis of everything from the sources of revenue growth at Hewlett-Packard Co. under former CEO Mark Hurd to Wall Street’s earnings coverage.

The explosion in socially generated investment analysis is both a blessing and a curse, especially when you consider the volume of short messages containing financial content that are transmitted every day via Twitter, the microblogging service that is especially popular among active traders (see sidebar, opposite). To manage what traders might call the high “signal-to-noise ratio” of public web sites, at least three private online communities now cater specifically to professional investors: Value Investors Club and Distressed Debt Investors Club, which were founded in 2000 and 2009, respectively, and each cap their membership at 250 investors, who are anonymous to fellow users; and SumZero, which launched in 2008, combines user-generated investment research with social networking features and now boasts a membership of more than 4,000 buy-side analysts and portfolio managers.

All three sites are rivals of sorts but share some members. Generally speaking, they screen applicants based on the quality of a sample investment thesis and require members to post write-ups on securities and regularly rate other community members’ ideas. The sites may also offer incentives to encourage participation; Value Investors Club, for example, awards a weekly prize of $5,000 for the best idea.

SumZero is betting that scale, transparency and Facebook-style networking features will set the site apart from its two smaller rivals. “The dynamic is that the bigger the idea database gets, the more compelling it becomes to contribute to,” says co-founder and CEO Divya Narendra, a 28-year-old former analyst at Boston-based hedge fund Sowood Capital Management who is running the site while pursuing law and business degrees at Northwestern University.

Networks are something that Narendra has spent a lot of time thinking about. As an undergraduate at Harvard University, he co-founded social network ConnectU, and he remains locked in a long-running legal battle with Facebook and its co-founder Mark Zuckerberg, a Harvard classmate whom Narendra accuses of stealing his idea. SumZero’s name and tagline, “The opposite of zero sum,” suggest a Facebook-like zeitgeist. It’s a cheeky riff on the idea — which seems out of place in the cutthroat world of money management — that investors can create value for one another by openly collaborating and sharing ideas.

And they are. James Kilroy, a portfolio manager at Gainesville, Georgia–based Willis Investment Counsel, which oversees about $1 billion in institutional and high-net-worth assets, joined SumZero when it was a third of its current size. He says that he often posts a detailed investment thesis to the site after completing his research and building a position. His goal is to stress-test his ideas — “I want to understand how I can be wrong,” he says — and to share them with an influential community that is prepared to act on a persuasive argument.

“You want to be early and first,” explains Kilroy, a former Bear Stearns analyst who covered multi-industrials, “but ultimately you need other investors to share your point of view for the stock to go up.” Kilroy likes the fact that SumZero members must disclose whom they work for and the type of funds they manage. “It forces you to a higher level of accountability,” he adds.

Access to contrarian investment thinking is also a key driver of investor interest in these social media sites. Jackson credits Seeking Alpha’s success to the diversity of viewpoints expressed by the site’s writers and commentators, who create a wide-angle view of a stock that he says is unmatched by traditional Wall Street research. SumZero’s Narendra agrees. “Somebody might put up a thesis [on SumZero] where a stock trades at $2 and the target is $10,” he says. “That’s the kind of stuff that the investment community needs — a divergence of viewpoints, as opposed to herd thinking.”

Still, investors must proceed with caution. In a 2007 study of 340 buy and 160 sell recommendations posted on Seeking Alpha, Veljko Fotak, a Ph.D. student in finance at the University of Oklahoma, found that the stock picks exhibited some value and market impact, as measured by returns in the 20 trading days after publication, but that the quality of the investment advice varied. He found scant evidence of any factors that could predict the quality of a blogger’s recommendations.

Size may be the enemy of the good. Wesley Gray, an assistant professor of finance at Drexel University in Philadelphia and a co-founder of Empirical Finance, a recently seeded $50 million quantitative hedge fund, has studied the investment write-ups posted to Value Investors Club, whose founders, Joel Greenblatt and John Petry — longtime partners at New York hedge fund firm Gotham Capital — strictly enforce the 250-member cap. Gray’s analysis, which formed the basis of his Ph.D. dissertation at the University of Chicago Booth School of Business, found that stocks recommended on the site delivered an average one-year buy-and-hold return of 9.52 percentage points above the predicted return, after controlling for risk. Gray and his colleagues performed a similar, unpublished analysis of recommendations on the SumZero web site, which has a much larger user base and a shorter track record, and found no statistical evidence that the ideas posted there were, on average, market-beating.

That comes as no surprise to the Value Investors Club founders, who admit just one in 15 applicants. “If every member of the buy side joins SumZero, over time you’re going to have the aggregate return of the market,” says Petry.
Blogs, online communities and crowd-sourcing platforms like Twitter may hold promise for investors, but their reach is still limited, especially among more-seasoned professionals. “Most portfolio managers over 35 are ignoring this stuff,” says Steven Goldstein, co-founder and CEO of Alacra, a New York–based content aggregator that helps investment firms track information published on blogs, social media sites and other online sources.

Tapping into the right networks can be a Herculean task. “Yes, there is a proliferation of information and a lot of debates happening on social networking sites, but I think if anything it obfuscates the issues,” says Barry Hurewitz, chief operating officer of investment research at Morgan Stanley. He contends that good sell-side analysts, thanks to their own professional networks, are better equipped to define the debate and understand market expectations. “They tend to have the conversations with investors that matter the most,” says Hurewitz.

The proponents of online communities and social networking have no delusions of grandeur, but they are firm in their belief that these new online tools will ultimately change the way investors conduct research and vet new ideas. “I don’t want to sound ridiculous,” says SumZero’s Narendra, who positions his site as an alternative source of information that complements existing sources, such as sell-side research, 10-Ks and investors’ own proprietary models. Still, the entrepreneur can’t help but ponder the possibilities. “If we get to the stage where there are 10,000 to 20,000 buy-side analysts all in one community,” he says, “I think that’s really, really powerful.”

THE FACT THAT professional money managers share investment ideas online is perplexing to academic economists. After all, in an efficient and competitive market, money managers should be inclined to keep valuable insights private so that they can exploit the information advantage to outperform their rivals and attract greater sums of investment capital.

In practice, though, sharing has long been one of the most important ways that fund managers discover new investment ideas. Private “idea” dinners and gatherings like the twice-annual Value Investing Congress, launched by Whitney Tilson and John Schwartz, have long been a staple of the business. In a 1988 academic paper, written back when social networking meant working the cocktail party circuit rather than friending somebody on Facebook, Yale University economist Robert Shiller and then–Harvard economist John Pound found that roughly 53 percent of the institutional investors they surveyed attributed their initial interest in a stock to another investment professional. When the inquiry was limited to a small sample of stocks that had experienced rapid price increases, 75 percent of the investors traced the origins of their ideas to fellow fund managers.

Sharing good ideas with competitors, it turns out, is an entirely rational undertaking. Drexel’s Gray cites three reasons: the collaboration argument (originally put forward by another academic, Harvard economist Jeremy Stein), which holds that managers will share information if doing so provides access to constructive feedback; the diversification argument, which holds that sharing is rational when it gives managers access to a wider pool of high-quality ideas; and the awareness argument, known more pejoratively as “talking your book,” in which a manager profits by persuading other investors to buy, thus bidding up the price.

The speed and scope of information sharing among investment professionals got a big boost in the late 1990s with the rapid adoption of instant messaging on Wall Street. With IM, brokers and traders — much like the teenagers who popularized the technology — found that they could share information with multiple individuals simultaneously and that sending an IM was more real-time than e-mail and more convenient than the telephone.

Sensing an opportunity, Reuters and Bloomberg introduced their own instant messaging platforms in 2002 and 2003, respectively, marking an important turning point. Unlike most consumer IM platforms at the time, both companies offered investment firms security, auditing and privacy controls, helping compliance officers get comfortable with the technology amid growing scrutiny by the SEC and other regulators that oversee brokerage firms.

As Reuters and Bloomberg terminals became ubiquitous in the investment business, they emerged as linchpins in what might be deemed Wall Street’s formal network for the distribution of research and stock calls to the buy side. Today, once an analyst releases a research report, it is typically published to the firm’s password-protected web site for clients and distributed simultaneously to entitled customers via Thomson Reuters (as the company is now known), Bloomberg or other third-party distributors, such as Capital IQ. Brokers and traders also e-mail research to clients, disseminate the substance via IM and host private conference calls or webcasts to discuss the investment opinions.

Thomson Reuters and Bloomberg are themselves working to build on strengths in instant messaging to create new opportunities for investment professionals to share and collaborate online — but in a way that affords firms ample control over who can see their content and how their employees share research and other proprietary information. Both companies’ flagship data products allows users to create profiles, follow updates from individual users and share charts and data, along with comments. “Bloomberg built systems to meet our customers’ networking needs before the concept of social media even existed,” says Jean-Paul Zammitt, Bloomberg’s head of core terminal products and services.

Even a Wall Street lawyer could love this kind of networking: As Eran Barak, Thomson Reuters’s global head of community strategy, puts it, the goal is to “bring the power of community and collaboration into financial professionals’ work flow,” while giving IT departments and compliance officers “all the tools to be compliant with regulation and perform risk management.”

Outside of this formal distribution network, socially generated investment opinion is for now less heavily regulated, but potentially very lucrative, for those who can tap into the right source. Value Investors Club, the most exclusive of the online venues aimed at pros, is seen as a particularly fertile source of high-quality ideas. In early May, for example, user “cxix” recommended shares of NBTY, the world’s largest maker of vitamins and supplements, then trading at $39 a share. The company, cxix wrote, was “a better business than it’s generally given credit for” and prone to “blow-ups” — such as the one in the previous week, when shares fell 20 percent intraday — because management “doesn’t play the earnings guidance/smoothing game.” With the stock trading at $54 in mid-September, investors who bought on the dip were up nearly 40 percent.

“When you submit a good idea to Value Investors Club or SumZero, others get on board,” says Alan Axelrod, a member of both sites and a former managing director at Ziff Brothers Investments, who now oversees $50 million in separately managed long-short domestic equity accounts. “You can immediately see some volume change plus the stock going up on a long you might suggest or down on a short.”

THERE is NO DOUBT that invest ment recommendations posted to social networks, however exclusive they may be, can be subject to biases. The 2007 paper by Fotak of the University of Oklahoma found that the stock picks from bloggers on Seeking Alpha tended to focus on large-cap names with recent abnormal returns and trading volumes. Long picks were consistent with contrarian strategies, he found, while shorts reflected momentum strategies.

Conversely, stock picks posted to Value Investors Club and SumZero are more likely to be small-cap stocks or special-situations opportunities, according to Drexel’s Gray. He noted in his Ph.D. thesis that the median market cap of long ideas, which make up the vast majority of recommendations on both sites, was $393 million for Value Investors Club and $559 million for SumZero. Most users of both sites are themselves employed by small and midsize firms. Based on an analysis of SumZero’s membership, Gray found evidence that larger fund managers were less willing to share new ideas than smaller managers were. (His interest isn’t just academic: Gray’s hedge fund trades in part on quantitative models that analyze the flow of information through social networks like SumZero and Value Investors Club.)

Apart from discovering and vetting new investment ideas, these specialized social media sites — the ones that don’t permit anonymity, at least — also provide crucial networking opportunities. Narendra says that SumZero is in many ways an extension of the information provided by services like Bloomberg. He points out that a Bloomberg terminal can be used to find out the names of firms that are 5 percent holders of a company’s stock, but not the names of the analysts at those firms who actually cover the company. On SumZero, however, users can search for a 5 percent holder and find out which of its analysts is covering the company. Users can also figure out who they know in common, whether they both used to work at Goldman Sachs or even whether they attended the same business school. “We’ve taken elements from social networking and [online encyclopedia] Wikipedia and applied them to the buy side in a way that nobody really has in the past,” says Narendra.

Over time, social networking may reduce the advantage that more-sophisticated asset managers with deeper pockets enjoy over smaller firms. “You’re gaining an extension of your own staff of smart people to render an opinion,” says money manager Axelrod. Although he generally prefers anonymity when connecting with peers online, he hasn’t hesitated to take advantage of the networking opportunities afforded by SumZero, using the site to identify fellow investors with whom to strategize. “It provides avenues for what social media is all about: relationships,” says Axelrod. “Not frivolous relationships but very valuable points of access.”

Alexander Rubalcava, founder of Los Angeles–based wealth management firm Rubalcava Capital Management, agrees. He recently posted on SumZero an analysis of offshore oil exploration and production company ATP Oil & Gas Corp., which has substantial operations in the Gulf of Mexico. As the BP oil spill dragged on, the web site “helped me keep track of all the changes proposed by the government,” says Rubalcava, a former analyst at Santa Monica, California–based venture capital firm Anthem Venture Partners. “Keeping up with that was beyond any one firm, but a lot of people were exchanging their findings on SumZero.”

The market for online investment opinion is helping some firms reach new clients. Chicago-based independent equity research firm Applied Finance Group, which typically serves institutional investors and large bank trust departments, publishes a daily investment thesis on a proprietary blog called Value Expectations and regularly contributes ideas and analysis to Seeking Alpha. Co-founder Rafael Resendes says the exposure has helped introduce his firm to registered investment advisers and brokerage teams that haven’t typically been big buyers of independent research. “Who knows how this will change the client landscape,” he says.

The Big Picture’s Ritholtz also attributes business wins to his blog. His firm, Fusion IQ, runs an asset management business that has attracted more than $300 million in assets, primarily through word-of-mouth referrals. “I suspect there’s a comfort level thanks to my blog,” says Ritholtz. “It makes the process of someone validating you that much easier.”
Networking and information exchange may be especially valuable in niche areas of the market. A case in point is Distressed Debt Investors Club, the brainchild of a credit analyst who goes by the handle “Hunter” and has eight years of experience on the buy side. Hunter, who declines to reveal his real name or the name of his employer, says that about three quarters of the roughly 200 investment ideas on the web site are distressed-debt and event-driven plays, with the remainder split between equity and special-situations opportunities.

“A lot of people on the site have either formal credit training or a leveraged finance background, so people understand the bankruptcy and restructuring process,” explains Hunter, who says his site marries the best of Value Investors Club and SumZero. (He is a member of both.) “On other sites or in sell-side reports, you might not have people well versed enough to understand the implications of, say, a fraudulent conveyance ruling.”

Still, money managers trolling for new investment ideas must proceed with caution. Academic studies of retail investors have found strong evidence that stock message boards lead to confirmation bias. Studies of professional investors’ offline behavior suggest that they are prone to the same temptations. With the balkanization of online information sources and the rise of the number of networking sites for professionals, myopia is a hazard. “You run the risk of reading just the people who agree with you,” says Ritholtz.

Conflicts of interest are another danger. Seeking Alpha differentiates itself with a contributor policy that requires its bloggers, who range from hobbyist investors to professionals, to provide the site’s editors with their real names for verification purposes, even if they blog anonymously, and to disclose positions in the securities they write about. Still, compliance with the policy is not policed by the site and thus depends on contributors acting in good faith.

The founders of private buy-side communities that permit anonymity say that they too know everyone’s identity, even if fellow users don’t, and that their sophisticated, highly vetted user bases assume that people are writing about positions they already own. “It’s preselected for people who will see through pump-and-dump,” says Value Investors Club’s Greenblatt.

Will these nascent social networking sites for financiers flourish — or will they remain a pursuit for just a narrow slice of the investment community? There are challenges to growth. For starters, regulators and compliance departments alike are still trying to figure out how to adapt existing rules on disclosure, supervision and recordkeeping to the unruly world of social media communications. Many firms are ordering employees to steer clear, and in some cases they are simply blocking social media sites from office computers.

“The new technology keeps morphing,” says Margaret Paradis, a partner in the investment fund and asset management practice at law firm Baker & McKenzie in New York. “That’s the challenge on the regulatory side.”

Making money is another hurdle. Some sites, like Value Investors Club, will no doubt continue to be run as quiet side projects for a select few. But other sites, such as Seeking Alpha and SumZero, aim to become profitable businesses. Seeking Alpha relies primarily on advertising, but in October the site will launch a platform featuring more than 20 applications for stock and exchange-traded-fund research as well as screening and charting tools, says CEO Jackson. SumZero is contemplating a different model. Rather than pursuing advertising, Narendra and his partners are considering strategies for selling or licensing to third parties the investment selections and recommendations that are featured on the site.

Back on Wall Street, many of the major brokerage firms say they aren’t yet ready to discuss how they might deploy social media tools to extend the reach of their investment research. But at least one firm is taking a page from the digital media playbook. In August, Morgan Stanley became the first Wall Street firm to launch iPad and iPhone apps allowing institutional clients to search and browse its research. According to research COO Hurewitz, the firm has already begun streaming research presentations on video.

And in a world awash in information, Morgan Stanley is helping its analysts validate their investment theses by leveraging a three-year-old internal custom research group called AlphaWise, which uses tools like quantitative market research and data mining to uncover primary evidence on any topic, from casual dining trends in the U.S. to equity issuance in India.

By strengthening its research with proprietary data sources and delivering the content through new digital channels, such as apps that enable the firm to control access with a log-in, these initiatives are consistent with the firm’s protective stance in its case against Theflyonthewall.com, but at odds with the open, collaborative and freewheeling nature of the social web. Whether these two approaches to creating professional-quality investment opinion can coexist in the information age, or whether they will ultimately converge as they have in other industries, remains to be seen.

Len Costa is the director of innovation and emerging media at CFA Institute, a global association of investment professionals.

The Greek Problem!

2010-02-17T10:23:00.001-08:00

The Greek Problem!
By Macrostrategy.com

The biggest issue in the global financial market at this time is whether or not Greece is going to default on its sovereign debt. That depends on Germany. Germans are not keen on bailing out the profligate Greeks but German and Euro establishment may not have much choice. We'll see how the events unfold but the Greek 5-year CDS spread (355bp) implies 28% default probability over that period. The last time a sovereign defaulted was in 2002 when Argentina abrogated its obligations to international bondholders. How Greece and Europe deal with the problem will impact the Euro and the dollar. So, what exactly is the Greek's debt problem? Why is it become so now?

Greek debt became the headline issues late last year when the finance minister announced that the country's deficit to GDP ratio for 2009 would be 12.7% instead of 6.0% originally forecast. This raised alarm bells amongst international investors because Greece needs to roll-over Euro 16 billion of its debt in April/May. As the focus on Greek finance intensified more nefarious activities started to come to light. Specifically, Greece was accused of consistently under-reporting its debt to the Eurostat, the European statistical agency by using complex derivative transactions. In actuality this was an open secret; in fact, an Italian academic Gustavo Piga wrote a paper on this exact topic back in 2002.

The genesis of the problem goes back to 2001 when Greece joined the Euro. In lieu of its entry, it had to abide by the Stability and Growth Pact (SGP) established in 1996. SGP set two important targets for member states: a debt to GDP ratio of less than 60% and a deficit to GDP ratio of less than 3%. At the time of entry, Greece was within the deficit limits but its debt was over 100%. In 2002, the European Commission pressured Greece to reduce its debt not just interest payments on those debt. In order to comply, Greece used cross-currency swaps in very innovative ways.

A cross-currency swap involves the exchange of payments denominated in one currency for payments denominated in another over fixed time period. Payments are based on a notional principal amount the value of which is fixed in exchange rate terms at the swap's inception. Like any derivatives, cross-currency swap can be used either as a hedging instrument (against exchange rate fluctuations) or as a speculative instrument (to bet on movements in currencies and yield curves). Cross-currency swaps do not change the size of debt (principal) at the beginning of the contract. At the end of the contract, debt value can change or not change based on nature of the contract. Swaps do alter periodic interest payments depending on the relative movements of exchange rates and interest rates in reference countries.

Swaps do not reduce the size of debt, just the costs of borrowing. So how were Greeks able to reduce debt using cross-currency swaps? The simple answer is because the Eurostat accountants allowed them to. ESA95, the accounting standards for government debt and deficit allowed "up-front swap payment" to reduce debt because it did not take into account the corresponding increase in payment at the end of the contract. Greece and Goldman Sachs took advantage of this accounting loophole to comply with EC's demands.

Starting 2002, Greece and Goldman Sachs entered into series of cross-currency swaps exchanging Greek's dollar-denominated and Yen-denominated debt for Euro-denominated debt. The transactions totaled about US$ 10 billion with tenor (maturity) of 15 to 20 years. Instead of using spot Euro/US$ and Euro/Yen exchange rates to swap debt, they used "off-market" rates whereby the reference Euro rates were lower than spot rates. This in effect was equivalent to one-time foreign exchange gains for Greece causing Goldman Sachs to make US$1 billion up-front payment followed by higher than otherwise periodic interest payments. As per ESA95, Greeks reported this up-front payment as a reduction in debt. The currency gain was going to reverse and Greeks were expected to payback Goldman Sachs at the end of the contract but they did not have to report that to the Eurostat. Goldman Sachs on the other hand hedged its exposure to the Greek transaction by taking off-setting positions with Frankfurt-based Deutsche Pfandbriefe Bank.

