Babcock faces off adversarial investors

Babcock Capital Should Consider Winding Up, Says Pendvest

By Stuart Kelly

Nov. 29 (Bloomberg) -- Babcock & Brown Capital Ltd., a fund managed by Australia's second-largest investment bank, has performed so poorly on the stock exchange it should consider winding up, a U.K hedge fund said.

Pendvest LLP, the fund's second-biggest investor with a 5.2 percent stake, demanded a special meeting to vote on returning half the company to shareholders and consider options including winding up completely, according to a letter sent to Babcock yesterday, a copy of which was obtained by Bloomberg News. Pendvest said Babcock's assets are worth more than its share price.

``Babcock & Brown Capital is an inefficient vehicle where the underlying value of the investments may never be truly reflected in the stock price,'' London-based Pendvest said in the letter. Babcock Capital declined to comment on the allegations and agreed to hold a meeting on the matter.

Babcock capital's shares jumped 7.2 percent to A$4.77 on the Australian Stock Exchange at 10:56 a.m. in Sydney. The Sydney- based fund had advanced 0.5 percent this year as of yesterday's close, lagging behind the 12 percent gain in the S&P/ASX 200 Index. The fund posted a full-year net loss of A$132 million ($117 million) in August after earlier forecasting a profit of as much as A$30 million.

Babcock & Brown Capital said it will call a meeting within 21 days to consider the proposals, according to a statement to the stock exchange. Erica Borgelt, a spokeswoman for Babcock & Brown Capital, declined to comment further on the matter.

Pendvest wants Babcock to return A$425 million, or A$2.13 a share, to investors. The asset manager valued Babcock shares at between A$7.80 and A$10 each.

Irish Investments

Pendvest also said Babcock should consider selling its investments in Eircom Ltd., an Irish telephone business, and Golden Pages, which runs Israel's largest print and internet phone directories.

Babcock, which last year bought 57 percent of Ireland's largest phone company, said in August cutting 900 Eircom employees may cost as much as 175 million euros ($260 million), paring as much as A$165 million from earnings. It initially forecast an impact of as much as A$5 million.

Pendvest also demanded the company address A$122.6 million in fees paid to parent Babcock & Brown Ltd., saying some of the fees should be returned to shareholders. Babcock owns 7 percent of the fund.

Paul Samuelson on the central banks' roles

Balancing market freedoms

Paul Samuelson

(IHT) All through the years of the Great Depression, Wall Street publicists and President Herbert Hoover would repeatedly declare: "Recovery is just around the corner."

They were wrong. And history repeats itself.

Today, Federal Reserve Chairman Ben Bernanke admits that nobody, including him, is able to guess how near to bankruptcy the biggest banks in New York, London, Frankfort and Tokyo might be as a result of the real estate crisis.

As one of the economists who helped create today's newfangled securities, I must plead guilty: These new mechanisms both mask transparency and tempt to rash over-leveraging.

Why should non-economist readers care about these technicalities?

Because the policy tools that served so well for Alan Greenspan's Federal Reserve and for the Bank of England now have to be changed.

It used to be enough for a central bank to "lean against the wind." That means lower interest rates when unemployment is too high and when deflation threatens. And when business growth is too brisk, central banks are supposed to raise their interest rates to dampen growth and to forestall price-level inflation that threatens to exceed 2 percent per year.

Today, central bankers and U.S. Treasury cabinet officers cannot know whether current interest rates are too high or too low. This is surprising, but true. The safest bond interest rates are indeed low. But financial panic engendered by the burst bubble of unsound U.S. and foreign mortgage lending means that even a mammoth corporation like General Electric would find it expensive now to finance a loan needed to build a new and efficient factory.

The situation is not hopeless. New, rational regulations that discourage predatory lending and rash borrowing could help a lot. Also, as we learned during the Great Depression, the government's treasury and its central bank must be both the lenders of last resort and the spenders of last resort. Speculative markets will not stabilize themselves.

The best policy is actually the middle way: not too much freedom for market forces, and definitely not too little freedom.

Global markets have moved into a new epoch. China, India and even Russia and Ireland are currently growing at almost twice the pace of the United States and the core countries of the European Union. Gone are the days when an American president could command ocean tides to come in and go out.

The U.S. population is 5 percent of the global total, yet it enjoys per person about 20 percent of total global output. That's the picture now. Will this last?

When I come to write a newspaper article like this 10 years from now, I believe America may still be leading the pack in per-capita affluence. But in all probability, the China that has already displaced Japan as the economy with the second biggest total gross domestic product will likely have a total GDP equal to America's.

When that happens, a typical Chinese family will still be a lot poorer than a family in the United States or even Ireland. Remember, China's population is several times that of America or any European country. Don't even ask me what the U.S. dollar in 2017 will be worth.

President George W. Bush and Vice President Dick Cheney will have long retired on their respective ranches, but their rash 2000-2007 tax-cut-and-spend policies will by then have harvested the follies that they sowed.

Since we live ever in the short run, global leaders must make their best guesses about what to be doing in 2008. Here are my tentative suggestions:

Watch developments closely. If America's Christmas retail sales fail badly - as they could when high energy prices and high mortgage costs pinch consumers' pocket books - then be prepared to accelerate credit infusions by central banks on the three main continents.

Keep in mind threats of excessive inflation. But be aware that the skies will not fall if the price-level indices blip up from 1.9 to 2.6 percent per annum. What worsens the public's expectations about price instability are excessive spikes in the cost of living.

Finally, to reduce the burden of mass foreclosures of over-expensive mortgages, we should explore new quasi-public agencies, as we did with the Depression-era Reconstruction Finance Corp., that specialize in supplementing for-profit ordinary lenders. This suggests expanding in a controlled way the lending powers of quasi-public agencies such as Fannie May and Freddie Mac. Better that they should lose a bit when they help homeowners of modest means fend off foreclosures on their onerous mortgages.

Maybe such innovations will turn out not to be needed. But keeping in mind worst-case scenarios of the freezing-up of banks and other lending agencies, exploratory planning is worthwhile insurance.

What the world does not need now is tolerance for any persistent weakness in global Main Street growth. It is better when physicians worry too much about a patient's health than when they worry too little.

Richard Bookstaber on derivatives-driven contagion

Blowing up the Lab on Wall Street
Thursday, Aug. 16, 2007
By RICHARD BOOKSTABER

(Time Magazine) Looks like Wall Street's mad scientists have blown up the lab again. The subprime mess that is cutting so wide a swath through financial markets can be traced to the alchemy of creating collateralized debt obligations (CDOs) compounded by the enormous amount of leverage applied by big hedge funds. CDOs are derivatives — synthetic financial instruments derived from another asset.

Here's the recipe for a CDO: you package a bunch of low-rated debt like subprime mortgages and then break the package into pieces, called tranches. Then, you pay to play. Some of the pieces are the first in line to get hit by any defaults, so they offer relatively high yields; others are last to get hit, with correspondingly lower yields. The alchemy begins when rating agencies such as Standard & Poor's and Fitch Ratings wave their magic wand over these top tranches and declare them to be a golden AAA rated. Top shelf. If you want to own AAA debt, CDOs have been about the only place to go; hardly any corporation can muster the credit worthiness to garner an AAA rating anymore. Here's where the potion gets its poison potential. Some individual parts of CDOs are about as base as bonds can be — some are not even investment grade. The assumption has been that even if the toxic waste bonds really stink, the quality tranches can keep the CDO above water. And life goes on.

The problem is that CDOs were untested; there was not much history to suggest CDOs would behave the same way as AAA corporate bonds. After all, the last few stress-free years have not exactly provided much of a testing ground for what can go wrong — until, that is, subprime mortgages started their death march. Suddenly, investors realized things can actually head south in a big way, even stuff completely unrelated to CDOs. Like your stocks.

It's not the first time this has happened, yet Wall Street still isn't getting the message. One August day nine years ago, Russian bonds defaulted. A surprising result of this default was the spectacular failure of Long-Term Capital Management (LTCM), a hedge fund in Greenwich, Conn. Surprising because LTCM had nary a penny in Russian bonds. They nearly took the global financial structure with them.

Today we're seeing another improbable linkage. A number of hedge funds are failing; others are seeing returns plunge. Among these is Goldman Sachs's flagship Global Alpha Fund, which burned a quarter of its $10 billion value over the last few weeks. And just as LTCM was free of the Russian debt that precipitated its collapse, Global Alpha was not a player in subprime junk. Indeed, Global Alpha's problems have not come from mortgages at all, but from a portfolio of stocks.