The bottom line is that Greece will not be able to roll-over its debt without some kind of international guarantee but what form that takes and who leads it (Germany or IMF) if at all is an open question. Lets see how this plays out!

Reference
Bank of America, January 2007. Introduction to Cross Currency Swaps
Bernard Connolly and John Whittaker. What will happen to the euro? (6-Nov-2002)
BMO Capital Markets. Cross Currency Swaps
Economist. Financial WMD? (22-Jan-04)
Gustavo Piga. Do Governments Use Financial Derivatives Appropriately? Evidence from Sovereign Borrowers in Developed Economies, International Finance, Vol 4 # 2 (16 Dec 2002)
Nick Dunbar, Risk Magazine. Revealed: Goldman Sachs’ mega-deal for Greece (1-Jul-03)
Vishal_Damor. Greece Soverign Debt Crisis, The Way Forward, if Any! (11-Feb-10)
Wolfgang Reuter. Greek Debt Threatens the Euro, Spiegel (8-Dec-09)

2003 Risk Magazine Article Exposes Greeks-Goldman Swaps

2010-02-16T18:54:00.000-08:00

Revealed: Goldman Sachs’ mega-deal for Greece
Risk magazine, 01-Jul-2003
By Nick Dunbar

With the help of Goldman Sachs, Greece has been using giant swaps deals to ensure its national debt ratios meet EU targets. But these deals are likely to prove controversial. By Nicholas Dunbar

Ever since the deficit and debt rules for eurozone member states were drawn up in the early 1990s, there have been persistent rumours and allegations that governments have used derivatives to get around them. For some time, economists have argued that the combination of strict external targets with considerable local autonomy in sovereign debt management almost inevitably leads high-deficit countries towards derivatives.

It is now widely known that since 1996, Italy’s Treasury has regularly used swaps transactions to optically reduce its publicly reported debt and deficit ratios. Such trades remain controversial, and were the subject of fierce debate in late 2001, when Italian academic Gustavo Piga published a paper accusing eurozone countries of ‘window dressing’ their public accounts using derivatives (Risk January 2002, page 17).

Now, Italy has been joined by the Hellenic Republic of Greece, as evidence emerges of a remarkable deal between the public debt division of Greece’s finance ministry and the investment bank Goldman Sachs. The deal is not only likely to reopen an old debate on public accounting for derivatives, but also sheds light on the way banks charge clients for taking credit and market risk exposure.

Intended to rein in fiscal profligacy among aspiring eurozone entrants, the Stability and Growth Pact (SGP) – established in 1996 – sets two important targets for member states: a debt/GDP ratio of less than 60% and a deficit/GDP ratio of less than 3%. Of the two, the second is considered more important. Countries that show persistent breaches of the 3% target are liable to pay heavy fines to Brussels of up to 0.5% of GDP under the so-called Excessive Deficit Programme (EDP). Performing the key regulatory role of determining whether the targets have been met is the European Statistical Office (Eurostat).

Greece, which joined the single currency in early 2001, resembles mid-1990s Italy in certain respects. Until recently it was a country of high deficits and high inflation, and for this reason did not bother joining the first wave of eurozone countries in 1998. In the run-up to joining the eurozone, Greek inflation and budget deficits fell sharply, and GDP grew as the incumbent socialist government pursued a policy of UK-style public-sector reform. However, like Italy, Greece’s debt/GDP ratio has remained high, at over 100%, and as a result its interest costs are the highest in the eurozone.

Public statement

In November 2001, the Greek finance ministry’s public debt division made a public statement about its debt management strategy. It acknowledged that its debt was a ‘critical macroeconomic parameter’, and pledged to reduce debt servicing costs by means that included ‘the extensive use of derivatives’. Apparently, this was not enough for Brussels. In February 2002, the European Commission pointed out future deficit forecasts by Greece relied ‘primarily’ on achieving reductions in interest costs. It called for Greece to reduce its ‘very high’ debt ratio, and to provide ‘more detailed information on financial operations’.

Although Greece’s public debt division points out that it uses 18 derivatives counterparties, there is no doubt that the division, which is headed by Christopher Sardelis, has a particularly close relationship with Goldman Sachs. Indeed, the account has been handled personally at Goldman Sachs by Antigone Loudiadis, the London-based European head of sales for the firm’s fixed-income, currencies and commodities unit. Highly respected by other dealers, Loudiadis has enjoyed a successful career at Goldman, joining the firm’s partnership committee and attaining her present position in 2000. According to sources, by early 2002, Loudiadis and her team put together a deal aimed at alleviating Greece’s problem of debt ratios and high interest costs.

The transactions agreed between the Greek public debt division and Goldman Sachs involved cross-currency swaps linked to Greece’s outstanding yen and dollar debt. Cross-currency swaps were among the earliest over-the-counter derivatives contracts to be traded, and have a perfectly routine purpose in debt management, namely to transform the currency of an obligation.

For example, an issuer with foreign fixed-rate debt might choose to lock in a favourable exchange rate move. To do this, it could swap a stream of fixed domestic currency payments for a stream of foreign currency ones, referenced to the notional of the debt using the prevailing spot foreign exchange rate, with an exchange of the two notionals at maturity. Because they are transacted at spot exchange rates, cross-currency swaps of this type have zero present value at inception, although the net value (and credit exposure of either counterparty) may subsequently fluctuate.

However, according to sources, the cross-currency swaps transacted by Goldman for Greece’s public debt division were ‘off-market’ – the spot exchange rate was not used for re-denominating the notional of the foreign currency debt. Instead, a weaker level of euro versus dollar or yen was used in the contracts, resulting in a mismatch between the domestic and foreign currency swap notionals. The effect of this was to create an upfront payment by Goldman to Greece at inception, and an increased stream of interest payments to Greece during the lifetime of the swap. Goldman would recoup these non-standard cashflows at maturity, receiving a large ‘balloon’ cash payment from Greece.

Since neither Goldman nor Greece will comment on the deal, much of the details remain vague. It is not clear which exchange rates were used in the actual contracts. Under the terms of a similar ‘off-market’ deal transacted by Italy in 1997, the exchange rates prevailing at the time of the underlying bond issue were used, which would have made sense in the case of Greece since the deal happened after a period of euro strengthening against the yen and dollar.

Although the overall deal is believed to have consisted of three or four individual transactions or tranches, according to sources, the total cross-currency swap notional was approximately $10 billion, with tenors ranging from 15 to 20 years. While the size of upfront payment to Greece’s public debt division is not clear, it seems the total credit risk incurred by Goldman Sachs was roughly $1 billion. Effectively, Goldman Sachs was extending a long-dated illiquid loan to its client.

Goldman Sachs is known for its conservative approach to credit risk, and chose to hedge its exposure to Greece by immediately placing the risk with a well-known investor in sovereign credit: Frankfurt-based Deutsche Pfandbriefe Bank (Depfa). According to sources, Depfa entered into a credit default swap with Goldman Sachs, selling $1 billion of protection on Greece for up to 20 years. Depfa declined to comment.

Total charge

Details have also emerged of the way Greece’s public debt division was charged for the transaction. According to market sources, the total charge was approximately $200 million. This charge can be broken down into several components. First, Greece was charged for the credit risk in the transaction. Long-dated Greek government bonds were trading at a spread of 30 basis points in 2002. A billion-dollar investment in such bonds, purchased in asset swap form and held for 20 years, would yield about $60 million. According to Risk’s sources, Depfa demanded a substantial premium for taking on what was in effect an illiquid, privately placed loan.

Second, Greece paid a principal risk charge to Goldman Sachs for its market risk exposure. Although standard euro/dollar and euro/yen cross-currency swaps are highly liquid instruments that trade at tight bid-offer spreads in the interbank market, such large, off-market transactions cannot be hedged in this market without significantly moving the price against the dealer. Goldman Sachs may have hedged some of the risk using futures, forwards and interest rate swaps, while retaining substantial cross-currency and interest rate basis risks in its portfolio. Of course, the ultimate profit and loss experienced by Goldman Sachs on the transactions remains unknown.

Equally murky is the exact effect of Goldman Sachs’ transactions on Greece’s publicly reported national accounts. Since the deficit was a comfortable 1.2% of GDP in 2002, it is more likely that the cashflows were either used to help lower the debt/GDP ratio from 107% in 2001, to 104.9% in 2002 (by funding buybacks) or to lower interest payments from 7.4% in 2001 to 6.4% in 2002. But why did the large negative market value of the swaps not appear on the liability side of Greece’s balance sheet?

The answer can be found in ESA95, a 243-page manual on government deficit and debt accounting, published by the European Commission and Eurostat in 2002. As revealed by Piga, the drafting of ESA95’s section on derivatives was the subject of fierce arguments between the government statisticians and debt managers of certain eurozone countries.

The statisticians wanted derivatives-related cashflows to be treated as financial transactions, with no effect on deficit or interest costs, and with the derivatives’ current market value stated as an asset or liability. The debt managers opposed this, insisting on having the freedom to use derivatives to adjust deficit ratios. The published version of ESA95 reflects the victory of the debt managers in this argument with a series of last-minute amendments.

In particular, ESA95 states in a page-long ‘clarification’ that ‘streams of interest payments under swaps agreements will continue… having an impact on general government net borrowing/net lending’. In other words, upfront swap payments – which Eurostat classifies as interest – can reduce debt, without the corresponding negative market value of the swap increasing it. According to ESA95, the clarification only covers ‘currency swaps based on existing liabilities’.

Legitimate transaction

There is no doubt that Goldman Sachs’ deal with Greece was a completely legitimate transaction under Eurostat rules. Moreover, both Goldman Sachs and Greece’s public debt division are following a path well trodden by other European sovereigns and derivatives dealers. However, like many accounting-driven derivatives transactions, such deals are bound to create discomfort among those who like accounts to reflect economic reality. For example, the Greece-Goldman deal may be of interest to credit rating agency Standard & Poor’s, which upgraded Greece’s long-term debt from A to A+ in June 2003.

Among other derivatives dealers, the deal is bound to create envy at Goldman Sachs’ skill in solving the risk management needs of such an important client. As long as the current Eurostat rules do not change, the use of derivatives in deficit and debt management by eurozone sovereigns is likely to flourish. The planned expansion of the eurozone to include 15 east European countries may lead to especially rich pickings for dealers able to seize such opportunities.

Summary Provisions of $789 billion Stimulus Package

2009-02-16T10:38:00.000-08:00

AP, 12-Feb-09

Many provisions of the nearly $789 billion compromise stimulus plan expire in two years. Additional debt costs would add about $330 billion over 10 years.

Highlights:

Aid to poor and unemployed
$40 billion to provide extended unemployment benefits through Dec. 31, and increase them by $25 a week; $20 billion to increase food-stamp benefits by 14%; $3 billion in temporary welfare payments.

Direct cash payments
$14 billion to give one-time $250 payments to Social Security recipients, poor people on Supplemental Security Income, and veterans receiving disability and pensions.

Infrastructure
$46 billion for transportation projects, including $27 billion for highway and bridge construction and repair; $8.4 billion for mass transit; $8 billion for construction of high-speed railways and $1.3 billion for Amtrak; $4.6 billion for the Army Corps of Engineers; $4 billion for public housing improvements; $6.4 billion for clean- and drinking-water projects; $7 billion to bring broadband Internet service to underserved areas.

Health care
$21 billion to provide a 60% subsidy of health care insurance premiums for the unemployed under the COBRA program; $87 billion to help states with Medicaid; $19 billion to modernize health information technology systems; $10 billion for health research and construction of National Institutes of Health facilities.

State block grants
$5 billion in aid to states to use as they please to defray budget cuts.

Education
$54 billion in state fiscal relief to prevent cuts in state aid to school districts, with up to $10 billion for school repair; $26 billion to school districts to fund special education and the No Child Left Behind law for students in K-12; $17 billion to boost the maximum Pell Grant by $500 to $5,350; $2 billion for Head Start.

Homeland security
$2.8 billion for homeland security programs, including $1 billion for airport screening equipment.

Law enforcement
$4 billion in grants to state and local law enforcement to hire officers and purchase equipment.

Taxes
New tax credit
About $115 billion for $400 per-worker, $800 per-couple tax credits in 2009 and 2010. Credit phases out for individuals with adjusted gross incomes of $75,000 to $90,000 and couples with AGI of $150,000 to $190,000.

Alternative minimum tax
About $70 billion to spare about 24 million taxpayers from being hit with the alternative minimum tax in 2009. The change would save a family of four an average of $2,300.

Expanded college credit
About $13 billion to provide a $2,500 expanded tax credit for college tuition and related expenses for 2009 and 2010. The credit is phased out for couples with incomes over $160,000.

Home buyer credit
$3.7 billion to repeal a requirement that an $8,000 first-time home buyer tax credit be paid back over time for homes purchased from Jan. 1 to Aug. 31, unless the home is sold within three years.

Bonus depreciation
$5 billion to extend a provision allowing businesses buying equipment such as computers to speed up depreciation through 2009.

Auto sales
$2.5 billion to make sales tax paid on new car purchases tax deductible.

Today's Reading List

2009-01-07T16:39:00.001-08:00

CORPORATE GOVERNANCE
Satyam Chief Admits Huge Fraud
NYT, 7-Jan-09

Mr. Raju said Wednesday that 50.4 billion rupees, or $1.04 billion, of the 53.6 billion rupees in cash and bank loans the company listed as assets for its second quarter, which ended in September, were nonexistent... In the four-and-a-half page letter distributed by the Bombay stock exchange, Mr. Raju described a small discrepancy that grew beyond his control.

Satyam Computer Services, a leading Indian outsourcing company that serves more than a third of the Fortune 500 companies, significantly inflated its earnings and assets for years, the chairman and co-founder said Wednesday, roiling Indian stock markets and throwing the industry into turmoil ...

REAL ESTATE
Commercial Property Loses Shelter
WSJ, 8-Jan-08

New data from Deutsche Bank show that delinquencies on commercial mortgages packaged and sold as bonds nearly doubled during the past three months, to about 1.2%. The delinquency rate will likely hit 3% by the end of 2009... An unusually high number of the underlying CMBS loans that are going bad were made and securitized in the past three years... a $125 million mortgage secured by a shopping center in Corona, Calif. called Promenade Shops had cash flow of $6.3 million when J.P. Morgan underwrote the loan in July 2007 but the loan was based on the assumption that the cash flow would rise to about $10.5 million.

Delinquencies on mortgages for hotels, shopping malls and office buildings were sharply higher in the fourth quarter, as the weaker economy hit landlords and threatens to cause losses for investors in the $3.4 trillion market ...

VALUATION IMPAIRMENT
Timely Warning on Cable Values
WSJ, 8-Jan-08

A key determinant of asset impairment, in addition to market prices, is the long-term cash-flow generation potential of a business... By resetting the level of shareholders' equity through write-off they enhance future returns on shareholders equity.

Shareholders in cable-TV companies might have forgotten in recent weeks -- as they have congratulated themselves on their foresight in owning relatively recession-proof stocks -- that the industry isn't without its competitive challenges from phone companies and the Internet ...

TECHNOLOGY
Intel Outlook Pared Again; Rivals Unveil New Products
WSJ, 8-Jan-09

Intel said Wednesday it now expects to report $8.2 billion in revenue for the fourth quarter and the company had projected in mid-October that sales would rise 3% from the third period...The company also said that its gross profit margins will be at the bottom of the lowered estimate it issued in November of 55%, plus or minus a couple of percentage points. In mid-October, the company had said the range would center around 59%.

Intel Corp. issued a second warning about deteriorating business conditions, signaling further weakness in the computer sector ...

OIL
Bahrain Credit Outlook Is Downgraded
WSJ, 7-Jan-09

"Break even" oil prices for Iran ($90), Oman ($77), Bahrain ($75), Saudia Arabia ($49), Kuwait ($33), Qatar ($24), UAE ($23)... Bahrain holds fewer liquid assets -- such as foreign-exchange reserves or investments by government-controlled funds -- than other regional oil exporters... Last month, Saudi Arabia said it expects to run its first budget deficit in years, committing itself to spending heavily despite an expected fall in oil revenue.

Moody's Investors Service downgraded the credit outlook for the Kingdom of Bahrain on Tuesday, marking the first sovereign-rating hit to the oil-rich Persian Gulf amid tumbling crude prices and the global financial crisis ...

COMMODITIES
Steelmakers Move Cautiously To Raise Prices, Reopen Mills
WSJ, 7-Jan-09

Troubled auto makers, contractors, appliance and equipment makers have cut back on their steel purchases. The majority of mills closed over the last few months remain shuttered and many around the world are operating below 50% of their capacity... In China, several steel mills have announced price increases ranging from 5% to 25% for a variety of products.

In an early sign that some steel prices may have bottomed out, steelmakers in the U.S., China and some other countries are attempting limited price increases and reopening a handful of mills that were closed because of weak demand a few months ago ...

CREDIT
Defaults Pose a Reckoning for Stock Rally
WSJ, 7-Jan-09

U.S. investment-grade corporate-bond issuance jumped to $108 billion in December, according to Dealogic, near the record $111 billion set in May, and up from a nadir of $15 billion in September... In the U.S. alone, some $758 billion in corporate debt is coming due in 2009, according to Standard & Poor's.

Credit-worthy companies have recently found a healthy appetite for their new debt. It is the older stuff that could cause trouble, both for corporate borrowers and stock investors ...

The “Basic Speed Law” for Capital Markets Returns

2009-01-07T16:21:00.000-08:00

The “Basic Speed Law” for Capital Markets Returns
CFA Magazine
November/December 2008, Vol. 19, No. 6

The return of stock prices to levels more consistent with economic growth is mean reversion at work

Recent stock market behavior has been astonishing—down 22 percent in the first half of October, down more than 40 percent in the past 12 months. Much of this drop has been blamed on the current financial crisis, but there are deeper—and yet simpler—economic forces at work. Three truisms are too easily overlooked.

The first truism is that over the long-run real per capita economic growth in the United States, over and above inflation, has been remarkably steady at 1–2 percent, as the top line in Figure 1 shows. Growth over the past 25, 50, and 100 years has averaged 1.4 percent, 1.7 percent, and 1.9 percent, respectively. This real growth rate reflects improving productivity, which over periods of decades varies little. Share prices (the middle line) and per-share earnings for the broad market (the bottom line) exhibit much the same growth, albeit with much more variability. One nuance is often overlooked: Just as the economy is the shared production of a growing population, a growing roster of companies drives that economic growth. Entrepreneurial capitalism—new enterprise creation— is an important driver of economic growth, contributing roughly half of real GDP growth, on average, over time. The other half of overall real GDP growth is contributed by the growth of existing enterprises. This means that share prices and per-share earnings for broad indexes, such as the S&P 500, should match the growth of existing enterprises, roughly half of total GDP growth. As it happens, this growth closely mirrors per capita GDP growth.

The second truism is that if the aggregate real per capita growth rate in the economy is a bit under 2 percent, the broadest sectors of the economy, such as the corporate sector, have to deliver about the same per capita growth rate in the long run. If the growth rate were greater, that sector would eventually become larger than the entire economy, an outcome that is constrained by both economic and political forces.

Over the past several decades, Americans at all levels in business, government, and private life have behaved as if these first two truisms were no longer relevant. Implicitly, and in some cases explicitly, decisions were made, including investment decisions, that were based on the assumption of far greater growth. A common refrain was that even if real per capita growth in the aggregate economy is limited to about 2 percent, that does not apply to us or to our investments, whether our domain is housing, technology stocks, hedge fund investments, or the stock market.

The third truism is that valuation of long-lived assets, such as common stocks, are highly sensitive to the assumed rate of growth. The experience of Google is an obvious example; the stock price has plummeted to $330 from $750, despite continued impressive growth in earnings, because the earnings growth has not been fast enough to justify an initially lofty multiple and expectations for future growth have been continuously revised downward.

Applying these three facts to the market as a whole leads to several stark conclusions. First, as with any broad sector of the economy, corporate earnings are constrained by the same long-run 2 percent speed limit. This means that unless P/Es change, stock prices will also grow, on average, at no more than 2 percent in real terms for the truly long-term investor.

History supports this view. In the past 25, 50, and 100 years, real growth in S&P 500 per-share real earnings has averaged 3.2 percent, 2.0 percent, and 1.5 percent, respectively. Meanwhile, the S&P 500 price index has risen by 5.1 percent, 2.7 percent, and 1.9 percent, respectively, over and above inflation. The earnings have grown faster than per capita GDP growth in recent years, in large measure because of recent earnings that have subsequently proven illusory. Meanwhile, share prices have grown faster still, largely on the back of rising valuation multiples, which we dare not rely on in the future. This recent outsized growth in real per-share earnings and share prices, over and above the per capita real growth of the economy, may be helping to foment the populist backlash we’re now seeing.

In this historical light, the current crisis is seen as more than simply the result of a housing bubble or an overstressed financial system. It is based on a widespread hubris that somehow the laws of economic growth do not apply, that share prices and earnings can grow faster than the overall economy. That hubris was reinforced by organizational structures that allowed executives, insurers, derivatives traders, bankers, and many others to take large amounts of cash home as long as the euphoria continued and as long as customers were willing to set aside logic in favor of a promised nirvana.

The ultimate return of stock prices to levels more consistent with economic growth is nothing more than another example of mean reversion at work. The good news is that, from current levels, mean reversion need not exact as severe a future toll as it has imposed on us in the past 12 months. This too shall pass.

Brad Cornell is a visiting professor of finance at the California Institute of Technology and a senior consultant to Charles River Associates. Rob Arnott is chairman of Research Affiliates, LLC, and former editor of the Financial Analysts Journal.

Today's Reading List

2009-01-05T05:26:00.000-08:00

RISK MANAGEMENT
Risk Mismanagement
NYT, 4-Jan-09
By JOE NOCERA

VaR isn’t one model but rather a group of related models that share a mathematical framework. In its most common form, it measures the boundaries of risk in a portfolio over short durations, assuming a “normal” market. For instance, if you have $50 million of weekly VaR, that means that over the course of the next week, there is a 99 percent chance that your portfolio won’t lose more than $50 million... one of VaR’s flaws, which only became obvious in this crisis, is that it didn’t measure liquidity risk... the big problem was that it turned out that VaR could be gamed... It (the risk of CDS) was outside the 99 percent probability, so it didn’t show up in the VaR number. People didn’t see the size of those hidden positions lurking in that 1 percent that VaR didn’t measure.

THERE AREN’T MANY widely told anecdotes about the current financial crisis, at least not yet, but there’s one that made the rounds in 2007, back when the big investment banks were first starting to write down billions of dollars in mortgage-backed derivatives and other so-called toxic securities ...

REAL ESTATE
U.S. commercial property in a downward spiral
NYT, 5-Jan-09
By Charles V. Bagli

The Urban Land Institute predicts 2009 will be the worst year for the U.S. commercial real estate market "since the wrenching 1991-1992 industry depression"... Regional banks may be an even bigger concern. Over the past decade, they barreled their way into commercial real estate lending after being elbowed out of the credit card and consumer mortgage business by national players. Their weighting in commercial real estate has nearly doubled in the past six years, according to government data... In 2006 and 2007, nearly 60 percent of commercial property loans were turned into securities... Effective rents, which have already started to fall, are expected to decline 30 percent or more across the country from the euphoric days of the real estate boom, according to real estate brokers and analysts... The Real Estate Roundtable sees a rising risk of default and foreclosure on an estimated $400 billion in commercial mortgages that come due this year... Already, $107 billion worth of office towers, shopping centers and hotels are in some form of distress.
Vacancy rates in office buildings exceed 10 percent in virtually every major city across the United States and are rising rapidly, a sign of economic distress that could lead to yet another wave of problems for the beleaguered financial sector ...

Today's Reading List

2008-12-22T08:45:00.000-08:00

GOVERNMENT SPENDING
A Trap in Obama’s Spending Plan
NYT, 20-Dec-08
By LOUIS UCHITELLE

Public spending, American style, has worked best in good times, when people have jobs and executives are eager to invest. A new public highway is soon lined. A dollar spent by government generates three or four from the private sector... For all the money spent by the Roosevelt administration, public investment was failing to jump-start a key private-sector industry... Like Roosevelt’s dams, Mr. Obama’s expenditures will no doubt generate jobs and wages in the construction phase. But in 1937, Roosevelt, thinking that the private sector could sustain itself, pulled back on public spending. Some historians say this was a big reason the economy sank again.

As the recession deepens, President-elect Barack Obama is gearing up to spend hundreds of billions of dollars on public investment projects, counting on them to lift the economy, as they have in the past ...

CREDIT
Debt Recovery Prospects Darken
WSJ, 22-Dec-08

Professor Ed Altman of New York University's Stern School of Business expects 11% to 11.5% of U.S. high-yield bonds outstanding at the end of the third quarter to default within a year. His proprietary model suggests average recovery, given that default rate, of about 27 cents on the dollar... Loose covenants and the use of payment-in-kind (PIK) "toggles" exacerbate the problem.... There are two bigger problems for creditors to contend with. One is the higher use recently of senior loans, fueled by demand for collateralized loan obligations. The second problem is scarce debtor-in-possession (DIP) and exit financing: the credit extended to bankrupt firms to help them restructure and emerge from Chapter 11.

Bankrupt debtors used to be thrown in jail. Do that now, and America's prison system would collapse. Rather than seek incarceration, today's creditors are focusing on extracting better recovery rates: the amount they get back on defaulted debt. Unfortunately, excessive leniency during the boom years means not only having to deal with more defaults, but also getting very little back when that happen ...

CREDIT, REAL ESTATE
Developers Ask U.S. for Bailout as Massive Debt Looms
WSJ, 22-Dec-08

530 billion of commercial mortgages will be coming due for refinancing in the next three years -- with about $160 billion maturing in the next year... Unlike home loans, which borrowers repay after a set period of time, commercial mortgages usually are underwritten for five, seven or 10 years with big payments due at the end. At that point, they typically need to be refinanced. A borrower's inability to refinance could force it to give up the property to the lender.... At the heart of the financing scarcity is the virtual shutdown of the market for CMBS, where Wall Street firms sliced and diced commercial mortgages into bonds.... While commercial real-estate developers restrained themselves during the boom years when it came to speculative development, property investors bid up the prices of office buildings, malls and other projects to record levels assuming rents and occupancies would keep rising. With cash flows now falling, a growing number of developers are having a tough time repaying their debt... Delinquencies on commercial mortgages jumped to 0.96% in November, up from 0.62% in September. Some analysts predict the delinquency rate will leap to 2% by the end of next year. During the real-estate collapse of the early 1990s, the worst-performing commercial mortgages -- those that were made in 1986 -- sustained losses of about 10%.

With a record amount of commercial real-estate debt coming due, some of the country's biggest property developers have become the latest to go hat-in-hand to the government for assistance ...

PHARMA
Pharmacies Fight Tough Battle on Generic Prices
WSJ, 22-Dec-08

Retail pharmacy generic discount programs have proliferated since Wal-Mart Stores Inc. introduced $4 generic prescriptions for one-month supplies of hundreds of unbranded drugs in 2006, and mass merchandisers and grocery stores responded with their own versions... Walgreen this summer started strongly marketing its Prescription Savings Club, which provides discounts on generics and 5,000 branded medications and rebates on store-brand products... CVS this fall introduced a discount program aimed at the uninsured, offering a 90-day supply of more than 400 generic drugs for $9.99 and a 10% discount at the company's store-based clinics... Rite Aid in late September rolled out nationally a prescription savings card offering hundreds of generic drugs at $8.99 for a 30-day supply or at $15.99 for a 90-day supply, plus discounts on branded drugs and Rite Aid products.

Retail pharmacies are waging what some consider a generic-drug price war that is threatening margins in a typically high-profit area and reflects the intense competition that drug-store chains face in attracting and keeping customers ...

CURRENCY
Why didn't the dollar collapse
Paul Krugman

Today's Reading List

2008-12-19T05:37:00.000-08:00

COMMODITIES
Platinum Falls to Gold's Level
WSJ, 19-Dec-08

On Wednesday, platinum prices settled below gold prices for the first time since the 1990s (Jan. 21, 1994), as prices have been pummeled on weak demand from the auto industry, which accounts for more than half of platinum consumption. That day, platinum settled at $865.20 and gold at $867.50.... Still, gold's edge over platinum probably isn't sustainable. Above-ground stocks of platinum are much smaller than those of gold.

Platinum prices are trading roughly on par with gold, a far cry from the white metal's $1,200 price lead earlier in the year and highlighting the woes of the auto industry, a big platinum consumer ...

OIL
Oil Drops Under $40 on Demand Fears
WSJ, 19-Dec-08

The big price drop over the past two days was exacerbated by the lack of available space at Cushing, Okla., the oil-storage hub where the physical barrels that underpin the Nymex futures contract are delivered. Inventories topped 27.5 million barrels at Cushing last week, just 500,000 barrels below the all-time high in April 2007, when a Texas refinery fire led to a stockpiling of crude... Investors with expiring contracts to buy crude need to sell out this week, or pay a hefty fee to avoid taking delivery. Physical delivery of crude contracted in the futures market is rare, but with tank space at Cushing difficult to come by, physical delivery is especially undesirable due to rising storage costs. The record gap between the first and second-month contracts -- $5.81 at Thursday's settlement -- reflects the scarcity of buyers willing to take crude for January delivery so close to expiration.

Oil's plunge below $40 a barrel is partly an anomaly due to the expiring January crude-futures contract. It also may be a sign of things to come ...

HOUSING
Tax Break May Have Helped Cause Housing Bubble
NYT, 19-Dec-08

But many economists say that the law had a noticeable impact, allowing home sales to become tax-free windfalls. A recent study of the provision by an economist at the Federal Reserve suggests that the number of homes sold was almost 17 percent higher over the last decade than it would have been without the law... The provision — part of a sprawling bill called the Taxpayer Relief Act of 1997 — exempted most home sales from capital-gains taxes. The first $500,000 in gains from any home sale was exempt from taxes for a married couple, as long as they had lived in the home for at least two of the previous five years. (For singles, the first $250,000 was exempt.).

Ryan J. Wampler had never made much money selling his own homes. Starting in 1999, however, he began to do very well. Three times in eight years, Mr. Wampler — himself a home builder and developer — sold his home in the Phoenix area, always for a nice profit. With prices in Phoenix soaring, he made almost $700,000 on the three sales ...

Today's Readings List

2008-12-11T18:14:00.000-08:00

COMMODITIES
Riding the rollercoaster
Economist, 11-Dec-08

For the six leading firms reviewed by The Economist, cash spent on deals in those two years (2006-07) accounts for four-fifths of their total net debt of $136 billion.... From their peak, analysts’ forecasts of operating profits next year have dropped by 30-50% for all six firms, leaving less cashflow than expected to support debt. Share prices have plunged too, so that net debt is comparable to, or well above, the firms’ market capitalisations....That (capex reduction), along with adequate liquidity for at least five of the six, makes survival likely. It also raises an intriguing question. The deals of recent years mean these industries are more concentrated and indebted than ever before. That in turn has forced huge, rapid cuts in actual and planned capacity, which could stabilise prices faster than in past downturns. It is a glimmer of hope during these bleakest of times.

IF A rollercoaster keeps cranking upwards for long enough it can be tempting to relax your grip—just for a moment. The bosses of some of the world’s biggest basic-materials firms did exactly this and are now suffering. Lulled by expectations that industrialisation in China and other developing countries would ensure sustained demand, leading firms in the steel, cement and mining industries have entered the recession with far more debt than is normally viewed as prudent ...

MEDIA
Broadcasting gloom
Economist, 11-Dec-08

Most forecasts for next year say that ad spending in America will decline by 5% or more....carmakers and dealers normally spend around $20 billion a year on advertising... Analysts at BMO Capital Markets predict that total spending on television ads will fall by almost 9% next year. Only newspapers, where a decline of 12% is expected, are forecast to fare worse...ZenithOptimedia, an arm of Publicis Groupe, another big agency, predicted this week that 89% of all growth in advertising spending between 2008 and 2011 will take place in developing countries.

THE Super Bowl is one of the biggest events on the advertising calendar, as companies vie to produce the most memorable and innovative ads. The battle for the National Football League’s ultimate prize attracts more viewers than anything else on American television and provides a “symbolic pulse-taking” for the advertising industry every February, says John Frelinghuysen, an analyst at Bain and Company, a consultancy. But this year the patient is in poor health. All the advertising slots for the 2008 Super Bowl had been sold by the end of November 2007, despite the $2.6m price of each. For 2009 the price has risen to $3m, but at least ten slots (out of 67) are still looking for a buyer ...

RETAILING
Rising Retailer Threat: Liquidations
WSJ, 12-Dec-08

4,632 announced store closings thus far; apparel (26.4%), others (23.4%), jewelry (18.1%), home entertainment (17.6%) and food & beverage (14.5%).

Retailers grappling with the grimmest holiday shopping season in decades face another threat: a boom in liquidation sales by competitors ...

TAXES
Swiss Gain as Tax Plan Dims Bermuda's Allure
WSJ, 12-Dec-08

The move to Switzerland will help the companies preserve the tax benefits they had in Bermuda and the Cayman Islands, while using Switzerland's tax treaty with the U.S. to shield them from possible adverse legislation from the incoming administration and next Congress. Bermuda imposes no corporate income tax. Switzerland has a corporate income tax, but doesn't levy it on profit earned by subsidiaries overseas.... The shifts to Switzerland carry some risk. Standard & Poor's announced Thursday it would remove Transocean from the S&P 500 stock index, as happened to ACE when it moved earlier this year.

Several big U.S. companies are reincorporating from Bermuda to Switzerland, helping them avoid expected legislation aimed at corporations located in tax havens ...

More on TARP

2008-10-07T04:43:00.000-07:00

Apart from the Troubled Assets Relief Program, the bill before the Senate includes:

Extensions of the AMT patch, tax deductions on state and local sales taxes, tuition, teacher expenses and real property taxes and tax credits for business research and new market investors

Energy tax credits and incentives to encourage wind and refined coal production, new biomass facilities, wave and tide electricity generators, solar energy property improvements, CO2 capturing, plug-in electric drive vehicles, idling reduction units on truck engines, cellulosic biofuels ethanol production, energy efficient houses, offices, dishwashers, clothes washers and refrigerators, and fringe benefits for employees commuting by bicycle.

A requirement for private insurance plans to offer mental health benefits on par with medical-surgical benefits
Tax relief provisions for victims of this summer's Midwestern floods, and Hurricane Ike

Freezing of deductions for sale and exchange of oil and natural gas, mandatory basis reporting by brokers for transactions involving publicly traded securities and an extension of the oil spill tax

But it also extends the following tax provisions:

* Economic development credit to American Samoan businesses
* $10,000 tax credit for training of mine rescue team members
* 50% immediate expensing for extra underground mine safety equipment
* Tax credit for businesses with employees from an Indian reservation
* Accelerated depreciation for property used mostly on an Indian reservation
* 50% tax credit for some expenditures on maintaining railroad tracks
* 7-year recovery period for motorsports racetrack property
* Expensing of cleaning up "brownfield" contaminated sites
* Enhanced deductions for businesses donating computers and books to schools, and for food donations
* Deduction for income from domestic production in Puerto Rico
* Tax credit for employees in Hurricane Katrina disaster area
* Tax incentives for investments in poor neighborhoods in D.C.
* Increased rehabilitation credit for buildings in Gulf area
* Reduction of import duties on some imported wool fabrics, transfers other duties to Wool Trust Fund to promote competitiveness of American wool
* Special expensing rules for film and TV productions

And there's more:

* Increasing cover of rum excise tax revenues to Puerto Rico and the Virgin Islands
* Making it easier for film and TV companies to use deduction for domestic production
* Exempting children's wooden arrows from excise tax
* Income averaging for Exxon Valdez litigants for tax purposes

Senate Vote Gives Bailout Plan New Life

2008-10-07T04:39:00.000-07:00

Senate Vote Gives Bailout Plan New Life
WSJ, 1-Oct-08
GREG HITT and SARAH LUECKArticle
Passage Gets Boost From Tax Breaks; Back to the House

The Senate handily passed a controversial financial rescue package Wednesday, giving the bill its first legislative victory but adding provisions that could complicate efforts to push the $700 billion plan through the House of Representatives.

The compromise bill represented a marriage of the rescue proposal with a host of measures designed to win the support of reluctant lawmakers. Additions include an increase in bank deposit insurance limits, a suggested change to accounting rules, and a $150.5 billion package of unrelated personal and corporate tax cuts.

The additions boosted support in the Senate, which voted 74 to 25 in favor, the latest twist in the proposal's roller-coaster ride this week. Opposition came from conservatives, populists and senators facing tight races where the rescue bill is drawing criticism.

Senate Majority Leader Harry Reid of Nevada said he expected the House would pass the bill, a sentiment echoed by other senators. House leaders expressed cautious optimism they could secure passage, but couldn't be definitive.

President George W. Bush has called the plan vital to secure the proper functioning of financial markets. But lawmakers and the administration have spent more than a week wrangling over the proposal amid a backlash from voters. The disagreements culminated in the unexpected rejection by the House on Monday, in defiance of congressional leaders and the White House, triggering the stock market to sink.

Stunned by the market response, lawmakers regrouped and added new items to the bill to win votes. Senate leaders took up the bill, which had stronger support in that chamber, with the aim of putting pressure on the House. Presidential rivals Republican Sen. John McCain and Democratic Sen. Barack Obama flew back to the Capitol to cast votes in favor.

The 10-year, $150.5 billion package of tax proposals includes a measure to ease the bite of the alternative minimum tax, as well as research-and-development tax credits coveted by high-tech companies and drug makers. Its addition is designed to secure the support of Republicans, who were overwhelmingly opposed in the House. But it could irk conservative House Democrats because the measure will add to the deficit.

The bill also reaffirms the Securities and Exchange Commission's authority to suspend so-called mark-to-market accounting, an issue that gained surprising traction among lawmakers looking for less costly alternatives to the Bush plan. The practice, adopted in the aftermath of the savings-and-loan collapse in the 1980s, pegs the value of assets to their current market price, rather than the price paid for them.

Banks have complained the strict application of mark-to-market rules have forced them to write down billions worth of mortgage-related securities for which there are no buyers, intensifying the squeeze in the credit markets. (See related article)

The bill, which started out less than three pages long, now comprises more than 400 pages.

A senior House Democratic aide said he was "cautiously optimistic" but put the responsibility on Republicans to come up with more votes. A spokesman for Rep. John Boehner of Ohio, the minority leader, said: "We believe we have a better chance of passing this bill than the one on Monday, but we'll have to wait and see." The House could vote Thursday or Friday.

The core of Mr. Bush's rescue plan survives in the Senate bill. The measure authorizes Treasury to borrow $700 billion to buy up tainted mortgages, securities and other financial instruments that have weakened the financial system and frozen credit markets.

While the change to deposit insurance could bring over some opponents, allowing them to argue that the bill does more to help consumers, the tax provisions could be a sticking point. The tax package had been on a separate legislative track and appeared dead because House Democrats balked at taking it up.

Fiscally conservative Democrats, who provided a solid bloc of 25 yes votes Monday, dislike the tax package because it isn't offset by spending cuts or other tax increases, adding to the deficit. The tax items could also drive away progressive Democrats concerned the bailout bill doesn't do enough to help average Americans, congressional aides said.

The move to raise deposit insurance offered by the Federal Deposit Insurance Corp. to $250,000 from $100,000 adds billions of dollars of new liabilities to the federal government. As part of the bill, the FDIC earned expanded authority to borrow taxpayer dollars to back the higher coverage. The agency's deposit insurance fund is already at historically low levels. It now has a $30 billion line of credit with Treasury.

Through 2009, the bill would permit the FDIC to request unlimited amounts to cover losses related to the higher limits.

House Majority Leader Steny Hoyer, a moderate Democrat from Maryland, said he is urging fiscally conservative Democrats, known as Blue Dogs, to focus on the "the bigger picture" and the need to stabilize the nation's shaky economy. "My gut tells me" they will still support the bill, he said.

Rep. Jim Cooper of Tennessee, a member of the Blue Dog Coalition, voted for the bill Monday and said he will again, despite the tax additions. "I think we have to ignore the Senate irresponsibility. The $700 billion issue is more important than the $30 billion issue," Mr. Cooper said.

Mr. Cooper said he hasn't spoken with colleagues about how they will vote, but expects House Democrats to pick up 10 or 15 votes. "I think a lot of people regret their vote on Monday," he said, "but they need some cover to change their vote," such as the increase in deposit insurance.

The legislation contains a number of tax breaks that have been attacked by fiscal conservatives, including an exemption from a 39-cent excise tax for children's wooden practice arrows, an extension of credits for businesses that employ residents of Indian reservations. The $18 billion in clean-energy incentives allow businesses to provide benefits to employees who commute to work by bicycle.

Even if Democrats hold the line, Republicans will have to find extra support. The House bill failed Monday on a 228-205 vote: 140 Democrats backed it, representing 60% of the Democratic caucus; Republicans brought 65 votes to bill, about a third of the party's ranks.

Party leaders in the House need 12 lawmakers to switch, assuming other votes stay the same. Mr. Hoyer is pressing Republican leaders to deliver 100 votes, half the Republican caucus.

House Minority Whip Roy Blunt (R., Mo.) and others in the Republican leadership were putting pressure on lawmakers in telephone conversations Wednesday. One focus was the Republican delegation from Texas. Despite calls from the president to his home-state lawmakers, more than a dozen Texan Republicans voted against the bill, including Rep. Joe Barton, the ranking Republican on the House Energy and Commerce Committee, and Rep. Ralph Hall, a personal friend of the president.