Why does this happen? Why is a hedge fund like Global Alpha affected by events in markets far removed from its bread-and-butter exposure? The root of the problem is high leverage. For example, when this debacle hit, one of Goldman's funds was leveraged 6 to 1, so every dollar of investor capital claimed six dollars of positions. This is the dry kindling for a market firestorm. When things go bad for a highly leveraged hedge fund, it gets a margin call and has to sell assets to reduce its exposure. Naturally, as it sells, prices drop. The falling prices mean a further decline in the fund's collateral, forcing yet more selling. And so goes the downward cycle. Hedge funds that hold the toxic CDOs can easily undermine those that don't. It can be difficult to sell the stuff that's causing the problem; those markets are beyond redemption. So if you can't sell what you want to sell, you sell what you can sell. The fund looks at its other holdings, focusing on the more liquid positions and reduces its exposure there. This causes pressure on these markets, markets that have nothing to do with the original problem, other than the fact that they happened to be held by the fund that got in trouble. Now that these markets are feeling the heat, other highly leveraged funds with similar exposure will have to sell. This leads to another cycle of selling, but in what was up to that point a healthy market unrelated to the initial turmoil.

As the subprime crisis propagates, it doesn't matter that some instruments are fundamentally strong and others are weak. What matters is who owns what, who is under pressure and what else they own. Hedge funds are constantly shifting their exposure, so it is difficult to predict the course a crisis will take. But if you are a highly leveraged fund precariously perched as these dominos fall — as Goldman's are today and as LTCM was in 1998 — you become part of the game. And if you are both highly leveraged and big, the problem that started in one insignificant little segment will now become your problem, and a much bigger one. Again, it's all about leverage. This is the case for crises in the past and will be the case for crises in the future. A world in which highly leveraged hedge funds share similar strategies makes it inevitable that what we are seeing now will occur again. And the more complex the strategies, the more surprising the linkages that will emerge.

Yet, incredibly, despite the risk this poses, no one keeps watch over leverage. No regulator knows how much leverage the hedge funds have or how that leverage is changing.

The lesson this time around with Global Alpha is the same as it was with LTCM. But we seem to be slow on the uptake. These funds hired the best and the brightest, yet they became embroiled in crises largely of their own making. If it could happen to them, it will happen again. And we'll all share in the consequences. Again.

Japanese stock markets take a toll despite strengthening yen

Japan's Topix Falls 20% From 2007 High, Signaling Bear Market

By Elizabeth Stanton

Nov. 22 (Bloomberg) -- Japan became the first of the world's 10 biggest stock markets to enter a bear market when the Topix index declined 20 percent from its 2007 peak.

The 39-year-old Topix, the broadest gauge of equity prices in the world's second-largest economy, fell 2.1 percent yesterday to 1,438.72, the lowest since October 2005 and down 20.8 percent from its 2007 high of 1,816.97 on Feb. 26.

Japanese companies are struggling with slowing economic growth in the U.S., their largest market for exports, the yen's appreciation and record crude oil prices. The Topix decline from a 15-year high in February signals the government's efforts to revive the economy from more than a decade of inconsistent growth, have hit a snag, investors said.

``Performance potential is limited by a deteriorating economic outlook, both foreign and domestic,'' said Florence Barjou, Paris-based strategist at Lyxor Asset Management, which oversees $100 billion.

The Nikkei-225 Stock Average, created in 1949, is just short of bear market territory. It fell 2.5 percent yesterday to 14,837.66, the lowest since July 2006 and down 18.8 percent from a six-year high of 18,261.98, also on Feb. 26.

The Nikkei is a price-weighted average of 225 Japanese companies including Toyota Motor Corp, Mitsubishi UFJ Financial Group and NTT Docomo Inc. with a median market value of 748.9 billion yen ($6.89 billion). The Topix is a capitalization- weighted index of 1,719 companies with a median market value of 469.8 trillion yen.

Less Than Stellar

The Topix decline ``would be an official bear market so to speak, but Japan hasn't been an area of stellar growth for 10 years,'' said Paul Hickey, managing partner at Bespoke Investment Group LLC in Harrison, New York.

Most stock markets have fallen this month, with the U.S. Standard & Poor's 500 Index down 8.6 percent, on pace for its worst month since September 2002. The declines reflect expectations that investment losses created by the biggest slump in housing since 1991 are curbing growth in the world's largest economy.

The MSCI World Index of developed-country shares is down 7.9 percent from a record on Oct. 31, and the MSCI Emerging Markets Index has fallen 11 percent from its high on Oct. 29.

Toyota, the Japanese company with the largest market value, fell 2.8 percent yesterday to a 16-month low amid concern U.S. sales will slow. Toyota is the second-biggest auto seller in the U.S. behind General Motors Corp.

Rising Yen

The yen has strengthened against all 16 major currencies since mid-year, making Japanese products more expensive in other countries. Against the dollar it has gained 9.8 percent, reaching a more than two-year high of 108.51 per dollar yesterday.

Losses in global credit-markets are fueling the yen's rise by spurring investors to sell higher-yielding assets that were purchased with yen borrowed at low interest rates and sold. The Bank of Japan's overnight call rate, the main rate at which banks lend to one another, is 0.5 percent, the lowest among the major economies.

Record crude oil prices, a problem for all manufacturing economies, are a particular disadvantage in Japan, which imports almost all of the oil it uses. Crude oil futures touched a record $99.29 a barrel in New York Mercantile Exchange trading yesterday, and are up 62 percent in the past year.

The Bank of Japan on Oct. 31 cut its growth estimate for the year ending in March to 1.8 percent from 2.1 percent. Reflecting reduced expectations for economic growth, the yield on 10-year Japanese government bonds yesterday fell to a 23-month low of 1.439 percent.

Investors in Japan's stock market have experienced worse over the past two decades than the drop from this year's peaks. In 1990, the Topix lost almost 40 percent of its value and the Nikkei lost almost 39 percent.

Market bets on lower interest rates on growth concerns

Fed Forecasts Spur Traders to Ignore Warnings on Cuts (Update1)

By Scott Lanman

Nov. 21 (Bloomberg) -- The Federal Reserve's first set of quarterly economic forecasts fueled speculation that it will cut interest rates again, contrary to warnings by policy makers in the past two weeks.

The degree of ``uncertainty'' about the growth outlook is greater than that for inflation, officials said in a supplement to minutes of their October meeting released yesterday. While officials expressed confidence price increases will ease, they viewed markets as ``still fragile and were concerned that an adverse shock'' would worsen economic risks.

The wariness about a continued credit collapse pushed odds of a rate cut next month up to 92 percent, according to federal funds futures, from as low as 70 percent. Investors differ with Chairman Ben S. Bernanke and other officials, who have said this month that the dangers of a slower expansion and faster inflation were ``roughly'' balanced.

``Risks aren't balanced,'' said Michael Feroli, a former Fed board staff member who is now an economist at JPMorgan Chase & Co. in New York. ``Recent developments in financial markets increase the likelihood that they will ease.''

Treasuries climbed today, sending yields on 10-year notes below 4 percent for the first time in two years as investors flocked to the safety of government debt.

As part of its new release on the three-year economic estimates of Fed governors and district-bank presidents, the central bank discussed risks to the outlook. ``Most participants judged that the uncertainty attending'' their growth forecasts ``was above typical levels seen in the past,'' the Fed said.

Growth Forecast

Officials predicted growth will slow to as low as 1.8 percent in 2008, according to the middle range of projections. That would be the weakest since the 2001 recession. The Fed's historical estimates indicate that the actual expansion is likely to be within 1.3 percentage points above or below the estimate.

In June, policy makers anticipated 2.5 percent to 2.75 percent growth next year. Officials left their projection for inflation, excluding food and energy costs, little changed at a 1.7 percent to 1.9 percent pace for the next two years.

``The focus in the minutes is on the downside risks to growth,'' which contrasts with an ``optimistic inflation forecast,'' said Robert Eisenbeis, the former head of research at the Federal Reserve Bank of Atlanta. ``They clearly will respond if needed.''

Rate Cuts

The Federal Open Market Committee lowered its benchmark rate by a quarter point on Oct. 31, to 4.5 percent, after reducing borrowing costs a half point in September.

Since the meeting, banks have warned of billions of dollars of losses on debt tied to subprime mortgages. Stocks have also retreated, while the number of private economists predicting a recession has risen, according to the National Association for Business Economics.

While the ``most likely'' scenario is consumer spending and business investment rise at a ``moderate'' pace, Fed officials recognized a market shock ``could further dent investor confidence and significantly increase the downside risks,'' the minutes said.

Such a disruption could come from ``a sharp deterioration in credit quality or disclosure of unusually large and unanticipated losses,'' the Fed said.

In their speeches and public remarks, policy makers have said they expect growth to accelerate by the middle of 2008 and warned that surging energy and commodity prices, and a falling dollar, may push up inflation.