"After Monday, there can be no doubts, going to the floor, about where our numbers are," said one Republican leadership aide. "There can be no failure."

Republican Rep. John Shadegg of Arizona voted against the original bill, favoring instead a change to accounting rules he thinks are partly responsible for the crisis. Mr. Shadegg said he spoke with SEC Chairman Christopher Cox for more than an hour Tuesday, and said a recent SEC move to tweak the rule and the increase in deposit insurance makes the bill "significantly" better and he is "leaning" toward voting for it.

The House vote revealed deep unease among rank-and-file lawmakers. In an effort to broaden support, Senate Majority Leader Mr. Reid and his Republican counterpart Sen. Mitch McConnell of Kentucky added the provision to raise federal deposit insurance. Supporters contend the increase is needed to bolster consumer confidence in the banking system. The increased coverage would be effective through 2009, although many people expect it to be permanent.

Another provision added by the Senate would require most employers and health insurers to put mental-health on par with physical illnesses. The star-crossed legislation has been in the works for the past decade without ever reaching the president's desk.

Ahead of final passage, members of the Senate cast the 'yeas' and 'nays' from their desks, a show of ceremony that underscored the gravity of the vote, politically and economically.

"This is the kind of vote we came here to have," said Sen. McConnell, who is in a difficult fight for reelection. The shaky economy is a big issue in Kentucky, and Mr. McConnell has taken a lead role in advancing the bailout.

Republican Sen. Gordon Smith, who is also up for reelection, said businesses and local budget officials in his home state of Oregon are starting to feel the impact of the crisis. He voted for the bill. "This is one of those moments where politics has to take a back seat," he said.

Mr. Smith's challenger, Democrat Jeff Merkley, is opposed. He swiftly issued a statement Wednesday night condemning the bill. "I believe it is just wrong to spend $700 billion of taxpayer money to bailout the very Wall Street financiers who created this crisis," he said.

Some 50 trade groups -- including the International Dairy Foods Association and the National Association of Plumbing, Heating and Cooling Contractors -- signed a letter expressing disappointment with the House's rejection of the bailout package. The list of signatories includes leaders of the real-estate and banking industries, such as the National Association of Realtors, the Associated General Contractors of America and the American Banking Association.

The Democratic Governors Association and the Republican Governors Association issued a joint statement pleading with Congress to "leave partisanship at the door and pass an economic recovery package."

Exports Prop Up Local Economies

2008-09-14T05:07:00.000-07:00

Exports Prop Up Local Economies
WSJ, 11-Sep-08
By TIMOTHY AEPPEL

Much of the world may be struggling with the economic downturn, but life has been getting better in Columbus, Ind., Kingsport, Tenn., and Waterloo, Iowa.

These out-of-the-way places have become trade hot spots as U.S. exports, fueled by the dollar's fall, continue to provide a rare spark in an otherwise gloomy economy.

While many economists expect a recent snapback in the value of the dollar and a spreading global slowdown to soften that growth, exports have become a key to greater local prosperity more than at any time in decades.(more...)

Click Here for Interactive Maps

Govt Takes Over GSEs

2008-09-07T12:57:00.000-07:00

Treasury and Federal Housing Finance Agency (FHFA) Action to Protect Financial Markets and Taxpayers
http://treasury.gov/news/index1.html

Key Paragraphs of the Press Release
Since this difficult period for the GSEs began, I have clearly stated three critical objectives: providing stability to financial markets, supporting the availability of mortgage finance, and protecting taxpayers – both by minimizing the near term costs to the taxpayer and by setting policymakers on a course to resolve the systemic risk created by the inherent conflict in the GSE structure.

Based on what we have learned about these institutions over the last four weeks – including what we learned about their capital requirements – and given the condition of financial markets today, I concluded that it would not have been in the best interest of the taxpayers for Treasury to simply make an equity investment in these enterprises in their current form.

The four steps we are announcing today are the result of detailed and thorough collaboration between FHFA, the U.S. Treasury, and the Federal Reserve. The four steps are as follows:

(1) Allow GSEs to grow their guarantee MBS books without limits but their mortgage portfolio modestly through the end of 2009 to $850 billion each , and then reduce at 10 percent a year, largely through natural run off to about $250 billion each.
(2) Treasury entered into a Senior Preferred Stock Purchase Agreement with each GSE. This commitment also eliminates any mandatory triggering of receivership. These agreements provide significant protections for the taxpayer, in the form of senior preferred stock with a liquidation preference, an upfront $1 billion issuance of senior preferred stock with a 10% coupon from each GSE, quarterly dividend payments, warrants representing an ownership stake of 79.9% in each GSE going forward, and a quarterly fee starting in 2010 (Details: http://www.treas.gov/press/releases/reports/pspa_factsheet_090708%20hp1128.pdf).
Terms of the Agreements:
* The agreements are contracts between the Department of the Treasury and each GSE. They are indefinite in duration and have a capacity of $100 billion each, an amount chosen to demonstrate a strong commitment to the GSEs’ creditors and mortgage backed security holders. This number is unrelated to the Treasury’s analysis of the current financial conditions of the GSEs.
* If the Federal Housing Finance Agency determines that a GSE’s liabilities have exceeded its assets under generally accepted accounting principles, Treasury will contribute cash capital to the GSE in an amount equal to the difference between liabilities and assets.

(3) The establishment of a new secured lending credit facility which will be available to Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. The facility will offer liquidity if needed until December 31, 2009. The Housing and Economic Recovery Act of 2008 provided Treasury with the authority to establish this facility.
* Funding will be provided directly by Treasury from its general fund held at the Federal Reserve Bank of New York (FRBNY) in exchange for eligible collateral from the GSEs which will be limited to guaranteed mortgage backed securities issued by Freddie Mac and Fannie Mae as well as advances made by the Federal Home Loan Banks (Details: http://www.treas.gov/press/releases/reports/gsecf_factsheet_090708.pdf).
* Loans will be for short-term durations and would in general be expected to be for less than one month but no shorter than one week. Loans will not be made with a maturity date beyond December 31, 2009
* The rate on a loan request ordinarily will be based on the daily LIBOR fix for a similar term of the loan plus 50 basis points (LIBOR +50 bp).
(4) Treasury is initiating a temporary program to purchase GSE MBS. Treasury financing of purchases of GSE MBS will be deemed as outlays and are subject to the statutory debt limit. Treasury will make available information on purchases through this program in the Monthly Treasury Statement (http://fms.treas.gov/mts/index.html) (Details: http://www.treas.gov/press/releases/reports/mbs_factsheet_090708hp1128.pdf)

About Conservatorship
* At present, there is no exact time frame that can be given as to when this conservatorship may end.
* The Company will continue to run as usual during the conservatorship
* During the conservatorship, the Company’s stock will continue to trade. However, by statute, the powers of the stockholders are suspended until the conservatorship is terminated (voting rights of all stockholders are vested in the Conservator). Stockholders will continue to retain all rights in the stock’s financial worth; as such worth is determined by the market.
* Under a conservatorship, the Company is not liquidated. The Director of FHFA does have the discretion to place any regulated entity, including the Company, into receivership. Receivership is a statutory process for the liquidation of a regulated entity. There are no plans to liquidate the Company. Once, the company is in Receivership, it can only be dissolved by an Act of Congress.
(Details: http://www.treas.gov//press/releases/reports/fhfa_consrv_faq_090708hp1128.pdf)

There are several key components of conservatorship:
(1) Monday morning the businesses will open as normal, only with stronger backing for the holders of MBS, senior debt and subordinated debt.
(2) The Enterprises will be allowed to grow their guarantee MBS books without limits and continue to purchase replacement securities for their portfolios, about $20 billion per month without capital constraints.
(3) As the conservator, FHFA (Federal Housing Finance Agency) will assume the power of the Board and management.
(4) The present CEOs will be leaving, but we have asked them to stay on to help with the transition.
(5) Herb Allison will be the new CEO of Fannie Mae and David Moffett the CEO of Freddie Mac. They will be joined by equally strong non-executive chairmen.
(6) At this time any other management action will be very limited.
(7) In order to conserve over $2 billion in capital every year, the common stock and preferred stock dividends will be eliminated, but the common and all preferred stocks will continue to remain outstanding. Subordinated debt interest and principal payments will continue to be made.
(8) All political activities -- including all lobbying -- will be halted immediately.
(9) Lastly and very importantly, there will be the financing and investing relationship with the U.S. Treasury, which Secretary Paulson will be discussing.

LINKS
* Paulson Remarks on Housing GSE Actions
* FHFA Director Lockhart Remarks on Housing GSE Actions (pdf)
* Fact Sheet: FHFA Conservatorship (pdf)
* Fact Sheet: Treasury Preferred Stock Purchase Agreement (pdf)
* Fact Sheet: Treasury MBS Purchase Program (pdf)
* Fact Sheet: Treasury GSE Credit Facility (pdf)

The Peso Problem

2008-07-16T09:12:00.000-07:00

The story below is referenced whenever the phrase "Peso Problem" pops up. I have to admit that I was unware of it, or rather, I was unware of that particular phrase. I soon realized that Peso Problem is just a cute phrase for what statisticians call a "tail risk". If you google Peso Problem you get all kinds of financial variables from interest rate curves to equity risk premium linked to Peso Problem.

Krugman aruges on his blogthat Friedman should not be credited for coining the phrase "Peso Problem" but rather him or his MIT classmate Bill Krasker. Go figure.

Equity prices and the ``peso problem''
The Hindu, 1-Oct-2000
B. Venkatesh

INFOSYS Technologies currently trades at a price-earnings multiple of over 100 whereas BHEL trades at just five times its earnings.

What drives investors to pay over 100 times the current earnings to buy one share of Infosys? Or, why are they reluctant to pay more than five times the earnings to buy one share of BHEL?

Research papers on asset values contain answers to this question. One such research paper by Mr Keith Sill, an economist at the Federal Reserve Bank of Philadelphia, states that a financial asset is valued after factoring the possibility of some unprecedented event in the future.

For argument's sake, BHEL may be trading at only five times its earnings because the market fears the company will be eventually forced out of business by ABB.

Such an event may or may not occur. But at this point in time, it may be just that the market is factoring the improbable event into the stock price.

Economists call such a condition the ``peso problem''; for, such a condition was observed by the Nobel laureate, Milton Friedman, in the Mexican peso market in the early 1970s.

At that time, the exchange rate between the Mexican peso and the US dollar was fixed. The interest rate in Mexico was, however, far higher in the US.

Such a situation presented investors opportunity for easy profits. How? An investor could borrow at a lower rate in the US, convert the money into peso and invest in Mexican bonds. On redemption of the bond, the investor could reconvert the peso at the same exchange rate, pay the loan and pocket the gains.

Milton Friedman stated that the interest differential between the two countries may have been due to the market expecting the peso to be devalued against the US dollar. And sure enough, in 1976, the market expectation actually came true as the peso was allowed to ``float'' against the dollar.

Hence, the next time you find an otherwise good stock trading at low levels, think for a moment whether it is because of some ``peso problem''!

Gas Prices versus Income

2008-07-12T08:40:00.000-07:00

One of the interesting debates in the macro-land is how rising gas prices in the US is going to affect employment growth. Given increasingly difficult job market, a potential employee might have to take a job that requires long commute, but the question then becomes, will he or she take it if she spends disproportionate amount of income on gasoline. Well, that depends on how much of income is spent on gasoline. According to the New York Times cartographers, it depends on where one is based. In the densely populated east and west coasts, spending on gas, even at the current high prices is minimal - less than 5%. So it is unlikely that gas prices will affect people's willingness to take jobs or in econo-speak, the labor force participation rate should not affected by high gas prices.

The Varying Impact of Gas Prices
New York Times

Gas prices are high throughout the country, but how hard they hit individual families depends on income levels, which vary widely.

Bear (Stearns) Story

2008-07-01T12:45:00.000-07:00

The collapse of Bears Sterns on the weekend of March 14th 2008 was unprecedented in the history of Wall Street. As an observer myself, the zig-zagging of BSC's stock price around that time was quite unnerving. I have always wondered about the details of the collapse. The Wall Street Journal had a 3-piece report on it couple of weeks ago but I don't think it did a good job at identifying the critical events. The Vanity Fair article does that, and it boils down to 2 words "novation" and "repos".

Bringing Down Bear Stearns
Vanity Fair, August 2008
Bryan Burrough

On Monday, March 10, the rumor started: Bear Stearns was having liquidity problems. In fact, the maverick investment bank had around $18 billion in cash reserves. But soon the speculation created its own reality, and the race was on to keep Bear’s crisis from ravaging Wall Street. With the blow-by-blow from insiders, Bryan Burrough follows the players—Bear’s stunned executives, trigger-happy reporters at CNBC, a nervous Fed, a shadowy group of short-sellers—in what some believe was the greatest financial scandal in history.(>>>...)

Backwardation without Speculation

2008-06-29T17:48:00.000-07:00

The unprecedented rise in oil price has given birth to many theories about the cause. Everything from the imbalance of demand & supply to the weakness dollar to the onset of credit crisis and the collar-strategy implemented by oil producers is blamed on the rapidity of the rise in oil price. Another is of course the speculation in the oil market given that there is no "contango" in the oil future market. Mr. Krugman points why there may not be "contango" without speculation on the oil market.

Speculation and Signatures
Paul Krugman
June 24, 2008

One of the problems in the debate over the role of speculation in oil prices is that hardly anyone, even among the economists, is writing down models. As a result, it’s not always clear what people are saying; and I’d argue that some of my colleagues aren’t clear on the implications of their own analysis.

So here’s some quick and dirty modeling that I think captures the essence of the debate.

A point of agreement between Guillermo Calvo and myself is that there’s a downward-sloping relationship between the current price of oil and the expected change in prices. Suppose, for example, that investors believe that the price one year from now will be PF, and they cling to that belief whatever the spot price P is. Then the expected rate of change of the oil price is (PF – P)/P. You don’t have to believe in this specific relationship; all I need is that there is a downward-sloping relationship between the spot price and the expected rate of change in the spot price.

Figure 1 shows that relationship. It also shows the cost of holding oil in storage, which consists both of the rent on the tank, or whatever, and the interest foregone by tying up wealth in physical commodities. (Yes, the independent variable is on the Y-axis. There’s a reason for that.)

Figure 1
Now, what Calvo and others suggest is that speculative expectations are currently determining the spot price – that the spot price is determined by the intersection of the two blue curves in Figure 1.

This certainly could happen – but only under certain circumstances. To see what those circumstances are, look at Figure 2, a back-to-back diagram that adds the flow supply and demand for oil – that is, the oil pumped by producers and burned by consumers.

In Figure 2, the horizontal dashed line indicates the spot price. We have a short-term equilibrium in which the quantity of oil produced exceeds the quantity consumed, but speculators are willing to buy up the excess supply and store it, believing that the spot price will rise enough to make that a good investment. In this case expected future prices – and, speaking loosely, the futures market – are determining the spot price.

This isn’t unheard of. In fact, the market for wholesale gasoline normally looks like this in the late fall, winter, and early spring, as refiners accumulate stocks for the summer driving season.

Figure 2
But notice that this kind of speculatively driven spot price has two “signatures” – things one should see in the markets that go along with that kind of equilibrium. First, the point I’ve emphasized a lot: because of the excess flow supply, somebody must be accumulating inventory.

But the second signature is probably just as important: for this kind of situation to occur, the future and spot markets have to be in “contango”: futures price above spot, sufficiently so to make storage worthwhile.

What if that’s not true? Then the market looks like Figure 3:

Figure 3
Here the spot price, again indicated by the dotted line, is determined by flow supply and demand. Inventories aren’t growing, and the futures market is characterized either by “backwardation” – futures price below spot – or by a contango too weak to make storage profitable.

And here’s the thing: the actual data we have on crude oil don’t show the signatures of a market driven by speculative demand. Inventory data don’t show a big accumulation; and the market has mostly been in backwardation, not contango. It made news when, late last month, a slight contango developed – because until then there had been backwardation.

Maybe I’m misinterpreting what the advocates of a speculative story are thinking. But in that case, what are they thinking? I’m curious.

David Einhorn - The Hedge Fund Man of the moment

2008-06-29T08:54:00.000-07:00

Interesting article on the Hedge Man of the moment, David Einhorn. It is truly encouraging that he is willing to go public with his negative investment thesis on Lehman. As New Yorker magazine points out, he is truly "The Confident Man".

The Confidence Man
New York Magazine, Jun 15, 2008
By Hugo Lindgren

Hedge-fund manager David Einhorn believes his public attack on Lehman Brothers wasn’t just about making money. So what was it about?

Six years ago, hedge-fund manager David Einhorn made a speech at an annual investment conference about a stock he didn’t like—a mid-cap financial company called Allied Capital—and the world came crashing down on top of him. He was investigated by the Securities and Exchange Commission for conspiring with other investors to sink the stock. Allied stole his personal phone records in an attempt to prove the conspiracy. An article in The Wall Street Journal compared his treatment of Allied to “a mugging.” New York’s then–Attorney General, Eliot Spitzer, vowed to do his own investigation. And Einhorn’s wife, an editor at the financial weekly Barron’s, mysteriously lost her job. (...>>>)

Mortgage Market

2008-05-02T10:07:00.000-07:00

Mortgage Market
25-Feb-2007

Buttonwood: Action replay

2007-10-02T18:16:00.000-07:00

There current credit crisis has been compared to many things in the financial press - 1987 crisis, LTCM etc - and the Economist seems to think that it is a more protracted like 2001, where initial Fed was received with euphoria but the subsequent ones were taken with trepedition given their implications about the economic growth trends. The Economist think that the final shoe to fall will be the dollar.

Buttonwood: Action replay
The Economist
Sep 27th 2007

Was the script for the recent turmoil written in 1998, 1990, or is it new?

LIKE generals condemned to fight the last war, investors seem fated to hark back to the last financial crisis. When markets plunged on “Black Monday” in October 1987, people feared a repeat of the Wall Street crash of 1929. Central banks cut interest rates in part because they wanted to avoid a re-run of the 1930s' depression.

But the world has suffered a lot of financial crises and it is not always clear which one to use as a benchmark. Take the central banks' responses to the recent problems in the credit markets. Do they suggest that we are looking at a repeat of 1998, when Long-Term Capital Management, a hedge fund, wobbled, or at 1990, when there was a financial crisis at savings-and-loans banks, then the main providers of American mortgages?

As David Bowers of Absolute Strategy Research points out, it makes an enormous difference which crisis (if either) is being replayed. In 1998 rate cuts quickly restored the animal spirits of investors and the dotcom bubble followed. If that pattern is to be repeated, investors should be piling into growth-sensitive sectors like emerging markets and commodities.

But in 1990 several rate cuts failed to stop the American economy from sliding into recession. That may be what happens once again now, especially as most observers believe it takes 12-18 months for changes in interest rates to have much economic effect. Figures released on September 25th showed that the inventory of unsold American homes is at its highest level since 1989. If we are following the 1990 script, then investors should be opting for the safety of Treasury bonds.

The strength of the world's stockmarkets since the Federal Reserve cut rates on September 18th indicates that most investors are, to misquote Prince, “partying like it's 1998”. The MSCI emerging-markets index reached a record high on September 24th, and the best-performing industries in share-price terms over the past month have been economically sensitive ones, such as mining and chemicals.

Ajay Kapur of the hedge fund First Horse Capital says that America's stockmarket normally returns 7.2% over the six months after the first rate cut in the cycle, even in periods when the economy is slipping into recession. When a downturn is avoided, the average six-monthly gain is 20.1%. Mr Kapur says the world is dominated by “fiat currency democracies” in which governments and central banks tend to give in to popular pressure and “print money” to avoid hard times. He believes the recent actions of the Fed, the European Central Bank and the Bank of England endorse his view.

Those bears who believe the drama is more likely to resemble 1990 than 1998 base their case on what they think are excessive levels of consumer debt. Clearly, many of them were far too early in predicting a debt-driven crisis; Peter Warburton's jeremiad “Debt and Delusion”, for example, was published back in 1999.

But they have a point now. As economies become more sophisticated, it may make sense for consumers to take on more debt as a means of smoothing their consumption over their lifetimes. Indeed, this should add to economic stability. Ironically, however, greater stability only encourages consumers to take on more debt since they are less fearful of losing their jobs in recessions.

Consumer debt cannot keep growing faster than income forever. That evil day has been delayed, over the past 20 years, by the downward trend in interest rates. But the bears think the crunch has now arrived, as it did in Japan in the 1990s.

The world may not have to wait too long to see whether they are right. As David Rosenberg, an economist at Merrill Lynch, recalls, the stockmarket rallied in response to a half-percentage-point rate cut in early January 2001. But by the time the Fed lowered rates again at the end of that month, its move was seen by investors as a sign of desperation.