`Rough Patch'

Economic reports confirming a ``rough patch'' in the economy ``would not, by themselves, suggest to me that the current stance of monetary policy is inappropriate,'' Fed Governor Randall Kroszner said Nov. 16. Further rate cuts may increase the risk inflation will accelerate, he signaled.

Federal Reserve Bank of St. Louis President William Poole said in a Nov. 15 interview with Dow Jones that ``there can only be chaos'' if the Fed follows traders' expectations in setting policy.

``When you think about the effects of monetary policy, you are going to be thinking about several quarters ahead,'' said Douglas Elmendorf, a former assistant director of the Fed's research and statistics division who is now a senior fellow at the Brookings Institution in Washington. ``The FOMC is very focused on maintaining and building their credibility on keeping inflation low.''

Yesterday's forecasts are the product of a 1 1/2-year review commissioned by Bernanke to improve how the Fed communicates its policy objectives. He said in a Nov. 14 speech that the new reports will help show ``how our policy decisions respond to incoming information and will enhance our accountability.''

Less Optimistic

Fed policy makers are less optimistic about the 2008 expansion rate than private economists. The median Fed estimate of about 2.25 percent is less than the 2.4 percent consensus prediction of the Blue Chip survey of forecasters. Four of 17 Fed governors and presidents expect growth of 1.8 percent or less.

Fed officials will have more opportunities to send investors a message before the Dec. 11 meeting. Next week, at least four regional-bank presidents speak, including Philadelphia's Charles Plosser and William Poole of St. Louis. Bernanke speaks Nov. 29 at an event in Charlotte, North Carolina.

``There is a very slow movement toward understanding the severity of financial market problems and the impact on the economy,'' said Kurt Karl, chief U.S. economist at Swiss Reinsurance Co. in New York. ``The question is, what is the Fed waiting for?''

Yen carry trades unwind

Yen Trades Near Two-Year High Versus Dollar on Growth Concerns

By David McIntyre and Kosuke Goto

Nov. 22 (Bloomberg) -- The yen traded near a two-year high against the dollar on concern widening credit-market losses will slow global economic growth, pushing investors to sell higher- yielding assets financed by borrowing in Japan.

The yen was also close to the strongest in about two months against the Australian and New Zealand dollars, favorites of the so-called carry trade, as global stocks fell. The dollar reached an all-time low against the Swiss franc on concern the Federal Reserve will cut interest rates for a third time this year to prevent subprime mortgage losses dragging the U.S. economy into recession.

``There is yen strength to come,'' said Peter Pontikis, treasury strategist at Suncorp-Metway Ltd. in Brisbane, Australia. ``People are unwilling to take carry trade positions. You can't have the subprime sector implode without any consequences.''

The yen traded at 108.41 per dollar at 9:21 a.m. in Tokyo after touching 108.26 yesterday, the strongest since June 2005. The currency was at 161.01 per euro from 161.13 late yesterday, when it reached 160.08. Gains in the yen will accelerate should it rise above 108.20 per dollar today, Pontikis said.

The yen traded at 94.53 per Australian dollar from 94.39 yesterday in New York when it reached 93.72, the strongest since Sept. 11. It was at 81.41 against New Zealand's dollar from 81.50 yesterday when it touched 80.72, the highest since Sept. 18. The Nikkei 225 Stock Average fell 0.7 percent today,

Thanksgiving Holiday

Currency fluctuations may be exaggerated because U.S. stock and bond markets are closed today for the Thanksgiving holiday, said Kazuyuki Takami, a manager of the currency trading department at Bank of Tokyo-Mitsubishi UFJ, a unit of Japan's largest publicly traded bank by assets.

The dollar traded at $1.4855 per euro and 1.1018 against the Swiss franc. The U.S. currency dropped to a record low of $1.4870 per euro yesterday and earlier touched 1.1015 versus the franc.

The dollar has declined 11 percent this year against the euro as the Fed's two rate cuts since September to 4.5 percent reduced the allure of U.S. assets. The U.S. Dollar Index traded on ICE Futures U.S. in New York touched a record low of 74.944 yesterday, the weakest since the gauge started trading in 1973.

Fed Rate Cuts

The odds of the Fed cutting rates a quarter-percentage point to 4.25 percent on Dec. 11 were 90 percent, up from 68 percent a month ago, futures contracts traded on the Chicago Board of Trade show.

Reports yesterday showed the Reuters/University of Michigan's final consumer sentiment index for November fell to 76.1, while the New York-based Conference Board's index of leading U.S. economic indicators slid 0.5 percent in October.

The yield advantage of U.S. two-year Treasuries over similar-maturity Japanese government debt shrank to 2.26 percentage points today, the narrowest since 2004, making U.S. assets less attractive to international investors. The two-year German bund widened its yield advantage over comparable-maturity Treasuries to 65 basis points, the widest since 2004.

Gains in the yen may be limited by speculation importers will take advantage of its gains to buy foreign currencies.

`Good Opportunity'

``This level is a good opportunity for Japanese importers to buy the dollar against the yen,'' said Tokyo-Mitsubishi UFJ's Takami. ``They will take advantage of the yen's rally.''

Japan's currency may fall to 109.50 a dollar today, Takami forecast.

The yen has advanced against all 16 of the most-actively traded currencies this month as investors reduced holdings of carry trades. In that time, Australia's dollar declined 12 percent, New Zealand's currency weakened 8.6 percent while South Africa's rand lost 11 percent.

In carry trades, investors borrow money in low-yielding economies such as Japan and lend the funds in high-yielding countries to profit from the spread. The risk is that currency moves wipe out earnings. When the trade weakens, traders sell high-yielding assets and buy yen to repay borrowings.

Volatility Declines

One-month implied volatility for the yen fell to 14.75 percent today, down from 14.98 percent yesterday. Implied volatility on one-month euro-dollar options also slid to 17 percent from 18 percent yesterday.

The benchmark interest rate in Australia is 6.75 percent while New Zealand's is 8.25 percent. Japan's borrowing cost is 0.5 percent while Switzerland's is 2.75 percent.

``People are worried about a slowdown in global growth and they are running away from risky assets, giving a boost to the yen's strength,'' said Michael Malpede, a senior currency analyst in Chicago at Man Global Research, part of MF Global Ltd., the world's largest broker of exchange-traded futures and options contacts. ``The fear is that we may see a few more shoes drop.''

The cost of borrowing in dollars for three months rose to the highest in four weeks yesterday, said the British Bankers' Association. U.S., European and Asian stocks sank. The Standard & Poor's 500 Index fell 1.6 percent, erasing its gain this year.

The spread, or extra yield, investors demand to own emerging-market dollar bonds instead of Treasuries widened to 2.6 percentage points yesterday, the most since 2005, according to JPMorgan Chase & Co.'s EMBI Plus index.

Will booming emerging markets remain an oasis of growth amidst US recession?

Recession in America
America's vulnerable economy
Nov 15th 2007 From The Economist print edition
Recession in America looks increasingly likely. Can booming emerging markets save the world economy?

IN 1929, days after the stockmarket crash, the Harvard Economic Society reassured its subscribers: “A severe depression is outside the range of probability”. In a survey in March 2001, 95% of American economists said there would not be a recession, even though one had already started. Today, most economists do not forecast a recession in America, but the profession's pitiful forecasting record offers little comfort. Our latest assessment suggests that the United States may well be heading for recession.

Granted, GDP grew by a robust 3.9%, at an annual rate, in the third quarter. Granted also, revisions may well push this figure up. But that was the past. More timely signs suggest that the economy could stall in this quarter. By early next year, output and jobs could be shrinking. The main cause is the imploding housing market. Experts said that house prices could never fall nationwide. But fall they have, by 5% in the past 12 months. Residential investment has collapsed, but a glut of unsold homes means that prices have much further to drop. Americans' spending is likely to be dented much more by a fall in house prices than it was in 2001 by the stockmarket's collapse. With house prices lower and credit conditions tighter as a result of the subprime crisis, households can no longer borrow against capital gains to support their spending.

Dearer oil is set to squeeze households further (this week's drop in crude prices notwithstanding). Consumer confidence has already fallen sharply. It cannot be long before consumer spending stumbles, which in turn would hurt companies' profits and investment. The weak dollar will boost exports, but at only 12% of GDP, exports are too small to make up for a weakening of consumer spending, which accounts for 70%.

I want to break free

Will an American recession drag the rest of the world down with it? The economies of Europe and Japan rebounded strongly in the third quarter, but look likely to slow down. Although both should be able to keep chugging along, neither is likely to set any great pace. Strengthening currencies will hurt exporters in both places. Europe's own housing hotspots are cooling, and some of its banks have been sideswiped by America's subprime ills.