Three months ago Buttonwood pointed to three portents that would suggest investors should prepare for the worst. One of those, higher credit spreads, has indeed appeared. Another was a resurgence of inflation. Although that looks unlikely in the short term, especially if economies weaken, the long-term chances of higher inflation must surely have gone up. Gold is at its highest level since it last peaked in 1980.

The final sign was a burst of yen strength (which would indicate an unwinding of speculative bets). The yen has risen against the dollar since June but there has been no sharp lurch higher; perhaps because the Japanese economy is itself weak. But if the gloomsters are to be proven right, we must surely see some turmoil in the currency markets first.

Todays Reads

2007-10-01T16:22:00.000-07:00

Bill Gross Still Mr. Bond Bull
Bill Gross is still bullish on bonds owing to the housing downturn that shows not end in sight and the potentially larger impact of housing than of stock prices. His firm (PIMCO) has rule out of thumb that says a "Fed easing cycle historically has required a destination of 1% real short rates or lower. Under a conservative assumption of 2.5% inflation, that implies Fed Funds at 3.75% or so over the next 6-12 months." And he suggest that such forecast is not totally out of the realm of possibility give than the Bernanke Fed might have asymmetric reaction to asset price movements al la Governor Kohn emulating an escalator on the way up (25bp increases) and an elevator on the way down (50bp reduction).

Investment Outlook - What Do They Know?
October 2007
Bill Gross

If you’re struggling to find something that symbolizes the transition from the old-fashioned markets of yesteryear to the seemingly inexplicable wildness of today’s derivative-driven, conduit-imploding financial complex, you need look no further than the contrast between old television’s Louis Rukeyser and thoroughly modern Jim Cramer. Calm, stately, with deep-throated baritone certainty, Rukeyser was the spokesman for aging boomers who wanted assurance that a nostril-snorting bull market would reign supreme. No less a cheerleader, but with soprano-inflected importuning decibels louder than any rival on the flat screen, Cramer, in recent weeks at least, has been willing to recognize that the momentum could turn in favor of the visiting bears. At a moment of courageous yet seemingly reckless abandon during a week when Treasury, Fed, and White House officials were trying to calm investors with an “all clear” story line, Cramer screamed at the CNBC camera, “They know nothing, they know nothing!” Just who “they” were was left to the imagination, but it was clear that in Cramer’s world Rukeyserian bullishness was not the order of the day. (more... )

Chinese Economy Will Continue to Roar Ahead
The Chinese economy continues to surprise the doubters. But given several macroeconomic headwinds - US economic slowdown, Chinese food price inflation, rising non-performing loans, stock market bubble - the article argues that they are actually a blessing in disguise. It looks like the Chinese economy is here to stay.

China's economy - How fit is the panda?
The Economist
Sep 27th 2007

NO COUNTRY in history has sustained such a blistering rate of growth over three decades as China. Its economy grew by a staggering 11.9% in the year to the second quarter. Since 1978 it has grown by an average of almost 10% a year—more than Japan or the Asian tigers achieved over similar periods when their economies took off. But eventually every sprinter trips. Japan's growth averaged 9.5% in the two decades to 1970, but slowed to 4.7% in the 1970s and to only 1% by the 1990s. (more...)

Of Markets & the Economy

2007-04-26T06:22:00.000-07:00

The US market has roared mightily since the dip in mid-summer last year but the GDP growth profile has only become less optimistic during the same period (see chart). This divergence is very puzzling. Is the market move driven by fundamental factors (i.e. expecting growth to rebound in H2 07) or is it more a technical phenomenon - AMZN jumped 25% yesterday because of short covering post good earnings numbers (15% of the stock outstanding has short position)? It is hard to know for sure but Wall Street Journal tries to address the debate over the fundamental underpinning of the stock movements.

The stock market has been a lousy barometer of the economy.

From the beginning of 2004 through the first quarter of 2006, economic growth averaged an impressive 3.4%. The Dow Jones Industrial Average rose just 6%. Since then, economic growth has slowed to a little more than 2%, yet the blue-chip index has leapt 18%, ending yesterday's session at a record 13089.89, the first time it has closed above 13000.

So, is the stock market providing reassurance? Or is it out of touch? (more >>>)

Bernanke Music Video - "Every Breath You Take" -

2007-04-20T05:31:00.000-07:00

Every Breath You Take
Columbia Business School Follies
Spring 2006

Lyrics

[George W. Bush:] "Ben Bernanke is the right man to build on the record that Alan Greenspan has established. I will urge the Senate the act promptly to confirm Ben Bernanke as the fourteenth Chairman of the Federal Reserve."

Every breath you take
Every change of rate
Jobs you don't create
While we still stagflate
I'll be watching you

Every single day
Bernanke takes my pay
When growth goes away
Inflation will stay
I'll be watching you

Oh can't you see?
The Fed's where I should be
How my poor heart aches
With each of your mistakes

First you move your lips
Hike a few more BPS
When demand then dips
And the yield curve flips
I'll be watching you
Since you came supply's lost without a trace
I dream at night that I punch you in the face
Your interest policies I cannot embrace
I feel so wronged and I long for Greenspan's place
I keep cryin': Benny! Benny! Please...

Oh can't you see?
The Fed Chair should be me
How my poor heart aches
When prices escalate

Every move you make
Every oath you take
Hope your models break
Bet that beard is fake
I'll be watching you

CBS is great
Wouldn't change my fate
But we'll be watching you
We'll be watching you

Daily Musing: Sino-Phobia

2007-04-19T12:57:00.000-07:00

One of today's business headlines was a surprisingly strong Chinese GDP growth for Q1 2007 (11.1% vs 10.4% expected). The Bloomberg story, Asian Stocks Post Biggest Drop in a Month on China Rate Concern promptly declared that unexpectedly strong growth will prompt Chinese authorities to hike rates - which will slow Chinese growth and also weaken the US$. That could impact the rest of Asia, thus the fallout on Asia equities today.

Let's analyze the facts. Chinese interest rates matter to the world only to the extent that they impact Chinese growth. Chinese growth is very important for global growth and inflation. But a worry about China's growth at this time is unwarranted. China needs to grow, and grow at a high single-digit rate to absorb the vast number of rural migrants pouring into the cities everyday. It is the key to the legitimacy of the Communist Party. Other issues like huge foreign reserve, current account surplus, pollution, human rights et. al. are secondary. So I won't lose my sleep over the China's economy.

Interest rates in China are very low. The benchmark rate, the so-called 12-month lending rate is at only 6.39% compared to 10%+ growth in real GDP (see Figure). A rule of thumb says that equilibrium real rate should be equal to real GDP growth. So if anything, China's rate should be higher (in fact at least double the current rate if we take into account 3.3% CPI) notwithstanding today's strong GDP number. Btw, the Economist magazine argued for higher rate in its Mar 22 issue. The article also discussed why Chinese monetary policymarkers have penchant to change rates in 27bp increments versus 25bp increments by their western counterparts (read the article).

NY Fed Conference on, "The euro and The dollar: Pillars in Global Finance"

2007-04-19T11:01:00.000-07:00

"The euro and The dollar: Pillars in Global Finance"

Participants

H.E. Ambassador John Bruton, Delegation of the European Commission to the United States
Timothy F. Geithner, President and Chief Executive officer, Federal Reserve Bank of New York
Joaquín Almunia, Commissioner for Economic and monetary Affairs, European Commission
Richard Clarida, Professor of Economics and International Affairs, Columbia University
Mickey Levy, Chief Economist, Bank of America
Nouriel Roubini, Professor of Economics and International Business, New York University
Charles Wyplosz, Professor of Economics, Graduate Institute of International Studies, Geneva
Andrew Crockett, President, JPmorgan Chase International
William Dudley, Executive Vice President, Federal Reserve Bank of New York
Alberto Giovannini, Chief Executive Officer, Unifortune Asset management SGR
Jacques de Larosière, BNP Paribas
Paul Volcker, Chairman of the Board of Trustees, International Accounting Standards Committee
Pervenche Berès, Chair, Committee on Economic and monetary Affairs, European parliament
Kathleen l. Casey, Commissioner, US Securities and Exchange Commission
William Rutledge, Executive Vice President, Federal Reserve Bank of New York
David Wright, Director, DG Internal Market and Services, European Commission
Jan Hatzius, Chief US Economist, Goldman Sachs
Caio Koch-Weser, Vice Chairman, Deutsche Bank Group
Edwin M. Truman, Senior Fellow, Peterson Institute
Sir Nigel Wicks, Chairman, Euroclear
Jean-claude Trichet, President, European Central Bank

What Spending Slowdown?

2007-04-18T15:19:00.000-07:00

The BusinessWeek article adds to the current debate on capex. The debate centers around government data (non-defense capital goods ex-air in M3 release) showing slowdown in corporate capex and the impact it could have on future economic growth and productivity trends. Basically the article argues that one can't take the government's data on face value because the issue has become complex owing to globalization. There is a huge discrepancy between what the government is saying about capex and what the businesses are saying and that ought to give pause to anyone who is worried about the state of capex.

When is a slowdown not a slowdown? On the face of it, the government's statistics tell a very convincing story about cautious companies and weak business investment. For example, so far in 2007 new orders for nondefense capital goods, such as computers, trucks, and machinery, are barely higher than they were a year ago, an omen, perhaps, of tough times ahead for corporate profits.

There's only one problem. Corporate America is still spending big time, just increasingly outside the U.S. A BusinessWeek analysis of financial reports from more than 1,000 large and midsize U.S.-based companies shows that global capital expenditures in the fourth quarter of 2006 were actually up 18.1% over the previous year, a number that includes nonresidential construction as well as info-tech equipment and machinery. The comparable growth for domestic business investment, which is all the government reports each quarter: only 8.9%, without adjusting for inflation. (more >>>)

Debunking Messrs Roubini & Hatzius

2007-04-18T10:36:00.000-07:00

Read a blog, "Explaining the Mystery of Why Housing Jobs Have Not Fallen Much...and the Worsening Housing Recession... " by Prof Roubini where he discusses the apparent discrepancy between "dismal" housing sector and "apparently" strong construction employment numbers. He cites two possible reasons (1) according to Goldman Sach economist, Jan Hatzius, homebuilders have not started laying off workers (2) undocumented workers hide the actual job losses in the construction industry. May be I am not looking at the same (correct?) data as Mr. Hatzius and Prof Roubini but I come with different conclusions.

Data I look at do not support Mr. Hatzius' argument. Homebuilders have been laying off workers. If you look at employment in S&1500 Homebuilders (BZH, CHB, CTX, DHI, HOV, KBH, LEN, MDCj, MHO, MTH, NVR, PHM, RYL, SKY, SPF, TOL), they have declined in 2006, to 78,000 from 104,000, a whopping 25% decline (first chart). If you look at the data for the broad construction industry, all the available sources - BLS (second chart), Manpower Survey (third chart), Challenger Survey (fourth chart) - show dismal trends in construction employment. What is interesting however is that the woes in construction sector have not permeated into the broader economy. Private payroll growth in the non-construction sector is ok; hiring is fine; and layoffs are actually trending lower.

Prof Roubini's argument about undocumented workers can cut both ways, so net-net it should have no impact. If undocumented workers were not recorded in the current construction employment slowdown, I bet they were not recorded during the boom time either. The anecdotes from the New York Times article are just anecdotes.

So what's my point? My point is that unlike Messrs Roubini & Hatzius, I believe that the problems in the residential housing sector are well-established by the data. That should not be the debate. The debate should be whether that problem is going to spread to the rest of the economy and when. Of course there are people on both sides of the fence. Homebuilders' stock prices seem to suggest that the worst is over for housing but there are others who think that "we ain't seen nothing yet" by pointing out to the housing inventory data. My gut feeling based on variety of housing data is that housing has bottomed and will start to become less of an issue past the summer. Of course, I could be dead wrong. The current slump could persist for another 6-9 months prompting consumers to curtail their holiday spending, and that’ll be the end of the current cycle.

The Economist - Browsing the bourses

2007-03-31T20:52:00.000-07:00

Browsing the bourses
The Economist, 29-Mar-2007

Companies scour global exchanges to find a better price for their shares

BASED in Toronto, Golden China Resources is a mining company with the kind of scary but alluring profile you might expect for a firm that goes prospecting for gold. Established only three years ago, it is still losing money. But it boasts an intriguing technology using bacteria in the refining process, promising rights in China and what appears to be a growing inventory of established reserves.

With bullion prices rising and economic doubts gathering, times should be good for gold producers. But on the Toronto Stock Exchange, Golden China has lost its lustre. Its share price has fallen by half since early 2006. In response, the company has embarked on a different kind of prospecting. It is studying how different bourses around the world value companies like itself. Its findings are a challenge to anyone who believes financial markets are consistent or rational.

Take, for example, the market's view of “in situ” ounces, meaning gold that is in the ground. According to an outside analysis, Canadian exploration companies are valued at $75 an ounce on average. As refined gold now sells for more than $650 an ounce, this leaves some margin for processing and mining risk.

If the deposits controlled by these Canadian companies are in China, the valuation slips to $43 an ounce. This may reflect worries that China's methods of verifying potential assets are less stringent. It may also be a consequence of more general fears about property rights in China.

That would be the end of the story were it not for an odd detail. Golden China then went on to look at the valuation of gold producers listed in Hong Kong or on the Chinese mainland. The results were striking: they were valued at $180-240 an ounce. Sino Gold, an Australian company which on March 16th made a secondary listing on the Hong Kong exchange, is priced at about $190 an ounce.

There may be some simple explanations for these big disparities. For example, the Chinese companies in the study all turn a profit. But investors in gold exploration probably care more about the treasure to be unearthed than the trickle of income from ongoing sales.

In fact, Golden China has hit on a broader seam of market discrepancies: the value of a share often depends on where the stock is floated. The most glaring examples are provided by Hong Kong-listed firms that also list in Shanghai, where they almost always get a better price for their shares. No wonder Hong Kong feels threatened by the migration of listings to its mainland rival.

More subtly, global exchanges disagree about the value they put on everything from food companies to banks, even after taking account of differences in a firm's local prospects. Perhaps investors feel better protected and better informed by some bourses rather than others. Exchanges often claim that stiff auditing and disclosure standards add a premium to the shares listed on them. But strangely, valuations right now seem highest in murky stockmarkets like China's.

Bourses may also attract their own distinctive base of investors, interested in some sectors more than others. America's markets attract the technophiles, China's lure the gold bugs. Like retail arcades, exchanges each seem to draw their own tribe of customers who know what they want, pay a premium for it and ignore bargains that would fetch much higher prices elsewhere. Golden China is like an electronics store trying to sell its wares (cheaply) on London's Savile Row rather than Tokyo's Akihabara market.

To profit from such disparities, enterprising investors have long combed the world's bourses looking for cheap stocks. It makes perfect sense for companies to do the reverse: scour the world for markets that will pay high prices for their shares, thus reducing the cost of their capital.

Unfortunately, bagging a higher valuation is not always as easy as listing on a different exchange. For example, lots of international companies coughed up for a Tokyo listing in the late 1980s, hoping to share in the euphoric multiples then applied to Japanese firms. But they were disappointed; their share prices remained tied to those back home.

Golden China is considering a more dramatic migration. Already most of its 700 employees work in China. The company's executives are thinking about joining them, and shifting their primary listing from Toronto to Hong Kong in the process. At the moment, they reckon the company's $50m market value plus its debt is worth only as much as its plant and outside investments, giving it no credit for its 1.5m ounces of gold. If more appreciative customers for their shares exist elsewhere, why not bring the company to them? It would appear the only rational response to an irrational market.

The Great Inflation - Anatomy of a hump

2007-03-28T07:58:00.000-07:00

Anatomy of a hump
The Economist, Mar 8th 2007

What caused the Great Inflation? And what might bring it back?

IF YOU were to draw the path of inflation in the typical big, rich economy over the past half century, your picture would look much like a dromedary's back: a low flat line in the 1960s; a knobbly hump of high and volatile price rises in the 1970s; dramatic disinflation in the 1980s; and low, stable inflation rates since. Japan and Germany, which were quicker to quell inflation, are well-known exceptions. But for the rest, the shape and timing of the Great Inflation bulge look remarkably similar.

This is a bulge that today's central bankers are anxious not to repeat. So it is no surprise that several governors from America's Federal Reserve are attending a conference on March 9th to discuss a new report* on the Great Inflation, written by a weighty group of macroeconomists from academia and Wall Street.

Most scholars agree on a basic explanation of the hump, placing both blame and credit squarely on central bankers. Consumer prices accelerated in the late 1960s because monetary policy was too loose. German and Japanese central bankers realised this earlier than others and tightened policy accordingly. Eventually others followed suit, and general disinflation began in the early 1980s. Since then inflation has stayed under control because central bankers are credibly committed to price stability and far better at their job.

Beyond that broad tale lie several debates about important details. Economists differ on how much non-monetary phenomena, such as closer trade integration, affect the inflation process. They also offer competing explanations for why central bankers botched things so badly a generation ago. One possibility is that they simply got the numbers wrong, consistently overestimating their economies' speed limits. Others blame theoretical misjudgments, particularly the belief that higher inflation could buy a lasting drop in unemployment. A third approach emphasises political pressure. Inflation got out of hand because central banks were under the thumb of politicians who preferred rising prices to higher joblessness.

In this latest report the authors subject such controversies to painstaking cross-country forensics. They show that price stability across the G7 countries has been far more closely correlated than economic stability. Almost everywhere, inflation took off between 1969 and 1970. And every country, except Germany and Japan, failed to tame it until the mid-1980s. Output, however, was less tightly synchronised. Although recessions in many countries have become less wrenching in recent decades, output volatility began to ease in the mid-1980s in America, but not until the early 1990s in Britain, Canada and France.

What to make of these differences? The Great Inflation, because it was felt simultaneously across countries, must have had a common cause. This cannot have been the 1970s oil shocks, because consumer prices started accelerating long before the price of crude did. Easy money is the only remaining suspect. And although the Great Disinflation was also simultaneous across many countries, GDP growth settled down at very different times. This implies that better monetary policy cannot take full credit for today's less painful recessions.

The statistical magnifying glass also casts doubt on some favourite alibis for monetary misrule. Bad data, for example, do not get central bankers off the hook: revisions to statistics on trend growth and unemployment were not big enough to excuse the scale of inflation. Instead, monetary policy was simply too loose. The authors show that the central bankers of the 1970s failed to adhere to the modern “Taylor rule”, a formula that links the appropriate level of short-term interest rates to the deviation of output from its trend and inflation from its target. Of course John Taylor, a Stanford economist, did not formalise his rule until 1993. But even without this guide, central banks should not have flunked the basic tenets of sound money.

Hawks v camels

Neither the Taylor rule, inflation targets nor any other bits of the modern central bankers' toolkit were necessary to end high inflation. But the scholars think these tools have helped to keep inflation down, which, in turn, has spawned a virtuous circle. When inflation is low and stable, a temporary uptick in consumer prices has far less impact on long-term price trends. The economists' model implies that less than 1% of a temporary price surge is translated into a permanent rise in inflation today, compared with 60% three decades ago.

That may give today's policymakers more leeway than their predecessors enjoyed. But since this wiggle-room is the legacy of low inflation volatility, it cannot be taken for granted. Were central bankers to lose their guard, inflation could soon resurge.

More worrying, the economists pour cold water on many a policymaker's favourite gauge of his own performance, namely the public's expectations of future inflation. Central bankers often cite low inflation expectations as evidence that monetary policy is appropriate. That may be a mistake. This paper argues that expectations were a good guide to future price pressure only when inflation was high. But now, if anything, inflation expectations are a backward-looking indicator, lagging measures of actual inflation.

All told, this statistical sleuthing suggests today's central bankers have little room for complacency. Inflation remains low and stable because policymakers are vigilant, not because any deep, structural changes insulate the modern economy from price pressure. If central bankers relax, higher, more volatile inflation could easily return. Rudyard Kipling's camel, remember, got its hump for being “most 'scrutiatingly idle”.

"Understanding the Evolving Inflation Process" by Stephen Cecchetti, Peter Hooper, Bruce Kasman, Kermit Schoenholtz and Mark Watson

Fed Governor Mishkin, "Inflation Dynamics"

The Economist - What's it all about, alpha?

2007-03-27T15:57:00.000-07:00

What's it all about, alpha?
Mar 22nd 2007

Demystifying fund managers' returns

TOO many notes. That's what Emperor Joseph II famously said to Mozart on seeing his opera “The Marriage of Figaro”. But surely to think of a musical work as just a series of notes is to miss the magic.

Could the same be said about fund management? It is the fashion these days to separate beta (the systematic return delivered by the market) from alpha (the manager's skill). Investors are happy to pay high fees for the skill, but regard the market return as a commodity. Distinguishing the two is, however, difficult.

A fund manager might beat the market because of luck or recklessness, rather than skill, for example. Suppose he packed his portfolio with oil stocks. When the crude price rises that would pay off, but it would be a pretty risky portfolio. More generally, alpha sceptics often attribute eye-catching returns to “style bias”, such as favouring stocks with a high dividend yield.