The best hope that global growth can stay strong lies instead with emerging economies. A decade ago, the thought that so much depended on these crisis-prone places would have been terrifying. Yet thanks largely to economic reforms, their annual growth rate has surged to around 7%. This year they will contribute half of the globe's GDP growth, measured at market exchange rates, over three times as much as America. In the past, emerging economies have often needed bailing out by the rich world. This time they could be the rescuers.

Of course, a recession in America would reduce emerging economies' exports, but they are less vulnerable than they used to be. America's importance as an engine of global growth has been exaggerated. Since 2000 its share of world imports has dropped from 19% to 14%. Its vast current-account deficit has started to shrink, meaning that America is no longer pulling along the rest of the world. Yet growth in emerging economies has quickened, partly thanks to demand at home. In the first half of this year the increase in consumer spending (in actual dollar terms) in China and India added more to global GDP growth than that in America.

Most emerging economies are in healthier shape than ever. They are no longer financially dependent on the rest of the world, but have large foreign-exchange reserves—no less than three-quarters of the global total. Though there are some notable exceptions, most of them have small budget deficits (another change from the past), so they can boost spending to offset weaker exports if need be.

This does not mean emerging economies will grow fast enough to make up for the whole of a fall in America's output. Most of them will slow a bit next year: for instance, China's growth rate may dip to “only” 10%. So global growth will ease—which, after five years at an average of almost 5%, close to its fastest pace ever, it needs to do. But thanks to the vigour of the new titans, it will stay above its 30-year average of 3.5%.

A tale of two prices

The rising importance of the world's new giants will not only boost growth. It will also shift relative prices, notably those of oil and the dollar. And the consequences of this will be less comfortable for developed countries, especially America.

The oil price has risen mainly because of strong demand in emerging economies, which have accounted for as much as four-fifths of the total increase in oil consumption in the past five years. In past American recessions the oil price usually fell. This time it is likely to hold up. That will not only hurt the finances of Western consumers, but may also make the jobs of their central bankers harder, by combining inflationary pressure with economic slowdown.

The enfeebled dollar—lately in sight of $1.50 to the euro—would be weaker still without enormous purchases by central banks in emerging economies. This support is now waning. China and others are putting a smaller share of increases in reserves into the American currency. And Asian and Middle Eastern countries with currencies linked to the dollar are facing rising inflation, but falling American interest rates make it harder to tighten their own monetary policy. They may have to let their currencies rise against the sickly greenback, meaning they will need to buy fewer dollars. More important, as international investors wake up to the relative weakening of America's economic power, they will surely question why they hold the bulk of their wealth in dollars. The dollar's decline already amounts to the biggest default in history, having wiped far more off the value of foreigners' assets than any emerging market has ever done.

The vigour of emerging economies is good news for the world economy: for its growth, it has much less need of a strong America. The bad news for America is that this, in turn, may mean that the world also has less need of the dollar.

Hard landing expected

With Recession becoming inevitable the Concensus shifts towards the Hard Landing View. And the Rising Risk of a Systematic Financial Meltdown
Nouriel Roubini | Nov 16, 2007

It is increasingly clear by now that a severe U.S. recession is inevitable in next few months. Those of us who warned for the last 12 months about a combination of a worsening housing recession, a severe credit crunch and financial meltdown, high oil prices and a saving-less and debt-burdened consumers being on the ropes causing an economy-wide recession were repeatedly rebuffed the consensus view about a soft landing given the presumed resilience of the US consumer.

But the evidence is now building that an ugly recession is inevitable. Thus, the repeated statements by Fed officials that they may be done with cutting the Fed Funds rate are both hollow and utterly disingenuous. The Fed Funds rate will be down to 4% by January and below 3% by the end of 2008.

More revealing of the change in mood the financial press and some of the most prominent market analysts are coming to the realization that a recession is highly likely. The Economist has a cover story and long piece arguing that a US recession highly likely (and citing this author's work with Menegatti and our views on the inevitability of such a recession).

More importantly, on Wall Street some of the leading analysts that had been in the soft landing camp for the last year have now moved their forecast in the direction of hard landing. It is not just David Rosenberg of Merrill Lynch who has been informally in the hard landing camp and is now explicitly talking about a consumer recession. It is not just Jan Hatzius of Goldman Sachs who was always more bearish relative to the soft landing consensus and is today explicitly talking about a US recession and a credit crunch reducing lending by $2 trillion.

Even in soft landing houses such as Morgan Stanley and JP Morgan the tone is completely different now. At Morgan Stanley Steve Roach was the in-house bear while Richard Berner (a most sophisticated economist and analyst) was the in-house soft landing optimist. With Roach now gone to run Morgan Stanley Asia, the commentary by Richard Berner has become increasingly darker. And the latest Monday piece by Berner is titled “The Perfect Storm for the US Consumer” where his points on the headwind forces hitting the US consumer are completely overlapping with my analysis of such risks in my recent “The Coming US Consumption Slowdown that Will Trigger an Economy-Wide Hard Landing. Berner starts with

“Serious pressures are mounting on the US consumer on five fronts: Job growth is slowing, surging energy and food quotes are draining purchasing power, adjustable rate mortgages are resetting, lending standards are tightening, and housing wealth will likely decline. Do these dark clouds finally and ominously herald the perfect consumer storm?”

And he concludes with:

“Risks to the consumer are rising, and the risk of outright US recession is higher now than at any time in the past six years: Housing is in sharp decline, consumers are vulnerable, and companies may cut capital spending and liquidate inventories. A strong contribution from global growth is still a huge positive, but spillovers from US weakness to trading partners may hobble that lone source of strength. These pressures could last longer or be more intense than I expect. And even if the economy skirts overall recession, corporate earnings will likely decline.”

An even more persistently bullish bank was JP Morgan that kept on warning for the last year that the biggest risks to the US economy was not a growth slowdown but rather a growth pickup and the risk that inflation would surprise on the upside and force a behind-the-curve Fed to raise the Fed Funds rate above 6%. This analysis obviously proved wrong and now the very smart – but mistaken - Bruce Kasman has had to throw in the towel and accept that the downside risks to grow are sharp and that the Fed will cut the Fed Funds rate to 4%. As he put it in his latest note:

US outlook change: More drag, more ease -- Drags from energy, and credit tightening push GDP forecast to 1% on average for current and upcoming quarter -- Fed is likely to recognize growing downside risk and ease 50bp, to 4% by end of 1Q08 -- December meeting outcome remains close, but we now expect 25bp move from a proactive Fed As the US moves through the fourth quarter, incoming economic news remains consistent with our forecast of a growth “pot hole”. Powerful drags now in place — from tighter credit conditions and an intensified contraction in residential investment — are evident in the decline in output and employment in the goods producing industries and in a slowing in consumption spending…. …three developments over the past month look set to increase downward pressure on growth.

• Oil on the boil. Global crude oil prices rose more than $10 dollars during October, and has held at an elevated level this month. If current levels are maintained, it would represent a drag on annualized household income of approximately one percentage point between now and the end of the first quarter. This drag, which has yet to have been felt, adds to the forces weighing on consumer spending.

• Temporary lifts to fade. Although an upward revision to 3Q07 growth to close to 5% now looks likely, this outcome is partly borrowing from growth in the quarters ahead. Defense spending, which has grown at a 9% annualized pace in the past two quarters, is almost certainly due for a pause. And a significant upward revisions to inventory building in 3Q07, points to an adjustment ahead. Indeed, the latest rise in ISM customer inventory index, combined with auto production schedules pointing to cutbacks through year end, suggests that stockbuilding is likely to subtract from growth this quarter and next.

• Credit tightening broadens. Results of the Fed’s latest Senior Loan Officers Survey indicates that credit conditions are tightening broadly and that demand for credit is slowing. Most recently, credit conditions have tightened significantly for commercial construction projects with CMBS securitizations plunging over the past couple of months. While the quantitative effects of this tightening is hard to measure, credit conditions look set to remain tight for a longer period than anticipated in our current forecast.

Taken together, these developments warrant a downward revision to an already sluggish growth forecast for the coming quarters. The trajectory of GDP growth is being lowered by one half percentage point per quarter through the middle of 2008, with the path of consumption, stockbuilding, and nonresidential construction activity shouldering much of the burden. During this quarter and next, GDP growth is expected to be particularly soft, averaging a meager 1% percent. The underlying resiliency of the US corporate sector will be severely tested through a period in which profits are expected to contract. While we continue to believe that firms are unlikely to retrench in a manner that produces a recession, the risks of a recession remain uncomfortably high. We currently place the risk of a recession taking hold in the coming two quarters at 35%. The Federal Reserve has made it clear that it is willing to act preemptively in the face of elevated recession risks. Having moved 75bp in two meetings, its October statement signalled that it viewed the risks to growth and inflation as balanced — a message that the bar for further easing was high. Against this backdrop, the Fed will need to shift materially its perceptions of risks about the outlook in the direction of our forecast change to produce ease. We now believe such a shift will take place and produce 50bp of additional ease by the end of the 1Q08.