But should they be biased against style bias? After all, the only portfolio utterly free of bias would be one that included the entire market. Were a Britain portfolio to exclude just one stock, such as BP, it would have a small-cap bias, a sector bias and a currency bias (most of BP's revenue is in dollars). Hence any excess return must stem from some element of style.

Academics have entered this debate, trying to pin down the factors that drive a fund's performance. These might include the difference in returns between small-cap and large-cap stocks (fund managers tend to favour the former) or the level of credit spreads and so on. Bill Fung and Narayan Naik of London Business School have come up with a seven-factor model which, they say, can explain the bulk of hedge-fund performance. After allowing for these factors, the average fund of hedge funds has not produced any alpha in the past decade, except during the dotcom bubble.

This approach suggests the whole idea of alpha might be an illusion. Academics can explain most of it, and the only reason they cannot explain all of it is because they are not clever enough to think of the missing factors.

However, it is also possible to take the opposite tack. This type of analysis gives managers no credit for choosing the systematic factors—the betas—that drive their portfolios. Yes, these betas could often have been bought for very low fees. But would an investor have been able to put them together in the right combination?

It is as if a diner in Gordon Ramsay's restaurants were brave enough to tell the irascible chef: “This meal was delicious. But chemical analysis shows it is 65% chicken, 20% carrot, 10% flour and 5% milk. I could have bought those ingredients for £1.50. Why should I pay £20?” The chef's reply, shorn of its expletives, might be: “The secret is in the mixing.”

This debate matters because people are now trying to replicate the performance of hedge funds with cloned portfolios. Indeed Messrs Fung and Naik have shown that their model would have produced an annual return over the past four years of 11.6%, well ahead of the average fund of hedge funds. Their performance was purely theoretical. But Goldman Sachs and Merrill Lynch have launched cloned hedge funds on the market.

There are two potential criticisms of the cloned approach. One is that it will simply reproduce all the systematic returns that hedge funds generate and none of their idiosyncratic magic. However, this “magic” is hard to pin down. Even if it does exist, Messrs Fung and Naik suggest it may be worth no more than the fees hedge funds charge, so the managers are the only ones to benefit from their skills.

The second criticism is that the clones will always be a step behind the smart money. You cannot clone a hedge fund until you know where it has been. But by then it may have moved on. As a result, the clones may pile into assets that the hedge funds are selling, making the classic mistake of buying at the top. This may not be a fatal flaw, however. It is possible to imagine some clones taking contrary bets, buying the betas that seem temporarily out of favour, in the hope that they will be purchasing what the hedge funds are about to buy.

There are some nice ironies at work here. Hedge-fund managers often rely on secretive “black box” models: the investor puts his money in at one end and sees the returns spat out at the other, but no more than that. Now, armed with just that information, academics are coming up with their own models, which almost match the hedge funds' performance.

Mozart might have sympathised. His operas were more than the sum of his notes. But even if the great composer had no peers, he has had plenty of imitators.

Why hard assets are not easy to find

2007-02-14T05:58:00.000-08:00

Why hard assets are not easy to find
By Raghuram Rajan
Financial Times, Feb 12 2007

Signs of extremely benign financing conditions are plentiful, ranging from low long-term interest rates to historically narrow credit spreads on risky assets. Many observers call this a liquidity glut, thereby implicating central banks and their accommodative policies. But in my view, these conditions may primarily be driven by a global shortage of hard assets.

My argument relies on two global ingredients. The first is that, in spite of substantial worldwide income growth, if anything there has been an increase in the desire to save out of it. In emerging markets where income growth is rapid, savings increase. Household consumption in developing countries takes time to catch up with higher incomes – either because households take time to be confident that the increase is permanent or because credit constraints prevent them from borrowing to consume against future incomes.

Also, emerging market governments, including oil producers, not only have higher revenues but have become more careful about expenditure, given past experiences with deficits.

But perhaps most intriguing is the increase in corporate savings, especially in industrial countries. Profitable corporations, made more profitable by lower taxes and interest rates, retain earnings rather than hand them back as dividends to shareholders.

This is where we come to the second ingredient. Nominal corporate investment in hard assets – such as inventories, property, plant and equipment – has been restrained, especially relative to the quantities that might be warranted by the tremendous productivity growth of the past few years. Instead, more corporate savings have been invested in financial assets.

A number of possible explanations exist. Some sectors may have invested too much during the technology boom and be still working it off. A competitive need to improve inventory management and, more generally, utilisation of capital may also be at work. The cost of capital goods has fallen, which implies that less nominal investment is needed to achieve the same level of real investment. Furthermore, the nature of required investment may be changing, especially in industrial countries – from physical capital to human capital.

Perhaps the key factor, though, in holding back investment in hard assets may be economic uncertainty – ranging from corporate takeover threats to the increasing cost-competitiveness of emerging markets. Indeed, it makes less and less sense for corporations in industrial countries to make large domestic investments in the manufacturing sector. But as they look to invest in non-industrial countries, they become subject to the uncertainties of policy there. Not only do they have to worry about whether China is a better place to invest than Vietnam but also whether it will continue to be better 10 years from now. No wonder many corporations are focused on trying to improve the efficiency of their existing capital and stock of knowledge.

The mismatch between unabated global desired savings and lower realised investment has led to a financing glut, particularly pronounced in debt markets. With subdued investment in hard assets, there are fewer assets that can be used as collateral on which to base corporate debt. Given that a substantial portion of the world’s desired savings are put to work by central banks and financial institutions, many of which have statutory requirements (or matching considerations) to buy debt, we have many buyers for debt but too few debt instruments being issued.

Consider some implications. First, given that markets are integrated, the glut has spilt over into areas such as property and pushed prices higher. Especially affected have been the most illiquid markets and assets that have a debt-like character, such as utilities, which pay a steady dividend. Some of these markets are frothy, given the long-term prognosis for the savings-investment balance.

Second, while corporations may have learnt to be cautious through recent experience, builders and households have not faced adversity for some time and may have a greater propensity to over-invest. Third, sophisticated financial systems such as that of the US, have been particularly adept at creating instruments the market wants. This has helped the smooth financing of the US current account deficit and may be partly a cause of the deficit.

Finally, easy financing conditions the world over are not primarily because of the accommodative policy followed by the Group of Three central banks in recent years, though clearly monetary policy can add or subtract at the margin by affecting liquidity conditions and carry trades.

What is hard to forecast is how financing conditions will change. As capacity constraints tighten and as the policy environment in emerging markets becomes more clear, more investment will naturally be undertaken, reducing the financing imbalance and pushing up long-term interest rates. If this happens smoothly, the froth in exchange and asset markets will dissipate without much disruption. If long-term rates move more rapidly, for instance because of an inflation scare, the ride could be far more volatile.

The writer is a professor of finance at the Graduate School of Business at the University of Chicago

Some Interesting Stories I Read Today

2007-01-31T15:21:00.000-08:00

New Jersey Lottery May Trump Turnpike for Corzine Asset Sale
Rehlaender Bets on Asia Real Estate After Europe Made Him No. 1
Loss at Goldman Hedge Fund Racks Duo at Secretive Global Alpha

Some Interesting Stories I Read Today

2007-01-30T15:48:00.000-08:00

Bernanke's Conundrum: Job Market Refuses to Slow With Economy
Bill Gross - 100 Bottles of Beer on the Wall
The Collapse of Amaranth (Commodity Hedge Fund)

Bernanke's Conundrum: Job Market Refuses to Slow With Economy

2007-01-30T15:40:00.000-08:00

Bernanke's Conundrum: Job Market Refuses to Slow With Economy
Bloomberg, 2007-01-30
By Scott Lanman

Call it the Federal Reserve's new conundrum: If the U.S. economy has slowed as much as some data suggest, why is the labor market still so strong?

Chairman Ben S. Bernanke and his colleagues are debating the significance of an unemployment rate that's near a five-year low and 2006 job growth that's almost as strong as the prior year's. Either the labor market is lagging behind the slowdown by a few months, or the economy is stronger than official numbers suggest.

Better-than-forecast growth would increase the danger that the Fed, whose policy makers meet today and tomorrow to set interest rates, will lose ground in its fight against inflation. San Francisco Fed President Janet Yellen, calling the situation a ``puzzle,'' says there's a ``serious risk'' of faster price increases.

``The labor market has proved surprisingly tight in the face of what has been a decent slowing in growth,'' said Bruce Kasman, chief economist at JPMorgan Chase & Co. in New York, who predicts the Fed will raise interest rates by year-end. It's the ``key issue in the inflation outlook.''

Minutes from the Fed's last Open Market Committee meeting cited the labor market as members' chief inflation concern, and economists expect a similar signal in the Fed's statement tomorrow. The strength in employment is dashing some investors' hopes of a rate cut anytime soon.

Last month, policy makers left their benchmark lending rate at 5.25 percent for the fourth straight meeting after ending two years of increases in August, betting that economic growth was slowing enough to bring inflation down. All 107 economists surveyed by Bloomberg News forecast the Fed will again leave the rate unchanged.

`Gangbusters'

There is little dispute among Fed officials and economists about the demand for labor. Yellen, 60, told an audience in Scottsdale, Arizona, on Jan. 17 that the labor market is ``going gangbusters,'' language she repeated in Reno, Nevada, five days later.

Employers last month added 167,000 workers, capping a year in which growth averaged 153,000 a month compared with 165,000 a month in 2005. The December unemployment rate of 4.5 percent was the lowest year-end level since 2000 and was down from 4.9 percent a year earlier.

The chief U.S. economic-growth indicator has been giving the opposite signal. Expansion in gross domestic product slowed to a 2 percent annual pace in the third quarter from 2.6 percent in the three months through June and 5.6 percent in the first quarter.

Expanding Economy

The signal may change this week. The government's initial estimate of fourth-quarter GDP, to be published tomorrow, will show growth accelerated to a 3 percent rate at the end of 2006, according to the median estimate in a Bloomberg survey of economists.

Economists raised their predictions this month after higher- than-forecast retail sales and a narrower trade deficit bolstered the notion that the economy may be in better shape than earlier figures indicated.

``This disconnect story looked much more compelling several weeks ago, when the fourth quarter looked weaker,'' said former Fed Governor Laurence Meyer, now vice chairman of forecasting firm Macroeconomic Advisers LLC in Washington.

Labor Costs

A report tomorrow from the Labor Department may show its employment cost index, a measure of compensation costs, rose 1 percent from October to December for the second straight quarter, the fastest pace in more than two years. That comes as average hourly earnings last month jumped 4.2 percent from a year earlier, a gain last exceeded in 2000.

Yellen says she doesn't consider such readings troubling. Over the past year, increases in the employment cost index have been ``remarkably restrained,'' she said in her January. 22 speech. Overall, the labor market shows ``at best a mixed picture'' and the situation is more likely to be ``benign,'' she said.

One economist who agrees is Jim O'Sullivan of UBS Securities LLC in Stamford, Connecticut.

``We do think ultimately that growth is going to weaken enough to push unemployment up,'' he said. ``I don't think there's any doubt that if real GDP stayed as weak as 2 percent, that the unemployment rate will start going up.''

UBS expects the jobless rate to rise to 5.1 percent in the fourth quarter and real GDP to increase at a 2.2 percent rate for the full year.

This would ease the Fed's main inflation concern. Other economists reckon unemployment is likely to fall.

`Tight Resources'

``If the unemployment rate falls further, as I'm thinking, later on this year, that will create additional tight resources; workers will demand greater wages; and that can push up inflation in the future,'' said Christopher Rupkey, senior financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. ``That's why the Fed would want to restart its rate hikes.''

Some economists say the job market's strength may not be a puzzle at all; instead, it could be evidence that borrowing costs are still low enough to stimulate investment. In fact, this conclusion is shared by analysts with opposing views on whether there's a tradeoff between inflation and unemployment.

``When the Fed gets easy, typically, but not always, you'll see a tightening labor market and a more rapidly growing economy,'' said Brian Wesbury, chief economist at First Trust Advisors LP in Lisle, Illinois, and a former economist for Republicans in Congress.

Assistance From Fed

Jared Bernstein, an economist at the union-backed Economic Policy Institute in Washington, said the Fed's rate stance is ``absolutely'' helping the labor market by not being too restrictive.

The extent to which the job market's tightness generates inflation may depend on something outside the Fed's control: productivity. Richmond Fed President Jeffrey Lacker, the only official to publicly favor higher interest rates in the second half, said on Jan. 19 that productivity growth will keep any wage-inflation in check.

Bernanke, 53, doesn't see a productivity slowdown yet. He said in an August speech that ``strong'' growth in productivity will probably go on for ``some time'' as companies make better use of computers to raise workers' per-hour output.

``The key unknown is projections of what productivity is going to be,'' said New York University economics professor Mark Gertler, who taught Lacker in the early 1980s at the University of Wisconsin and has collaborated on research with Bernanke. ``The economy can weather high wage adjustments if they're accompanied by high productivity growth.''

Junk Bonds are Overvalued, Defaults to Rise, NYU's Altman Says

2007-01-30T15:37:00.000-08:00

Junk Bonds are Overvalued, Defaults to Rise, NYU's Altman Says
Bloomberg, 2007-01-25
By Caroline Salas

High-yield, high-risk bonds are overvalued and may tumble as default rates in the U.S. more than triple this year, said Edward Altman, a New York University professor who in the 1960s created a widely used mathematical formula that measures the risk of bankruptcy.

Altman predicts 2.50 percent of the $1.1 trillion junk bond market will default this year, up from 0.76 percent at the end of 2006. The rate will climb to 2.72 percent in 2008, he said last night at a Fixed-Income Analysts Society Inc. event in New York.

With companies having little trouble meeting interest payments, investors have pushed yield premiums on speculative- grade bonds to the lowest in a decade. Junk bonds yield 2.63 percentage points more than Treasuries on average, down from 3.54 percentage points a year ago, according to data compiled by Merrill Lynch & Co..

Even with a ``modest spike'' in defaults, ``it's hard to see how this market is going to do well,'' Altman, 65, said. Some investors predict default rates will remain below 1 percent this year and ``they have to say that'' to justify why they are buying bonds at such narrow yield spreads, he said.

Junk bonds are rated below Baa3 at Moody's Investors Service and below BBB- at Standard & Poor's. The securities returned 11.8 percent last year, including reinvested interest, their second- best performance since 1997, Merrill Lynch index data show. Bonds rated CCC and lower did the best, gaining 18.6 percent.

Z-Score

Altman in 1968 created the Z-score, a mathematical formula that measures a company's bankruptcy risk. Ratios such as working capital, or the amount of money available to run a business, to total assets are used in determining the Z-score. The lower the score, the higher the risk of bankruptcy.

Money from hedge funds and private equity firms are giving the riskiest borrowers access to capital and keeping default rates low, said Altman, who predicted in January 2005 the rate would rise to 4.27 percent last year from 3.37 percent.

``Just about everybody who forecast defaults was wrong,'' said Altman. ``I don't know if I am eating humble pie.''

Cheap debt has helped fuel a record amount of leveraged buyouts, where takeover firms use a combination of their own funds and debt issued in the target's name to fund the acquisition. Private equity firms and management announced more than $700 billion of takeovers last year, a record.

``We're able to borrow at unusually low spreads,'' Steven Rattner, co-founder of buyout firm Quadrangle Group LLC, said in an interview at the World Economic Forum in Davos, Switzerland. ``I'm not sure I'd want to be the buyers of that high-yield paper. The world isn't pricing risk appropriately.''

Record Sales

Companies sold a record $184 billion of junk bonds last year, and loans with below-investment-grade ratings reached an all-time high of $682 billion, according to data compiled by Bloomberg.

``There's an incredible amount of liquidity, primarily coming from non-bank institutions,'' Altman said. He estimated hedge funds account for as much as 40 percent of all trading in high-yield bonds.

Sales of the riskiest junk bonds, those rated CCC, may spur defaults, Altman said. Junk bonds that were rated B- or lower when they were issued accounted for 42 percent of high-yield sales last year, according to S&P.

Open Solutions Inc., a provider of software for financial- services companies, last week sold $325 million of 9.75 percent eight-year notes to finance its $1.4 billion takeover by the Carlyle Group and Providence Equity Partners Inc. The debt is rated Caa1 by Moody's and CCC+ by S&P.

`Very Disturbing'

``These chickadees are going to come home to roost,'' Altman said. ``But they're very happy eating in their barnyard, and they haven't. Which is very disturbing.''

The percentage of bonds considered in distress fell to a record low of 1.3 percent this month from 1.6 percent in December, S&P said this week in a report. Seventy companies had bonds trading at distressed levels, down from 97 in December, according to S&P, which defines distressed bonds as those with yields more than 10 percentage points above Treasuries.

Merrill Lynch's index of distressed bonds has shrunk to a face value of $6.5 billion from $27.4 billion at the end of 2005 and $161 billion in 2002.

``Every time there is a big bankruptcy we do open a bottle of fine wine in my household,'' said Altman. ``It's been a real dry spell. I am hoping for a more liquid situation going forward.''

Cohen, Granville, Acampora Don't Move Markets Anymore, Do They?

2007-01-13T08:28:00.000-08:00

Cohen, Granville, Acampora Don't Move Markets Anymore, Do They?
Bloomberg, 2006-11-29
By Daniel Hauck

Joseph Granville and Ralph Acampora aren't moving the U.S. stock market as they used to, and no one has come along lately to take their place.

When Granville told newsletter readers to ``Sell Everything'' on Jan. 6, 1981, the Dow Jones Industrial Average fell 2.4 percent the next day. The average rose after a similar forecast on Oct. 26 this year. Acampora helped boost the Dow to a 1.1 percent gain on Jan. 8, 1999, by saying a rally was beginning. This year, the average fell when he wrote in an Oct. 30 report that the worst was over for stocks in 2006.

Forecasts from fellow 1980s and 1990s pundits Elaine Garzarelli and Abby Joseph Cohen don't have the impact they once did either. And bearish projections from top-ranked strategists Francois Trahan of Bear Stearns & Co. and Merrill Lynch & Co.'s Richard Bernstein this year failed to dent stocks' rally.

``It's gotten a lot more difficult to make that call,'' said Warren Simpson, who helps manage more than $3 billion at Stephens Capital Management in Little Rock, Arkansas. ``It's kind of passe, isn't it? There's too much risk.''

Making accurate forecasts is harder than it was 20 years ago because the rise of hedge funds has created a bigger pool of money, muting the impact of any one strategist, said Cummins Catherwood, who helps manage $700 million at Walnut Asset Management in Philadelphia.

Pundits also are dealing with a more fickle audience that is ``privy to much more information than they used to be,'' said Simpson. ``In the old days, you were dependent on your broker to tell you what the market was doing. Now people have it on their desks all over the country.''

`Sell Everything'

Investors now have more and faster information about markets from the Internet. Microsoft MSN Money, Yahoo Finance and AOL Money each attracted more than 10 million people in the U.S. in October, according to ComScore Networks Inc., a market researcher in Reston, Virginia.

Granville, 83, and Acampora, 65, helped pioneer technical analysis, or the study of price charts to make buying and selling decisions. Their influence diminished after they maintained for too long the positions that made them famous.

Granville, who got his start at what was then the brokerage E.F. Hutton in 1957, correctly forecast the bear market of 1977- 78 before his ``Sell Everything'' call.

``Joe was extremely powerful,'' said Robert Stovall, global strategist at Wood Asset Management Inc. in Sarasota, Florida, who worked with him at E.F. Hutton. ``If he gave the thumbs down to a market, it was like the emperor in the coliseum. The market would go down.''

Granville's Call

Granville later failed to foresee the rally that started in 1982 and lasted for five years. He also called for losses in 1995 before the so-called Internet bubble began.

Not all his most accurate calls were long ago. On March 11, 2000, a day after the Nasdaq Composite Index peaked at 5048.62, he wrote that investors in technology stocks ``will soon be burned.'' The index, which now gets 42 percent of its value from computer-related shares, sank 78 percent through Oct. 9, 2002.

Now he predicts the Dow average will fall as low as 7100 within six to 18 months. He draws on the observation that only five of the Dow's 30 members reached new 52-week highs when the Dow closed above 12,000 on Oct. 19 and none set records.

``When I make a prediction or a statement, it's coming from somebody who's gone through 50 years of markets,'' he said in an interview from Kansas City, Missouri, where he's based.

Dow 10,000

Acampora, a 40-year Wall Street veteran, became known for his forecasts during the 1990s at what's now Prudential Equity Group LLC. When the Dow stood at 7600 in June 1997, he correctly predicted it would reach 10,000, a level breached in March 1999.

After that happened, he said the average would climb to 18,500 by 2006. The Dow industrials closed above 12,000 for the first time on Oct. 19.

He hasn't yet released his official forecast for 2007, though he said the current four-year advance in the Dow average may be extended at least through 2008. He wrote in a note last month that 21 stocks in the Dow are ``attractive technically'' and ``buys for the long-term.''