When the most prominent and respected and sophisticated “soft-landing” analysts on Wall Street turn this bearish and start talking about high probability of a recession and downside risks to growth and of a consumer recession you know that these are code words for admitting implicitly – short of an official and explicit endorsement of such view that very few analysts of Wall Street can afford to have because of sell-side research constraints - that they believe that a recession is highly likely.

So at this point the debate is less and less on whether we are going to have a recession that looks inevitable; but it is rather moving towards a debate on how deep, protracted and severe such a recession will be. But the financial and real risks are much more severe than those of a mild recession.

I now see the risk of a severe and worsening liquidity and credit crunch leading to a generalized meltdown of the financial system of a severity and magnitude like we have never observed before. In this extreme scenario whose likelihood is increasing we could see a generalized run on some banks; and runs on a couple of weaker (non-bank) broker dealers that may go bankrupt with severe and systemic ripple effects on a mass of highly leveraged derivative instruments that will lead to a seizure of the derivatives markets (think of LTCM to the power of three); a collapse of the ABCP market and a disorderly collapse of the SIVs and conduits; massive losses on money market funds with a run on both those sponsored by banks and those not sponsored by banks (with the latter at even more severe risk as the recent effective bailout of the formers’ losses by theirs sponsoring banks is not available to those not being backed by banks); ever growing defaults and losses ($500 billion plus) in subprime, near prime and prime mortgages with severe known-on effect on the RMBS and CDOs market; massive losses in consumer credit (auto loans, credit cards); severe problems and losses in commercial real estate and related CMBS; the drying up of liquidity and credit in a variety of asset backed securities putting the entire model of securitization at risk; runs on hedge funds and other financial institutions that do not have access to the Fed’s lender of last resort support; a sharp increase in corporate defaults and credit spreads; and a massive process of re-intermediation into the banking system of activities that were until now altogether securitized.

When a year ago this author warned of the risk of a systemic banking and financial crisis – a combination of global liquidity and solvency/credit problems - like we had not seen in decades, these views were considered as far fetched. They are not that extreme any more today as Goldman Sachs is writing today on the risk o a contraction of credit of the staggering order of $2 trillion dollars in the next few years causing a severe credit crunch and a serious recession. As I will flesh out in a forthcoming note the risks of such a generalized systemic financial meltdown are now rising. Hopefully by now some folks at the New York Fed and at the Fed Board are starting to think about this most dangerous systemic financial crisis that could emerge in the next year and what to do to prepare for it.

JP Morgan bullish on Chinese stocks

Focus on earnings not valuations, says JPMorgan

By Yi Tin Chak | 19 November 2007

The US bank remains bullish on Asian equities for 2008, projecting a fifth straight year of gains for regional markets.

Having correctly projected in September that the Hang Seng Index would reach 29,000 thanks to strong liquidity inflows, JPMorgan is now sticking its neck out suggesting there is still room for Asian equity valuations to rise. The investment bank’s current 2008 year-end target for the HSI is 35,000 points, indicating more than a 20% upside from current levels.

The bank’s other forecasts for next year include a 22,000-point call for the H-share index, indicating a 24% upside; and a 22,500-point target for the Mumbai Sensex index which is 18% above where it is trading at the moment.

Given that the Asia-Pacific ex-Japan indices are up 40% year-to-date and the 12-month forward price-to-earnings multiple of the MSCI Emerging Markets Free index has increased to 14.5 times from 8.2 times in the past five years – leaving it 2.7 standard deviations above the five-year average - one could argue that this is a pretty bold statement.

Most Asian equity markets have also seen very rapid gains since their August lows, which has caused concerns in some camps that a broader correction is due. Indeed, in a 2008 equity outlook report published last week, JPMorgan itself highlights that the risks for emerging markets is shifting from fundamental volatility to valuations.

“No one feels comfortable with the valuations today, because they are back to where they were in the very early-1990s,” remarks Adrian Mowat, chief Asian and emerging markets equity strategist at JPMorgan.

However if you want to keep running as winners, he said at a media briefing last week, “don’t use valuations to trigger a sell. Use concerns about earnings”.

Instead of getting stuck on valuations, Mowat prefers to focus on the issue of why Asia became so expensive in the first place. “Conditions that caused markets to become more expensive also generated more earnings growth. Have these conditions changed? I think the answer is that they haven’t changed and they have got even stronger.”

Accordingly, as the drivers of the re-rating over the past 12 months are still in place, Asian P/E multiples could rise further, he argues.

Global drivers of the re-rating include: a broadening of the investor base, notably through the Qualified Domestic Institutional Investor (QDII) scheme which is allowing Chinese institutional investors to buy overseas stocks; a convergence in risk free rates; and an expanding economic growth premium between emerging markets and the countries within the Organisation for Economic Co-operation and Development (OECD).

At a country level there are also other drivers such as low real interest rates, currency appreciation which discourages capital outflow, reform of the long-term savings industry and the improving historical performance of local equities.

According to Mowat, the average emerging markets company is expected to generate 16% earnings per share growth over the next 12 month, which is still pretty high.

“Our advice is to continue to pay up for growth. It is premium growth that attracts investors to emerging markets. This trend is increasing as local savers increase their exposure to equities,” the report states.

By the same token, companies that are growing at less than 10% may continue to underperform even if they trade at cheaper valuations, and companies that fail to deliver on growth are likely to de-rate quickly.

Mowat remains bullish on China, which is now one of the most expensive markets in the region. Against a forecast that China’s nominal gross domestic product will reach 14.1% next year, the strategist feels comfortable to say Chinese equities could attain an earnings growth of 20%. The ongoing strengthening of the Chinese currency should also help attract investors to Chinese stocks in Hong Kong as their earnings will be worth more when converted into Hong Kong dollars.

“When we look at H-shares and red chips, (many of them) are denominated in Hong Kong dollars. And 5% renminbi appreciation seems reasonable,” he says.

Mowat argues that productivity in China is under-reported. A couple of years ago when the renminbi first started to appreciate, margins came under pressure, which resulted in bottom line growth of the country’s top 5,000 companies generally lagging top line growth. Chinese corporations are of huge scale and traditionally very labour intensive. However, by making use of low borrowing costs to and hiring machines instead of labour, the improved productivity could drive profit growth in excess of nominal GDP growth.

Other forces driving up the H-share market, according to JPMorgan, include the potential for a convergence in valuations of H-shares and redchips on the one hand and A-shares on the other, through the expanding QDII programme. As the Chinese authorities encourage more domestic listings, Mowat notes there is a lack of H-share supply in the market.

Overall, the bank is overweight Hong Kong, Malaysia and Thailand in the region and has upgraded India to neutral. As Taiwan and Korea are more exposed to consumer demand in the OECD countries, which is expected to soften, the bank has downgraded these countries to underweight.

The party is over, says Roach

Roach attacks global inequality

By Dan Slater | 19 November 2007

Morgan Stanley’s Stephen Roach says disproportionate profit allocation could spell the end of globalisation.

As the chairman of Morgan Stanley Asia, Stephen Roach, wrapped up his early morning talk at the Asian Private Equity and Venture Forum in Hong Kong on Friday, he put up a dramatic diagram. The slide showed two lines, one angling sharply upwards, the other angling sharply downwards. The upward sloping line was the share of corporate profits as a share of the national income of the G7 countries. The downward sloping line was the share of employee compensation as a share of national income. According to the graphs, the former accounted for just under 60% and the latter around 10%. The significance of the graph is clear: the benefits of globalisation have accrued in a highly disproportionate manner to “the wealthy and the owners of capital”, as Roach put it.

"That is unsustainable," says Roach, “and provides a challenge to the future of globalisation.” On the topic of globalisation, Roach asserts that Asia has been a major beneficiary – most easily seen through the inexorable rise of exports as a proportion of GDP. But that growth model, based on open markets, could be threatened if social imbalances are not rectified.

“Politicians are not happy with those income figures. They want their voters to get more,” says Roach. Disgruntlement in the countries most affected by globalisation could lead not only to the traditional problem of trade protectionism, but also to financial protectionism. Financial protectionism is a new term referring to the US government not selling its treasury instruments to buyers it considers potentially unfriendly.

Other imbalances could also hurt globalisation. Roach makes the now well-known point that the US consumer binge of the past years was fuelled by rising asset prices being converted into cash by home and stock owners. Incomes have been relatively stagnant. “Consumption accounts for 72% of GDP, the highest levels seen any time in history.”

As the debt that was fuelling the asset bubble unwinds, people's incomes will inevitably be pinched, Roach concludes. “We are seeing the bursting of the world’s biggest bubble – US property," he says. The result is that “the US consumer is toast”, and will be unable to generate further economic momentum.

Roach says that current problems should have been foreseen, and that the dotcom crash of 2001 should have acted as the "canary in the coal mine". Despite only accounting for 6% of US equity market cap, the S&P500 had lost 49% two years later. Roach says that the downturn then was far more serious than anybody initially expected.

“There were similar arguments in August, with some commentators suggesting that since securitised mortgages only represent 14% of outstanding mortgages, there was little to worry about,” he says, predicting that the credit fall out would continue to worsen.

Consequently, Roach also sees a recession in the US next year as being "more likely than not”.

A crash now could be far worse than in the early-2000s, since business capital spent by the dotcoms accounted for 14% of GDP at the time. But the current personal consumption bubble is many times as large, since consumption represents 72% of GDP.

Nor will Asian consumption fill the gap left by the US consumer. “China accounts for around $1 trillion in personal consumption and $650 billion in India. The US accounts for $9.5 trillion of personal consumption.”

The impact on Asia of a US slowdown will be inevitable. “Asia is not an oasis from the US problems,” Roach says, given the steady rise of emerging Asia exports, from an average of 17% to 45% of GDP currently. Contrary to what many analysts say, Roach says consumption in emerging Asia has been trending down, while exports have been trending up. China has an export-to-GDP ratio of 37%, of which 21% goes to the US. Taiwan has a ratio of exports-to-GDP of 59%, of which 14.4% goes to the US. ASEAN has a corresponding figure of 72% of which 13.6% goes to the US. Japan registers a figure of exports-to-GDP of 22%, of which 13% goes to the US.

“Equity capital markets in Asia are frothy, because investors are assuming no impact on Asia. I suspect they are wrong,” he says.

Bond markets tell a different story

Bond Market to Bernanke: Recession Threat Means More Rate Cuts

By Daniel Kruger

Nov. 19 (Bloomberg) -- The headline in the financial futures market these days says Federal Reserve Chairman Ben S. Bernanke is withholding some vital information: The economy is so bad the central bank will have to lower interest rates at least three- quarters of a percentage point to avoid a recession.

Bernanke's two rate cuts since September failed to reassure the bond market, where volatility has risen four of the past five weeks, according to Merrill Lynch & Co.'s MOVE Index. Yields on Treasury bills, the haven for bond investors in times of turmoil, are near their lows of August, when losses on securities backed by subprime mortages froze credit markets.

While the record low dollar and the fastest inflation in 14 months give policy makers reasons to keep the target rate for overnight loans between banks at 4.5 percent, traders expect 3.75 percent early in 2008. Interest-rate futures on the Chicago Board of Trade show the Fed will cut borrowing costs in December and again in the first quarter, as the worst housing slump since 1991 deepens and retailers including J.C. Penney Co. and Macy's Inc. forecast slumping sales.

Investors are sending the message to Bernanke that ``you're wrong and we're going to lead you to the next ease,'' said Thomas Tucci, head of U.S. government bond trading in New York at RBC Capital Markets. The firm is the investment-banking arm of Canada's biggest bank.

Fed fund futures show traders see a 90 percent chance the central bank will reduce its target a quarter-percentage point to 4.25 percent at its Dec. 11 meeting, 67 percent odds of another 25-basis-point cut in January, and a 43 percent likelihood the rate falls to 3.75 percent in March. Policy makers already lowered the target from 5.25 percent in August.

Worse than LTCM

The Fed hasn't cut that much since 2001, when the economy shrank and policy makers lowered rates 11 times. Even when Russia defaulted and Long-Term Capital Management LP collapsed in 1998, policy makers only had to reduce rates 75 basis points.

The yield on the benchmark two-year note, the security most sensitive to rate expectations, fell 8.5 basis points last week to 3.34 percent, according to bond broker Cantor Fitzgerald LP. The price of the 3 5/8 percent Treasury due in October 2009 rose 4/32, or $1.25 per $1,000 face amount, to 100 17/32. The benchmark 10-year note yield declined 5 basis points, or 0.05 percentage point, to 4.17 percent.

Bernanke suggested the central bank is reluctant to lower rates again when he told Congress on Nov. 8 that the economy will likely ``slow noticeably'' this quarter while also citing ``upside risks'' to inflation. Fed Governor Randall Kroszner was more pointed, saying in a New York speech on Nov. 16 that ``the current stance of monetary policy should help the economy get through the rough patch during the next year.''

Stiglitz `Pessimistic'

Financial markets aren't buying it. Wells Fargo & Co. Chief Executive Officer John Stumpf said at a Merrill Lynch conference in New York on Nov. 15 that the housing market slump is the worst since the Great Depression.

Joseph Stiglitz, the Columbia University professor and Nobel-prize winning economist, said there is a 50 percent chance of a recession in the U.S. as a worldwide increase in credit costs following the collapse of the subprime mortgage market chokes off financing. ``I'm very pessimistic,'' Stiglitz said in an interview in London Nov. 16.

Financial companies may lose as much as $400 billion because of home foreclosures, based on a ``back-of-the-envelope'' calculation, Jan Hatzius, chief U.S. economist at Goldman Sachs Group Inc. in New York, wrote in a report last week. That will force banks, brokerages and hedge funds to cut lending by $2 trillion, he estimated.

Bill Yields

Merrill's MOVE index reached 112.08 on Nov. 9, the highest since Sept. 20, and was at 99.14 on Nov. 16. The gap between yields on three-month bills and the Fed's target rate widened to 1.25 percentage points, the biggest gap since Sept. 14. Bill yields fell as low as 3.16 percent on Nov. 15, near this year's low of 3.09 percent on Aug. 20.

For the first time since 2001, yields on Treasuries maturing from three months to 10 years are below the federal funds rate. Five of the past six times that has happened, the economy entered a recession, data compiled by Bloomberg show.

Most analysts don't expect a recession. After annual growth of 3.9 percent from July to September, the economy will cool to a 1.5 percent pace this quarter and expand 2 percent in the first three months of 2008, according to the median estimate of 72 economists surveyed by Bloomberg from Nov. 1 to Nov. 8. The Fed will cut its target to 4.25 percent next quarter and leave it there through 2008, a separate survey shows.

Faster Inflation

Faster inflation is making Bernanke's job tougher. Consumer prices rose at a 3.5 percent annual rate in October, the most in 14 months, the Commerce Department said Nov. 15. Crude oil soared 56 percent this year, reaching a record $98.62 a barrel. The dollar sank to a record low of $1.4752 per euro on Nov. 9 and import prices rose 1.8 percent in October, the most in 17 months, the Labor Department said.

``It seems like there's an awful lot of price pressures,'' said Jamie Jackson, who oversees government debt trading at RiverSource Investments, a Minneapolis firm that manages $100 billion of bonds. ``It's harder to be a credible inflation fighter if you ease into accelerating inflation.''

The Fed is done cutting rates and 10-year yields may reach 4.75 percent next quarter, Jackson said.

Futures traders are betting the slump in housing and losses in credit markets will reduce consumer confidence and trump the threat of inflation, which erodes Treasuries' fixed payments.

`Saving the Economy'

``The Fed will not only need to save the financial markets, in very short order they're going to have to start saving the economy,'' said Tom di Galoma, head of Treasury trading in New York at Jefferies & Co., a brokerage for institutional investors. The 10-year yield will fall below 4 percent by the end of June and two-year yields to 3 percent, he said.

Homebuilding declined 20 percent last quarter, the seventh straight drop, subtracting a percentage point from economic growth, government data show. The National Association of Home Builders/Wells Fargo may say today that its index of builder sentiment fell to 17 this month from an all-time low of 18 in October, according to the median forecast in a Bloomberg News survey. The index averaged 42 last year.

Plano, Texas-based J.C. Penney, the third biggest U.S. department-store company, cut its fourth-quarter profit prediction by as much as a third last week. Macy's, based in Cincinnati, lowered its fourth-quarter sales guidance.

``The Fed tends to be backward looking,'' said Lacy Hunt, chief economist at Austin, Texas-based Hoisington Investment Management Co., which is buying zero-coupon and 30-year Treasuries, the most bullish bets that inflation will cool. ``They're always looking at the way the world was, not the way it will be. Market rates reflect the buying and selling decisions of millions and millions of decision-makers.''

Hunt predicts the Fed may lower its target to 2 percent in the next few years.