Knight Capital Group Inc., the second-biggest matchmaker for trades on the Nasdaq Stock Market, hired Acampora in October 2005 after Prudential closed the technical research department he headed. This year, he ranked third among technical analysts in Institutional Investor magazine's annual fund-manager survey.

Acampora's Following

``Acampora currently has more of a following, more credibility, than Granville,'' said Stovall, who also worked with Acampora at Prudential. ``But they're both very serious students and the early Granville books written in the early 1960s added a lot to technical analysis.''

Garzarelli, who is 55 according to Marquis Who's Who, correctly predicted the 1987 crash as a Lehman Brothers Inc. strategist. In a June 2005 Bloomberg article, she estimated the S&P 500 would surge 25 percent in the next year. The index rose 2 percent in the 12 months, and her call didn't move the market.

``I don't have a platform,'' Garzarelli said in an interview from Springfield, Pennsylvania. She said her work, Granville's and Acampora's gets less attention from the media because they no longer are at ``major'' firms.

Since 1995, Garzarelli has headed her own firm. She uses a 14-indicator model to predict the market's moves, and expects the S&P 500 to reach a record in 2007.

Market Forecasting

Cohen, Goldman Sachs Group Inc.'s chief U.S. investment strategist in New York, made her name with bullish forecasts amid the Internet bubble. She was the top-ranked strategist in Institutional Investor's survey in 1998 and 1999.

She lost influence after underestimating the plunge that began in March 2000. In this year's survey, she wasn't listed among the top seven strategists.

Cohen, 54, was traveling and unavailable for comment, according to a Goldman spokesman, Ed Canaday. Her role has changed since the 1990s, Canaday said, as she focuses more on a ``longer-term, macro view'' than predicting daily market moves.

This year, Cohen has been a more accurate forecaster than Bear Stearns's Trahan and Merrill's Bernstein, the strategists now at the top of Institutional Investor's poll.

She said on June 13 that stocks had fallen too far and the S&P 500 would rebound to 1400 by year end. The index set its low for the year that day and has since risen 13 percent to 1386.72. Trahan has a year-end forecast of 1200, while Bernstein said at the start of 2006 that the index would slip 1.9 percent to 1224.

Pundits ``make calls and they're right sometimes,'' Stephens Capital's Simpson said. ``When they're wrong people don't listen to them as much anymore.''

Record Share Repurchases by U.S. Companies May Aid Stock Rally

2006-09-06T05:19:00.000-07:00

Record Share Repurchases by U.S. Companies May Aid Stock Rally
By Hilary Johnson
Bloomberg, 2006-09-05

U.S. companies are spending record amounts of money on their shares, and the repurchases may help stocks exceed the five-year highs reached earlier in the year.

Microsoft Corp., the world's largest software maker, bought back $3.8 billion of stock last month. Realogy Corp., the real- estate broker spun off from Cendant Corp., offered last week to pay as much as $736 million for some of its shares.

The offers followed $116 billion of repurchases in the second quarter, the most ever, according to Standard & Poor's. Buybacks announced in 2006 already exceed the record amount for a full year, according to Birinyi Associates Inc., a money- management and research firm. Record levels of cash and relatively low interest rates have spurred buying.

``Supply's shrinking,'' said Kenneth Fisher, chairman of Fisher Investments Inc. in Woodside, California, who oversees $32 billion. ``That's got to be bullish.''

Stocks rose last week as data on inflation, job growth, manufacturing and consumer confidence reinforced the Federal Reserve's view that economic growth is slowing gradually.

The S&P 500 ended the week 1.1 percent below this year's peak of 1325.76, reached May 5, when the index climbed at the highest level since February 2001. U.S. markets were closed yesterday for the Labor Day holiday.

Reports tomorrow may provide more evidence that the economy is meeting the Fed's expectations, suggesting policy makers may be done raising interest rates after 17 increases in two years.

Advisers' Optimism

The Institute for Supply Management may say banks, builders, retailers and other service companies expanded last month, according to a survey of economists by Bloomberg News. Productivity probably rose in the second quarter at a faster pace than first reported, another survey showed.

Speculation that the Fed won't lift rates sent optimism about U.S. stocks to a five-week high, according to the latest survey by Investors Intelligence, a New Rochelle, New York-based financial newsletter.

The number of bullish newsletter writers rose during the week ended Aug. 25 by 2.1 percentage points, to 42.1 percent. Bearish, or pessimistic, writers fell to 33.7 percent, a six-week low, from 34.7 percent.

The S&P 500 advanced 1.2 percent last week to 1311.01. The Dow Jones Industrial Average added 1.6 percent to 11,464.15 and the Nasdaq Composite Index increased 2.5 percent to 2193.16.

$40 Billion Plan

Microsoft has risen 20 percent since June 13, when the S&P 500 reached its low for the year. The Redmond, Washington-based company announced plans in July to repurchase $40 billion of stock, including $20 billion through a tender offer.

Investors tendered only $3.8 billion of shares. To make up the difference, Microsoft boosted its repurchase program to $36 billion on Aug. 18. That day, its stock gained 4.4 percent, the most in a month.

Realogy, the company behind the Coldwell Banker and Century 21 real-estate brokerages, offered to buy as many as 32 million shares on Aug. 28. The company agreed to pay $20 to $23 a share in the so-called Dutch auction, allowing shareholders to set the price they will accept. The offer expires on Sept. 26.

A week earlier, Realogy authorized a buyback plan for a maximum of 48 million shares. The company, based in Parsippany, New Jersey, said the purchases may add as much as 10 percent to earnings per share next year.

`Being Pushed'

U.S. companies spent 16 percent more on their shares during the second quarter than in the prior three months, according to Howard Silverblatt, a senior index analyst at S&P in New York. They also beat the record of $104 billion set in last year's fourth quarter, S&P data showed.

Buyback announcements in the first eight months of 2006 totaled $507 billion, up 88 percent from the year-ago period, according to Birinyi, based in Westport, Connecticut. The full- year record of $470.7 billion had been set last year.

Boeing Co., the world's second-largest maker of commercial aircraft, said on Aug. 28 that it would buy back as much as $3 billion of shares. Amazon.com Inc., the world's biggest online retailer, authorized $500 million in repurchases that day.

Companies are making these plans after amassing record amounts of cash. S&P 500 members had $614 billion available as of Aug. 30, according to S&P, whose total excludes utilities and financial and transportation companies.

``They're being pushed to do something with the money,'' Silverblatt said. Buybacks enable companies to return cash to shareholders without committing themselves to future payments, as dividends do.

`Too Cheap'

Relatively low interest rates have also been a boon for buybacks, Fisher said. S&P 500 companies will earn $87.17 per ``share'' this year, about 6.6 percent of the index's current level, according to the average estimates of analysts surveyed by Thomson Financial. Ten-year U.S. Treasury notes, a benchmark for borrowing costs, yield 4.72 percent.

``What they're really saying is that the cost of the stock is too cheap relative to the cost of borrowed money,'' he said, referring to companies.

Repurchases can increase per-share earnings by reducing the amount of stock outstanding. Analysts see profit growth slowing through the second quarter of 2007, providing an incentive to make repurchases.

After surging 16.3 percent in the second quarter, S&P 500 profits will rise 14.3 percent in the third, 13.4 percent in the fourth and 11 percent in next year's first quarter, according to Thomson. Second-quarter profit is projected to rise 8.9 percent.

`Lack of Confidence'

``Companies buying back their own shares may well reflect a lack of confidence,'' said James Paulsen, chief investment strategist at Wells Capital Management in Minneapolis, who helps manage $150 billion. ``They feel they don't have any good investment opportunities.''

Announcements don't always lead to purchases. Since 2000, companies have bought only 65 percent of the shares they said they would, according to Birinyi's data.

Still, many investors can't help but be optimistic about what the increase in buybacks may mean for the market.

``How much can you shrink the denominator before it explodes the price?'' asked Kevin Bannon, who helps manage $116 billion as chief investment officer at Bank of New York. ``We're getting closer and closer to that point.''

Bloomberg Tickers
TNI US BBK BN To see Bloomberg stories on share repurchases
CACT 50 US For a table of U.S. companies that have announced repurchase programs.

Al Gordon, Wall Street Icon at 105, Is Bearish on U.S. Stocks

2006-09-01T12:33:00.000-07:00

Al Gordon, Wall Street Icon at 105, Is Bearish on U.S. Stocks
By Christine Harper
Bloomberg, 2006-08-30

Albert H. Gordon took over Kidder, Peabody & Co. in 1931, turned it into an underwriting leader on Wall Street, and saw opportunities overseas before many rivals.

He's still looking abroad at the age of 105.

After eight decades as an executive and investor that spanned from the roaring 1920s to the age of terrorism, Gordon says he's ``bearish'' on U.S. stocks partly because of the $8.41 trillion national debt. He prefers shares of companies such as Canada's EnCana Corp., Wal-Mart de Mexico SA de CV and Petroleo Brasileiro SA.

``At least three-quarters of whatever I own is foreign stocks,'' he says from his Manhattan apartment overlooking the East River.

Gordon, who has outlasted Kidder as well as Wall Street staples like ticker tape, is a role model even to octogenarian elder statesmen such as former Goldman Sachs Group Inc. Co- Chairman John Whitehead and ex-President George H.W. Bush. This year, Gordon stopped going to the office at Deltec Asset Management, where his son John is a senior managing director.

A marathon runner into his 80s, Gordon now has a hearing aid and walks with a cane and assistance from a nurse. His opinions are still sought because he's one of the few living Wall Street investors who worked in the years leading up to the stock market crash of 1929.

While his three current favorite stocks each climbed at least 13 percent this year through yesterday, almost triple the 4.5 percent gain in the Standard & Poor's 500 Index, Gordon built his reputation as a salesman rather than as an investor, says Whitehead, 84.

Presidential Role Model

``He was a famous business-getter,'' says Whitehead, a former rival. ``Work hard and never give up -- those were very valuable lessons I learned from trying to compete with him.''

Whitehead, who joined Goldman Sachs in 1947, remembers vying for clients against the more experienced Gordon at Minneapolis- based 3M Co., where Gordon's relationship was so close with then- Chief Executive Officer William McKnight that Whitehead says he focused instead on cultivating the next generation of executives. It didn't work right away, he says.

When McKnight died, Whitehead says, his will stipulated that Gordon and Kidder should handle any sales of McKnight's stake in 3M.

Gordon's influence extended to the highest levels of the U.S. government. He befriended Prescott Bush, a U.S. senator from Connecticut from 1952 to 1963 and grandfather of President George W. Bush, and served as a role model to George H.W. Bush, the 41st U.S. president.

``He taught me a lot about ethics and values,'' says George H.W. Bush, 82. ``He's a very energetic man of great character.''

Harvard Benefactor

Gordon, the son of a successful leather merchant in Boston, graduated from Harvard University in Cambridge, Massachusetts, in 1923 and from Harvard Business School two years later.

Today, one of the main roads into the business school bears a plaque calling it ``Albert H. Gordon Road'' in recognition of his advice and donations over the years. Harvard declined to comment on the amount Gordon has given to the school.

``Al Gordon was a master salesman,'' says Samuel Hayes, 71, an investment-banking professor emeritus at Harvard Business School who met Gordon in 1961. ``He was an effective rainmaker long after he ceased to manage the firm on a daily basis.''

As a bond salesman at Goldman Sachs in the 1920s, Gordon says he considered stock values excessive and steered clear of the market before it crashed. That helped him a year later in 1930 to capitalize when a Harvard classmate, Edward Webster, approached Gordon to help rescue Kidder, a brokerage based at the time in Gordon's hometown of Boston.

Planes and Trains

They moved the firm to New York, and Gordon, who would go on to become the firm's senior partner and biggest shareholder, built up its sales and underwriting divisions. Gordon expanded across the U.S. and overseas, taking airplanes to see clients when his competitors were more comfortable on trains like the 20th Century Limited to Chicago, he says.

``People wouldn't fly,'' he says. ``So there was virtually no competition.''

With the advent of jet travel, he flew to Japan with his wife ``to see if the people were friendly,'' paving the way for an expansion in Tokyo.

``We did a tremendous amount of business in Japan,'' he says. That followed expansions in Asia and Europe in the 1950s, he says: ``We were the first people to have an office in Hong Kong, the first people to have an office in England.''

Gordon began turning over chief executive officer duties at Kidder to Ralph DeNunzio in the 1970s, staying on as chairman. In 1986 Gordon helped engineer the firm's sale to General Electric Co. and remained at the firm until 1994, when GE sold the company to PaineWebber Group Inc., now part of Zurich-based UBS AG.

`Gold Mine'

Kidder's final years included criminal inquiries. Martin Siegel, who had been the firm's top merger banker, pleaded guilty in 1987 to one count of conspiracy to violate the securities laws and one count of tax evasion for failing to report payments he received from arbitrager Ivan Boesky.

The firm fired bond trader Joseph Jett in 1994, accusing him of manufacturing $350 million of false profits. On March 5, 2004, the U.S. Securities and Exchange Commission ordered Jett to pay $8.4 million and barred him from the securities industry after concluding he committed fraud and created phantom profits. Jett maintained his innocence after the order.

Kidder should have spotted the activities sooner, and the inquiries hurt the firm's reputation, Gordon says. Until that time, he says, ``it really was a gold mine.''

Growth Strategy

When it comes to investing, Gordon looks for companies that will grow for years, says Arthur Byrnes, who is co-head of Deltec Asset Management with Gordon's son John.

``Despite the fact that he's an old man, he buys things not for a quick trade,'' Byrnes says. ``Al is a long-term investor, if you can believe that someone who's 105 years old can be a long-term investor.''

Gordon favors countries with economies that will support growth, and he says the U.S. has too much debt. He says he liked Petroleo Brasileiro partly because South America had been successful for Kidder. Wal-Mart de Mexico and EnCana, Canada's largest natural-gas producer, may grow, he says.

``I read that Wal-Mart was stationary but Wal-Mart's Mexican subsidiary was on the move so that was enough for me so I bought quite a bit of Wal-Mart Mexico,'' he says. ``EnCana was owned by the Canadian Pacific Railroad and so you knew that its background was business, not government.''

Sleep and Run

A non-smoker who says he used to pay people to give up cigarettes, Gordon ran in the London marathons for the two years after his wife died in 1980. He credits his long life to exercise and at least nine hours of sleep a night. He would often walk or run between city centers and airports in New York and Los Angeles. He has three sons and two daughters, all between the ages of 70 and 55.

When it comes to investing, at least one of Gordon's contemporaries agrees that overseas stocks can provide more robust returns than U.S. shares.

``Al Gordon is right,'' says Irving Kahn, 100, chairman of New York-based investment firm Kahn Brothers & Co. He says global wealth imbalances and the rise of extremists should give investors pause: ``You don't have to be too alert to see how much terrorism is spreading.''

Highlights of the FOMC Minutes

2006-09-01T12:29:00.000-07:00

Highlights of the FOMC Minutes
The Detailed Minutes
Aug 29, 2006

The staff forecast prepared for this meeting indicated that real GDP growth would slow in the second half of 2006 and 2007, and to a lower rate than had been anticipated in the prior forecast. The marking down of the outlook was largely attributable to the annual revision of the national income and product accounts, which involved downward revisions to actual GDP growth in prior years and prompted reductions in the staff’s estimate of potential output.

The rate of new home sale cancellations, which was identified as an important leading indicator by some contacts in the construction industry, had spiked higher.

Although business fixed investment in the second quarter was a little lower than had been expected, participants noted that this development appeared mainly to reflect the timing of purchases, particularly of transportation equipment, and not weakness in the underlying trend.... However, it was noted that if the reported slowing of increases in retail sales continued, businesses might trim capital spending plans.

Several participants took note of the revisions to historical data that painted a more worrisome picture of cost trends; measures of unit labor costs had been marked up, reflecting upward revisions to labor compensation and downward revisions to labor productivity.

The recent pickup in price increases appeared to be broad-based, and a number of business contacts reported greater ability to pass through higher costs. However, some types of price pressures were not likely to continue to increase. The recent acceleration in shelter costs, which contributed substantially to the increase in core inflation this year, could prove short-lived. Moreover, while energy prices had risen further in the intermeeting period, energy prices could well level out in coming quarters. Also, the anticipated moderation in aggregate demand implied that pressures on resource utilization likely would not increase and could abate to a degree going forward. Finally, inflation expectations appeared to have remained contained despite adverse news about prices. In light of these factors, most participants expressed the view that core inflation was likely to decline gradually over the next several quarters, although appreciable upside risks remained.

In view of the elevated readings on costs and prices, many members thought that the decision to keep policy unchanged at this meeting was a close call and noted that additional firming could well be needed.

All members agreed that the statement to be released after the meeting should convey that inflation risks remained dominant and that consequently keeping policy unchanged at this meeting did not necessarily mark the end of the tightening cycle

Chinese Economy - Progress on Strategic Petroleum Reserve for Chin

2006-09-01T12:28:00.000-07:00

Chinese Economy - Progress on Strategic Petroleum Reserve for Chin
G7 Group, Aug 29, 2006

China is in the process of building extensive storage capacity for a strategic petroleum reserve (SPR). The capacity goal is 90 days of net import volume, which is about 400 million barrels, but this is a long run target. China has not yet begun to fill the reserve (although it plans to start before year end), and the rate at which it supplies the reserve is dependent on petroleum prices. Large purchases of oil from the international market for the SPR are unlikely anytime soon unless the oil price drops significantly (say to under $60 a barrel). What is behind this effort?

Soaring oil prices combined with China’s increasing dependence on imported oil products have spurred the government to expedite the pace of building its strategic petroleum reserve. The purpose is to secure oil reserves in case of a supply shock and to cushion against the impact of oil price on China’s economic growth. China is aware that in the absence of a petroleum reserve it is increasingly susceptible to economic sanctions triggered by international conflicts and general supply interruptions. Currently, China's commercial petroleum storage can only meet the nation's consumption needs for 21.6 days, compared with about 160 days for the US and Japan. At what stage is the overall SPR project?

- Four reserve bases are currently under construction: Two at Zhenhai and Daishan in Zhejiang province, one at Huangdao in Shandong province, and one at Dalian in Liaoning province.

- After these four bases are put into operation in 2008, China’s total petroleum storage (including existing commercial storage) will be able to satisfy the nation’s 30 days consumption. The NDRC recently disclosed that all 52 oil storage tanks (16 of them already completed in October 2005) at the Zhenhai oil reserve base, the largest among the four, will be completed for use by the end of October this year. The total capacity of storage is
5.2 million cubic meters. The other reserve bases are expected to be completed in 2007-2008.

- But China’s buildup will go further than this. When the whole project is completed, China expects to have petroleum storage capacity of 400 million barrels, or equivalent to about 90 days of net import volume. The government is already starting to select the new sites for the second phase of the SPR. And after that, additional sites are expected to be built in the hinterland of the country (Phase Three). Total planned storage of strategic petroleum is 10-12 million tons during Phase One; 28 million tons at the end of Phase Two; and another 28 million tons at the end of Phase Three.

China plans to start filling the SPR this year, but it is expected to take a long time to complete. Some of the newly-found oilfield output is likely to be incorporated into the SPR; however, China is unlikely to choose this time to import large additional amounts of petroleum to build the SPR, because it does not recognize the current oil price as a good deal.

Moreover, the country’s new oil windfall tax does not encourage additional imports. Domestic oil producers will be charged a tax of 20% or higher when the price of crude oil stays above US$40 a barrel. The tax rate is 40% when the price rises above US$60 per barrel, which is indicative of how the policymakers perceive oil prices. Hence we may expect that the filling of China’s SPR to be a gradual process.

Large purchases of oil from the international market are unlikely at this point and may remain so unless the price of price drops significant (say, to under $60 a barrel). Obviously, this price point estimate is based on a current assessment of the likelihood of supply interruptions. If the geo-political environment becomes more risky for oil supply, the pace of supplying the SPR can change.

Bottom Line: China is building capacity for an ambitious SPR. But it is not filling the capacity yet and when it starts -- probably later this year-- it will not do so aggressively, given the high price of imported oil. The capacity building will take at least several more years, and filling will obviously take longer, perhaps much longer.

Asset – Credit Market

2006-09-01T12:27:00.000-07:00

Asset – Credit Market
New World's Banker
WSJ, Aug 26, 2006

Some fear the U.S. credit markets are about to be submerged under a flood of leveraged buyouts. With a number of large deals seeking financing, that could mean higher borrowing costs and smaller profits for private-equity investors. The buyout kings have found a way around this potential crisis, however -- they are turning to Europe.