Looks like a hedge fund to me

Pacific Overtures
James Grant 11.12.07, 12:00 AM ET

Great Quarter, guys!" I chirped, doing my best impression of a brokerage house analyst on a conference call, "and great 6 months and great trailing 12 months." The recipient of the flowery well wishes--for once, well deserved--was David J. Winters, founder and portfolio manager of the Wintergreen Fund.

Winters and his fund starred on this page a year ago. He was 44, his fund only one. Here was a strange turn of events, I observed: An established, moneymaking mutual fund investor had quit a big money management company, Franklin Mutual Advisers, to roll his own. His own mutual fund, that is. You'd have thought Winters would start a hedge fund.

Certainly he's got the investment record a hotshot from Greenwich, Conn. would envy: up an annualized 22.7% since inception, versus 15.9% for the S&P 500. The secret of his success? Finding terrific companies selling for less than they're worth. Simplicity itself.

Actually Winters could make things as complicated as he chooses. His remit is the world. No restrictions in his charter on where or how to invest. He can buy common stocks or sell them short; he can invest in distressed securities, foreign currencies or restricted securities. Think of your investment, he encouraged his shareholders in the first Wintergreen annual report, as "the antithesis of an index fund." Unhampered and unpigeonholed, he added, the fund can be "agnostic with respect to geography, market capitalization, sector and security type."

Winters is, in most ways, the archetypical "Yes, but" investor. He walks in the way of Graham and Dodd. He does his own thinking. And he's deeply cynical about Wall Street. Yet he's as cheery as a growth-stock investor when the Nasdaq is flying. "We're delighted with the way things have gone," he says, "and we think there are tremendous opportunities out there."

He mentions a long-established and faraway conglomerate, Swire Pacific Ltd. "It's family controlled," Winters relates. "It's essentially a Scottish conglomerate that's Hong Kong-based. We think it trades, give or take, at a 35% discount to net asset value. They've been consistent buyers of their own stock. The NAV grows, give or take, 10% to 15% [a year] over time. And they're really not promotional at all. They make no effort to encourage people to be enthusiastic owners of their stock, which we like."

Swire is Hong Kong-listed, and so is Shun Tak, which owns and develops real estate in Macau, the world's number one gambling destination--that is, not counting the Shanghai stock market. Of course, says Winters, not only are they not making any more real estate in Macau, they're also not reclaiming much. He estimates that Shun Tak, which has interests in hotels, ferry transport and investment securities, is quoted at a 20% discount to its net asset value and "it could be much bigger."

Members of the value-investing tribe generally steer clear of China, seeing that the mainland equities markets are bubbling as if it were 1999 again. Winters understands the argument but likens himself to the conservative merchants who sold jeans and shovels to the prospectors in California during the 1849 gold rush. "A lot of our companies capitalize on what's going on [in China]," he says, "but are undervalued as opposed to trading at 100 times earnings."

Winters admits to lighting up a cigar now and then, though not to chewing, dipping or cigarette-smoking. So it's not because he uses their products that he's built substantial positions for his fund in the makers and marketers of cigarettes: Japan Tobacco, Imperial Tobacco Group , Reynolds American and Altria. Tobacco companies can raise their prices and make the increases stick. How many other businesses can do the same?

A year ago Wintergreen fund held 25% of its assets in cash. Who knows? Winters then reflected. "We're just always waiting for that big, slow pitch in our zone," he said. In the July-August credit fright, says Winters now, he did swing, repeatedly. But the the beaten-down banks, brokers and mortgage lenders did not tempt him (indeed, HSBC, one of Winters' former favorites, got the heave-ho last spring).

His 2006 annual report closed with an expression of worry about excessive corporate leverage and a corresponding expression of hope for "a return of the bankruptcy cycle and opportunities to participate in the resulting restructurings." That time has not yet come, Winters observes today; too much money is chasing too few orphaned bonds. But, he adds cheerfully, better days--or rather, in this context, worse days--surely lie ahead.

Bernanke's new approach

Bernanke's Embrace of Forecasting Ends Greenspan `Decoder' Era

By Craig Torres

Nov. 15 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke's decision to publish more details about the outlook for economic growth and prices represents a break with the legacy of Alan Greenspan and the cryptic phrases he used to signal policy.

``If you haven't thrown out your Greenspan decoder ring by now, you should,'' said Ethan Harris, chief U.S. economist at Lehman Brothers Holdings Inc., a former head of domestic research at the New York Federal Reserve Bank. ``Ben Bernanke is a very straight shooter. He tells it like it is. There are no hidden messages.''

Bernanke said yesterday that Fed officials will add a third year to their forecasts and double the frequency to once a quarter. The reports will give investors and companies more details on why interest rates were adjusted and offer a map for where they are likely to go.

Analysis will shift to how the committee sees the outlook, away from trying to guess where the chairman stands, as was the case during Greenspan's 18 years at the helm, Fed-watchers said.

``He wants the committee to function like a committee,'' said former Fed Vice Chairman Alan Blinder, now a professor at Princeton University in New Jersey. ``He doesn't want to dictate.'' Greenspan declined to comment.

Bernanke's forecasting overhaul brings the Fed closer to international central-bank practices and comes at a time of diverging views between policy makers and investors.

Rate Expectations

Bernanke and other Fed officials have repeatedly underscored their confidence the economy will accelerate by mid- 2008 after a lull this quarter. That hasn't stopped traders from assuming the central bank will cut rates at least once more after lowering borrowing costs in September and October.

Futures markets show a 72 percent probability the Fed will cut the benchmark rate a quarter-point to 4.25 percent Dec. 11.

Bernanke, 53, took office in February 2006 having pushed for increased transparency when he served as a Fed governor. Yesterday's announcement was the product of his 1 1/2-year review of Fed communication, and it fell short of the formal inflation target that Bernanke advocated as an academic.

At the same time Bernanke spoke on the changes, the Federal Open Market Committee released a statement detailing the new practices, illustrating that the decision was made jointly among policy makers.

`Diversity of Views'

Bernanke praised the ``diversity of views'' among the 12 district-bank presidents and seven Fed governors, who discuss rate decisions at FOMC meetings. He said the range of opinions ``serves to limit the risk that a single viewpoint or analytical framework might become unduly dominant,'' a frequent criticism of Greenspan's chairmanship.

The Fed chief also took questions from the press after his remarks yesterday, another break from Greenspan, who avoided public exchanges with reporters.

In his speech, Bernanke framed transparency as critical to the central bank's ``democratic legitimacy'' with the public, Congress and financial markets -- constituents that critics say the Fed hasn't always served in a balanced way.

``If he wants to translate the dynamics of what makes the economy change in a language that ordinary people can understand, I think that is sensational,'' said William Greider, author of the 1987 book Secrets of the Temple, which described the Fed's secretiveness as ``the crucial anomaly at the very core of representative democracy.''

Greenspan Continuity

Bernanke did note continuity with Greenspan's incremental steps. The central bank first began announcing rate changes in 1994 and later issued statements after every meeting. Greenspan also oversaw a speeding up of FOMC meeting minutes releases, to a three-week lag instead of six.

The more-frequent outlooks will bring the Fed in line with the European Central Bank and counterparts in the U.K., Sweden and New Zealand, which publish quarterly projections. The Bank of Japan puts out a twice-yearly report.

Bernanke indicated yesterday was a first, not final, step in his efforts. The Fed still trails other central banks in openness in access to the media, as the Fed chairman doesn't give on-the-record interviews or press conferences.

Bernanke put Vice Chairman Donald Kohn, a former Greenspan adviser who was at odds with the chairman's views on the merits of inflation targeting, in charge of the communications project. The decision insulated the committee from the chairman's direct influence, with San Francisco Fed President Janet Yellen and the Minneapolis Fed's Gary Stern being the other members.

Forecast Dates

Fed officials will release their quarterly forecasts in minutes of FOMC meetings in January, April, June and October. The publications will include commentary on officials' thoughts about the risks to their projections, Bernanke said.

The first new predictions come Nov. 20, offering investors a glimpse of the Fed's most recent reading on the economy three weeks before it meets.

``This is depersonalizing monetary policy,'' said Vincent Reinhart, former director of the Fed's monetary affairs division, who worked with Bernanke on the plan and is now at the American Enterprise Institute in Washington.

``When he talks about the outlook, it is going to be the him talking about the committee's'' forecasts, he said, referring to Bernanke. ``Greenspan's testimony almost never referred to those numbers. It was his outlook.''

GE Exits CP and managed cash fund management

GE Bond Fund Investors Cash Out After Losses From Subprime

By Christopher Condon and Rachel Layne

Nov. 15 (Bloomberg) -- A short-term bond fund run by General Electric Co.'s GE Asset Management returned money to investors at 96 cents on the dollar after losing about $200 million, mostly on mortgage-backed securities.