This year U.S. companies have raised $20 billion of leveraged loans outside America, according to Standard & Poor's Leveraged Commentary & Data. That's almost double the amount from the comparable period last year. The financing for HCA's record $33 billion buyout adds to this trend. More than a tenth of the institutional loans for HCA are expected to come from Europe. Yet only a small part of HCA's revenues originate in Europe.
Not long ago, American firms shied away from the European syndicated loan market. In the old days this market was dominated by banks, whose rigid practices made loans more expensive. Emsurope has since become more competitive. Several U.S. debt specialists, including Bain Capital's Sankaty Advisors, have set up shop there. European investment firms have also established specialist funds for leveraged loans. This influx of new investors has improved the position of borrowers. American firms often pay less on riskier dollar loans raised in Europe than at home.

The U.S. trade deficit is another reason why Americans are looking abroad. With a lot more cash going out of the country than coming in, U.S. leveraged buyouts could face financing constraints if they were restricted to domestic credit markets. Europe runs a trade surplus and, with lower interest rates, liquidity remains abundant. With a large number of leveraged loans in the pipeline, other issuers are likely to follow the example of HCA and head across the pond.

Citigroup, Bank of America Squeezed by Bond Market

2006-09-01T12:21:00.000-07:00

Citigroup, Bank of America Squeezed by Bond Market
By Mark Pittman
Bloomberg, 2006-08-29

Citigroup Inc., Bank of America Corp. and JPMorgan Chase & Co. are among the biggest losers in the bond market, where the largest U.S. banks' relative borrowing costs are the highest in three years.

A slowing economy has prompted investors to demand an additional 11 basis points of interest, or $1.1 million for each $1 billion face amount, on bank bonds since February, according to data compiled by Merrill Lynch & Co. The widening yield premium amounts to a loss of $7.3 billion on bondholders' principal the past six months and a profit squeeze for banks, which make money on the difference between their borrowing and lending charges.

Bank bonds, which account for almost one fifth of the $5.2 trillion U.S. corporate bond market, are heading for their worst year since 1999 after the Federal Reserve increased interest rates 17 times, the government reported a 4.3 percent slump in new-home sales in July and oil prices rose 14 percent since January. Slower growth may cause bond defaults to quadruple by 2008, adding to bank losses, Standard & Poor's says.

``Whenever you see some weakness in the economy, that has to get into investors' minds,'' said Alvaro de Molina, chief financial officer of Bank of America, in an Aug. 24 interview. Some fund managers may be questioning whether the Fed has pushed the economy into a recession, de Molina said.

Investors are demanding 81 basis points more than the yield on similar-maturity Treasuries. The spread was as high as 83 basis points on Aug. 11, which was the most since 2003. The spread has widened twice as much as the 5 basis point increase in yield premiums, or spreads, for investment-grade bonds, according to Merrill. A basis point is 0.01 percentage point.

Falling Prices

Bank bond prices have fallen on average 2 percent this year, according to a Merrill index that tracks the performance of 579 securities worth $365 billion. By contrast, the Merrill index of AA rated debt declined 1.8 percent this year.

The total return on the bank index, including both capital appreciation and reinvested interest, is 1.64 percent this year, the worst since it declined 1.73 percent in 1999.

Citigroup's $1 billion of 6 percent bonds due in 2033 have fallen 7 cents per dollar of face amount this year to 99 cents as the yield climbed to 6.06 percent from 5.6 percent, according to Trace, the bond-price reporting service of the NASD. The spread has widened 10 basis points to 1.11 percentage points since Jan. 1.

Citigroup spokeswoman Shannon Bell in New York declined to comment.

JPMorgan's $1 billion of 5.875 percent notes due in 2035 have fallen 6 cents per $1 face amount to 94 cents since the first of the year, according to Trace. The bond's yield has gone up 45 basis points to 6.31 percent.

JPMorgan spokeswoman Brooke Harlow declined to comment.

Threat of Default

A slowing economy also may cause a growing number of borrowers to default, requiring banks to set aside more money for losses and leaving less for debt payments. Defaults will rise to 4 percent from their current record low of 1.03 percent by the first quarter of 2008, according to S&P.

``We're probably at the top of the mountain for loan quality, and it's going to start falling pretty soon,'' said James Hannan, who oversees $3 billion in fixed income at MTB Investment Advisors in Baltimore.

Hannan, whose holdings include bonds of Charlotte, North Carolina-based Wachovia Corp. and Mellon Financial Corp. of Pittsburgh, said he is seeking debt of banks that make money from trading, underwriting and advisory services. He's avoiding companies that focus on housing loans, such as Calabasas, California-based Countrywide Financial Corp., the biggest U.S. mortgage provider.

Investors now demand 23 more basis points in yield over government debt, or 1.36 percentage points, to hold Countrywide's $1 billion of 6.25 percent notes than when they were sold in May. The securities mature in 2016.

Yield Premiums

The average yield premium for banks has widened 11 basis points from the low this year of 70 basis points in February, saddling bank bond investors with the biggest losses, Merrill data show. Bonds sold by companies in the telecommunications industry lost $5.3 billion because of declining prices.

Banks have $30.7 billion in debt coming due by year-end, more than any other industry, according to data compiled by Bloomberg. Bank of America has the most, or $5.7 billion, just ahead of the $3.5 billion for Minneapolis-based U.S. Bancorp.

Higher borrowing rates have contributed to shrinking lending margins, a measure of profitability. S&P said earlier this month that those margins are at their lowest since 1991.

Interest Margins

Citigroup's net interest margin, the difference between the average rate the bank pays to borrow and what it charges in interest, fell to 2.8 percent in the second quarter, the lowest since at least December 2000.

The net interest margin at New York-based JPMorgan has shrunk to 1.96 percent, the smallest since September 2001. The rate at Charlotte, North Carolina-based Bank of America is 3.02 percent, the lowest since at least March 1999.

Lending margins are ``a key factor in their earnings, and they're continuing to see some pressure,'' Baylor Lancaster, a Coconut Grove, Florida-based analyst from debt research firm CreditSights Inc., said in an interview. ``We view a future deterioration in credit quality as pretty much inevitable,'' Lancaster said in an Aug. 8 report.

Commercial banks make about two thirds of their income from the difference between their borrowing and lending costs, according to James Moss, an analyst at Fitch Ratings in Chicago. He said a 1 percentage point increase in benchmark interest rates could reduce profit on average by 4.6 percent.

Sell Bank Bonds

Investors ought to sell bank bonds or buy derivatives that would benefit from a decline in the price of debt issued by Wachovia and Citigroup, said Barclay's Capital analysts Melody Vogelmann and Julie Schultz in an Aug. 17 report.

Wachovia, the fourth-largest U.S. bank, has few operations outside the U.S., so it would be hurt by a slower U.S. economy more than other competitors, Vogelmann and Schultz said.

``No question, it's a headwind with regard to revenue growth,'' said Bank of America's de Molina. Higher borrowing costs won't hurt credit quality because the bank can make up the lost revenue in other ways, he said.

By de Molina's estimate, the worst-case scenario for interest rates next year would cost Bank of America about $600 million. The bank will earn $20 billion this year, according to the average forecast of 16 analysts surveyed by Thomson Financial.

``That's a pretty small number in comparison to a $20 billion revenue stream,'' de Molina said

Target Rate

Fed policy makers this month decided not to raise borrowing costs after pushing their target rate for overnight loans between banks to 5.25 percent from 1 percent in June 2004. New-home sales in July fell more than forecast and the number of unsold houses climbed to a record, according to a Commerce Department report released last week. Purchases of new homes dropped to an annual pace of 1.072 million.

The central bank should have stopped earlier, according to Robert Shiller, the Stanley B. Resor Professor of Economics at Yale University in New Haven, Connecticut. Shiller, the author of the book ``Irrational Exuberance'' that in 2000 predicted a slump in the stock market, said this month that a slowdown in the housing market will likely cause a recession.

``Banking spreads are going to widen much more meaningfully than they have now,'' said Nouriel Roubini, a professor of economics at New York University. ``The banking system as a whole is hugely vulnerable to the risk of recession.'' Roubini says there is a 70 percent chance of a recession.

Consumer Confidence

Confidence among consumers this month fell to its lowest since October because of concerns about terrorism and high gasoline prices, the University of Michigan said Aug. 18. The school's preliminary index of sentiment dropped to 78.7 from 84.7 in July.

Almost 30 percent of banks said they anticipate residential mortgages will deteriorate over the next year as the housing market cools, an Aug. 14 report by the Fed said.

``Banks will tighten their lending standards by increasing loan spreads and by simply refusing to lend to some at any spread,'' said Paul Kasriel, director of economic research at Northern Trust Securities, in an e-mail on Aug. 18. ``This, in turn, will create even more drag on economic growth.''

The three biggest U.S. banks all reported record profits last year led by Citigroup's $24.6 billion. Bank of America's net income totaled $16.5 billion and JPMorgan had $8.5 billion.

Corporate Lending

Bank of America has scaled back its corporate lending exposure to $35 billion, less than one-fourth of the $130 billion in company loans that the lender and its predecessor companies had in 2000, the last time the Fed ended a series of rate increases, de Molina said.

``If you look at the amount of corporate credit risk that we have in this cycle versus the last cycle, it's much, much smaller,'' de Molina said.

An expanding economy allowed borrowers to tap banks for cash with little trouble even as the Fed was raising rates. The lending environment is still favorable for banks.

Debt deemed uncollectible by U.S. banks fell to 0.4 percent of all loans and leases in March, the least since before 1985, according to the Fed. Borrowers defaulted on high-yield, high- risk, or leveraged, loans at a 3.2 percent rate in the first quarter, down from 10 percent in 2002, according to S&P.

SunTrust's Loan

Atlanta-based SunTrust Banks Inc. was stuck with a non- performing $200 million loan because the borrower's business deteriorated before the bank had a chance to sell the loan to investors, said Richard Bove, who follows the bank for Punk Ziegel & Co. in Pinellas Park, Florida.

The loan was to ``a large corporate client whose operating fundamentals are deteriorating,'' SunTrust Chairman and Chief Executive Officer Phillip Humann said Aug. 14 during a presentation at Keefe, Bruyette & Woods Inc.'s bank conference in Kohler, Wisconsin. He declined to name the borrower, saying it was ``very legitimate company'' that lost a major customer.

SunTrust spokesman Barry Koling said the loss on the loan isn't connected to the economy. The bank is working with the company to try to recover the money, he said.

``SunTrust is definitely a bellwether,'' said Tanya Azarchs, managing director and coordinator of global research at S&P in New York. ``We're going to see a lot more of this.''

Story of the Day - Make Money When U.S. Congress Is Out of Session

2006-08-03T14:48:00.000-07:00

Make Money When U.S. Congress Is Out of Session
Bloomberg, 2 August 2006
Amity Shlaes

Weekdays in August are a good time to own stocks. The end of October isn't bad either. Christmas can be fine for equities as well.

What these dates have in common is that they are times when Congress isn't in session. Back in 1991, a Wall Streeter named Eric Singer noticed that equities that year tended to do better when lawmakers weren't in Washington. He published an op-ed in Barron's proposing that the correlation was no coincidence.

Later, he looked at a wider timeframe and went around the squash courts of New York telling people he might write a book about his thesis. Now Singer is going one step further. He has created a hedge fund, Singer Congressional Fund. Its goals include making money from the Congressional calendar.

Neat idea, and one bound to appeal to doctrinaire free-market thinkers. But market people disdain ideologues. Their question is: Do Congressional holidays and the market's movements truly correlate?

As it happens, yes. Choosing the Standard & Poor's 500 Index as his measure, Singer reviewed 40 years of stock data and government calendars. At least one chamber is in session for more than half of the 250-odd trading days of the year. Yet the index made a greater share of its price gains when Congress was in recess -- at least two to three times greater per day.

Singer isn't the only one to find a relationship. Economists Michael Ferguson of the University of Cincinnati and Hugh Douglas Witte of the University of Missouri at Columbia reviewed four indexes: the Dow Jones Industrial Average, the S&P 500, the Center for Research in Security Prices value-weighted index and the CRSP equal-weighted index.

Congressional Effect

For the Dow, the results were dramatic. Since 1897, the year after the Dow was created, an impressive 90 percent of the gains came on days when Congress was out. Their charts show that a dollar invested in 1897 with the strategy of going back to cash every time Congress met was worth $216 by 2000.

But an 1897 dollar invested on the reverse strategy was worth only $2 after a century. The big gap between performances began to show up after World War I, when it became clear that Washington would play a bigger role in the country.

Other indexes also reveal what the scholars call ``the Congressional effect.'' In all indexes but the Dow, daily volatility was lower when Congress wasn't in session. The
popularity of Congress mattered as well. Looking at Harris and Gallup polls, Ferguson and Witte found that market returns were yet lower when unpopular Congresses were in session. The two economists controlled for weather and seasonal behavior. The Congressional effect was still strong.

`Talk Is Not Cheap'

Both Singer and the Ferguson/Witte team suggest uncertainty is causing the difference. Politicians have long noticed that markets don't like regulation. What they sometimes fail to notice is that markets don't like even the prospect of regulation. (Chuck Schumer and Hillary Clinton, this is for you -- New York senators seem to specialize in ignoring market anxiety.)

Market guru Burton Malkiel once wrote: ``It is not so much the direct cost of regulation that has inhibited investment but rather the unpredictability of future regulatory change.'' Or as
Singer puts it, ``talk is not cheap.''

Since Democrats are perceived as more unpredictable when it comes to regulating business, the Congressional effect should be stronger when Democrats control Congress. And Ferguson and Witte found that to be the case. Franklin Roosevelt was one of the most unpredictable of presidents. It therefore comes as no surprise that the 1930s were the most volatile decade for the Dow.

To be sure, there is a certain circularity to all these arguments: Congress may be active because things are bad, rather than causing trouble by its activity. And there are exceptions that don't show the Congressional effect.

``The rule does not work well in a blow-off bubble,'' Singer says. ``It works better in bear markets.''

Clinton Scandals

Even some exceptions fit a variant of his thesis. 1998 was a good year, though Congress was in session. Singer tries to explain it was clear in 1998 that Congress wasn't going to do much. By forcing President Bill Clinton to defend himself in scandals, Republicans effectively prevented both him and themselves from undertaking any major legislative initiative.

How to profit from the effect? To ensure your money is in stocks during all Congressional holidays and all in cash when Congress is in Washington, you'd have to go in or out of the
market 15 or 20 times each year. Singer doesn't say how he's addressing such challenges, or share his results.

Still, the facts are there: If you applied his thesis from the end of 2000 through 2005, and stayed out of the S&P 500 while Congress was working, you earned close to 7 percent a year. If you stayed in the S&P 500 the whole time, the annual total return (including dividends) was less than 1 percent. There may be money in ideology, after all.

You don't have to buy into any political philosophy to find the Congressional effect interesting -- if only as an explanation for why some people stay at their terminals right up to Labor Day. Congressional breaks are short, but to investors, they feel like an endless summer.

Equity Strategists: Top-Ranked Analysts Become the Most-Bearish

2006-05-25T12:54:00.000-07:00

Bloomberg News
Equity Strategists: Top-Ranked Analysts Become the Most-Bearish
2006-05-25 15:16 (New York)
By Daniel Hauck and Brian Sullivan

May 25 (Bloomberg) -- Wall Street's top-ranked equity strategists, Francois Trahan of Bear, Stearns & Co. and Abhijit Chakrabortti of JPMorgan, are also the biggest bears on the U.S. stock market.

Trahan, the No. 1 rated U.S. strategist in last year's survey by Institutional Investor magazine, cut his 2006 forecast for the Standard & Poor's 500 Index by 11 percent to 1200 this week, just above Chakrabortti's 1190 estimate, which is the lowest among 14 strategists polled by Bloomberg News.
``I have been worried about the performance of the equity market for a while now,'' Trahan, 37, said in an interview in New York today. The pullback ``is really about economic growth and economic growth slowing.''

Chakraborrti, who serves as both U.S. and global strategist at JPMorgan, was ranked the best analyst of world markets in the last two Institutional Investor surveys.

If the two are right, the S&P 500 will finish down as much as 4.7 percent this year. A retreat this month from five-year highs has pushed the index on the verge of giving up its 2006 gain as investors grow increasingly concerned inflation is rising, while profit growth is slowing.

Their outlook contrasts with strategists such as Ed Keon of Prudential Equity Group LLC and Abby Joseph Cohen of Goldman Sachs Group Inc., who defended owning equities this week on the premise that profits will continue to rise enough in the face of higher interest rates.

Keon and Cohen each maintained their forecast for the S&P500 to reach 1410 and 1400 respectively this year. The index closed yesterday at 1258.57 more than 10 percent below those estimates.

Growth Will Slow
Profits increased for S&P 500 companies by 14 percent in the first quarter, according to Thomson Financial. That's the 11th consecutive period of growth above 10 percent and the second-longest streak since 1950. Analysts expect companies to extend that streak to a record 14 quarters the rest of the year.

Chakrabortti, 38, said the economy doesn't have the strength to support a record profit expansion and sees earnings growth slowing to ``virtually zero'' by the end of the year.

``We're entering a very difficult period for stocks,'' Chakrabortti said yesterday from New York. ``The economy and earnings are going to lose growth momentum, and at the same time inflation is going to pick up.''

The strategist has been responsible for global equity strategy for JPMorgan, the No. 3 U.S. bank, since 2000 and moved to New York from London in April 2005 to focus more on U.S. stocks.

Bernanke & Inflation
Chakrabortti said he also expects the Fed to raise the benchmark lending rate as high as 6 percent from the current 5 percent, in part because new Fed Chairman Ben S. Bernanke will have to establish his credentials as an inflation fighter.

``This is a Fed that has to be more biased towards fighting inflation rather than a balanced view between growth and inflation,'' Chakrabortti said. ``That is because of the change in stewardship in the Fed.''

A government report lifted stocks today by suggesting to investors that the economy is indeed expanding without sparking too much inflation.

Gross domestic product increased at a 5.3 percent annual rate, faster than the government first estimated, yet slower than the median forecast from economists of 5.8 percent.

The S&P 500 rose 9.87, or 0.8 percent, to 1268.44 as of 2:15 p.m. in New York, its first back-to-back gain in two weeks.

Global Calls
Chakrabortti was too pessimistic in 2005, predicting a second-half decline of about 7 percent. The S&P 500 rose 4.8 percent in that period. His original 2006 S&P 500 forecast was even lower, at 1125. He's the top global strategist because of calls on countries such as Japan. In July, he said Japanese stocks may outperform those in the rest of the world. The Nikkei 225 Stock Average has since climbed 31 percent.

Trahan was too bearish last year as well, lowering his 2005 S&P 500 forecast at midyear to 1150, 7.8 percent below its eventual close. The strategist said investors are too optimistic about an end to the Fed's rate increases.

Previous rallies that followed a Fed stoppage were spurred by a decline in bond yields, according to the strategist. Stocks this time are unlikely to get the same boost with yields historically low, he said. The yield on the 10-year Treasury note is at about 5.08 percent, below the average yield of 6.3 percent the last 20 years.

``People believe that once the Fed is out of the way the market will soar,'' Trahan said. ``Unfortunately, I think we're in for a rough ride here.''

Commentary - Is Brazilian stock market as hot as Gisele Bundchen?

2006-03-30T17:06:00.000-08:00

The Brazilian stock market has been volatile lately, I mean in the past week. The reason is entirely sentiment-driven. A well-regarded finance minister, Antonio Palocci resigned because of bribery scandal. His replacement, Guido Mantega is not considered a credible inflation fighter. Moreover, with the presidential election looming in 6 months, there is fear that the Lula administration will pursue expansionary fiscal policy. Is this a valid reason for investors to worry about? No, not in my view. Let me explain.

Like all emerging markets, the Brazilian market has been hot, indeed very hot. Bovespa is up 13% YTD compared to 12% for MSCI EMEA and 5% for S&P500. The Brazilian ETF, EWZ had similar run (see the chart). For those who have taken the ride, I’d say stay on, you ain’t seen nothing. For those on the sideline, it’s time to jump on the bandwagon. Here is a simple reason.

Brazil has one of the highest interest rates in the world. The benchmark rate, called Selic has come down around 400 basis points from August last year but remains at 16.5%. This rate would have been justifiable had there been inflation but there is none. 12 month inflation is around 4% and the market expects it to remain there for the next 12 months. On the backdrop of this week’s events, President Lula has re-committed himself to fighting inflation . There is no need to doubt his words. Compare the Brazilian experience to it neighboring Argentina where the benchmark rate is 11% and inflation is also 11%. The timing also looks good, EWZ has hit the 50-day moving average (see the chart), a good entry point, I think.

I’d say the Brazilian stock market is not only as good as but better than Gisele Bundchen – it has the future Gisele doesn’t, especially after she broke up with Leonardo DiCaprio.

Important Dates for Brazilian Investors
April 17 - Central bank decision on interest rate.
July 5 - Candidates register for the election.
July 19 - Central bank decision on interest rate.
August 30 - Central bank decision on interest rate.
September 30 - Election for President, Governors and Congressmen.
October 18 - Central bank decision on interest rate.
October 28 - 2nd round of election.
November 29 - Central bank decision on interest rate.