The GEAM Trust Enhanced Cash Trust, a short-term bond fund with about $5 billion in assets, told non-GE investors on Nov. 8 that they could withdraw their money before losses mounted. Enhanced cash funds usually offer higher yields than money- market funds by investing in riskier assets.

All outside investors, who together held ``several hundreds of millions of dollars'' in the fund, pulled their money, Chris Linehan, a GE Asset Management spokesman in Stamford, Connecticut, said yesterday in an interview. Most of the fund's money before the redemptions came from GE's corporate pension plan and remains invested.

Enhanced cash funds ``never promised to be stable value, though investors may have believed that,'' said Peter Crane, founder of Crane Data LLC, the Westborough, Massachusetts-based publisher of the Money Fund Intelligence Newsletter. There are a number these funds ``under duress,'' he said.

Barron's first reported the GE fund's losses yesterday.

Linehan said the losses were from mortgage-backed securities, including those linked to subprime home loans. He couldn't say how much the fund had invested in mortgage debt. The fund didn't own collateralized debt obligations, which are securities backed by pools of bonds and loans, or commercial paper or notes issued by structured investment vehicles, known as SIVs.

Taking More Risk

The collapse of the subprime-mortgage bond market, caused by rising defaults by home buyers with poor credit histories, has driven down global debt prices as investors flee all but the safest investments.

Some money managers market enhanced cash funds, as well as ultra short-term bond funds, as alternatives to money funds, which are considered the safest investments outside of insured bank accounts and government debt. Money funds are required to hold debt that matures in 13 months or less, with a weighted average maturity of 90 days or less. The securities must have top short-term corporate debt ratings. Money funds strive to maintain a $1 a share net asset value.

Short-term bond funds have more leeway to boost yields by buying lower-rated securities. Some have run into trouble amid the credit squeeze, including the $1.4 billion State Street Limited Duration Bond Fund, which lost more than a third of its value in the first three weeks of August, the Boston Globe reported Aug. 28.

Money Funds

Several money-market funds have recently shown signs of strain from subprime-related holdings. Bank of America Corp., the nation's second-largest bank, said Nov. 13 that it may provide as much as $600 million to funds that bought asset- backed securities. Legg Mason Inc., SEI Investments Co. and SunTrust Banks Inc. also have stepped in to make sure investors don't lose money by arranging financing so their funds don't fall below the $1 a share net asset value, known as ``breaking the buck.''

Funds that channel mortgage debt to other investors, such as SIVs, have also come under stress. Unable to refinance their debt, SIVs including Cheyne Finance Plc have defaulted.

Worried that the turmoil among SIVs will further hurt the commercial paper market, banks have rallied behind U.S. Treasury Secretary Henry Paulson's efforts to put together what's being a called a Super-SIV, to be run by Bank of America, Citigroup Inc. and JPMorgan Chase & Co.

The Super-SIV would buy assets from SIVs in an attempt to prevent a forced sale of the roughly $320 billion in assets held by the 30 entities.

GE Asset Management, a unit of Fairfield, Connecticut-based GE, oversees more than $198 billion for individual and institutional investors, as well as pension funds for its parent company.

End of an era? Investors exiting from hedge funds

Value Partners Investors Raise $374 Million in IPO (Update1)

By Bei Hu

Nov. 14 (Bloomberg) -- Value Partners Group Ltd. priced the first Hong Kong initial public offering of an asset manager at the top end of a range, allowing two investors to raise HK$2.9 billion ($374 million), two people familiar with the sale said.

The Hong Kong-based company, ranked by Alpha magazine as Asia's second-biggest hedge fund manager by the amount of assets it oversees, priced the 381.6 million IPO shares on sale at HK$7.63 apiece, said the people, who declined to be identified before an official statement.

The IPO consists entirely of existing stock on sale from JH Whitney III LP and Value Holdings LLC, two U.S. private equity investors that bought shares of Value Partners before the public offering. The sale of a 23.9 percent stake in the company gives the manager of retail, hedge and buyout funds a market value of $1.6 billion.

Ping An Insurance Group (Group) Co., China's second-largest insurer, paid HK$1.1 billion for a 9 percent stake in the asset manager, according to Bloomberg calculations based on information provided in a share sale document. Value Partners managed $5.7 billion of assets at the end of June, according to the document.

Strong Demand

Investors are buying into a company which expanded assets under management 10-fold in the 14 years since its inception under the leadership of Chairman and Chief Investment Officer Cheah Cheng Hye.

Value Partners has benefited from the growing demand for asset management services as a result of aging populations, growing wealth and stock booms in Hong Kong and China. The fund manager specializes in picking small- to medium-sized companies.

``They have built a nice company which is very profitable at the moment,'' said Sebastiaan de Bont, who manages $2 billion at Fideuram Asset Management in Dublin, which didn't buy the stock yesterday before the pricing. He voiced concern whether Value Partners could repeat its growth last year in a market downturn, because of its reliance on performance fees charged on excess returns.

JPMorgan Chase & Co. and Morgan Stanley arranged the sale.

Teresa Yu, a Hong Kong-based spokeswoman for Value Partners, Marie Cheung, a JPMorgan spokeswoman in Hong Kong, and Nick Footitt, a spokesman for Morgan Stanley in Hong Kong, declined to comment.

Oaktree raised another 4 billion for distressed debt

Oaktree Has $10 Billion to Purchase Distressed Debt (Update1)

By Cathy Chan

Nov. 14 (Bloomberg) -- Oaktree Capital Management LLC, the Los Angeles-based private equity fund with $51 billion in assets, has raised more than $10 billion in the past 12 months to invest in distressed debt, Chairman Howard Marks said.

Oaktree has raised $4 billion for a fund to buy leveraged buyout loans stuck with investment banks in the U.S. and Europe, Marks told reporters in Hong Kong yesterday. Some 40 percent of Oaktree's funds are linked to distressed investments.

``Debt in unsuccessful LBOs will be a major feature of the landscape in coming years and a major part of what we do in our new distressed debt funds,'' Marks said. ``Other people plant the seeds, when it goes bad, we harvest.''

Citigroup Inc., JPMorgan Chase & Co. and other banks have offered discounts of as much as 4 percent in the U.S. and Europe to clear about $300 billion of leveraged-buyout financing they promised before losses on subprime mortgages shut down the market for high-risk debt in July. Rising costs and tighter access to funding may undermine some borrowers' ability to service debt.

Oaktree profited in the early 1990s from buying distressed LBO debt as the U.S. economy was mired in a ``significant credit crunch,'' said Marks.

``You'd feel such a period may lie ahead and we're well- positioned to capitalize on that,'' he said. ``This time around, Europe has fully taken up the LBO mantra and we think there will be lots of opportunities.''

LBO Debt Backlog

Banks are saddled with high-yield loans as the worst U.S. housing slump in 16 years saps demand for all but the safest debt. Underwriters have only shifted 750 million pounds ($1.6 billion) of the 9 billion pounds of loans used to fund Kohlberg Kravis Roberts & Co.'s acquisition of U.K. drugstore chain Alliance Boots, Europe's biggest buyout.

The backlog of unsold leveraged loans is about 75 billion euros ($108 billion), up from 76 billion euros in August, Standard & Poor's analysts Taron Wade and Paul Watters in London wrote in a report published on Oct. 31.

``It's unwise to take actions today on the assumption that the worst is over,'' said Marks. ``In a period like this, you'll put the bar high and we will only make investments today if they have very substantial prospective returns.''

For corporate debt, Marks said he doesn't expect any ``big opportunities'' until the default rate climbs to about 4 percent from less than 1 percent in the last 12 months.

Blackrock and Goldman bets on credit crunch to impact financials

BlackRock's Fink Says Subprime Credit Losses to Rise (Update4)

By Sree Vidya Bhaktavatsalam

Nov. 13 (Bloomberg) -- Laurence Fink, who helped create the market for mortgage-backed securities, said the credit losses that have already cost banks and securities firms $45 billion are about to get worse.

Fink, chief executive officer of New York-based fund manager BlackRock Inc., said today at an investor conference that ``many institutions don't understand what the credit crunch is going to do to earnings and their balance sheet.'' At the same conference, Goldman Sachs Group Inc., CEO Lloyd Blankfein said his firm is continuing to bet that mortgage-backed securities and collateralized debt obligations will fall.

The outlook is another indication that the contagion from losses on mortgages to people with poor credit is continuing to spread. Bank of America Corp. Chief Financial Officer Joe Price said the second-largest U.S. bank may write down $3 billion of subprime-related debt in the fourth quarter.

At the investor conference in New York, sponsored by Merrill Lynch & Co., Blankfein said Goldman, the world's most profitable investment bank, doesn't plan to take any significant writedowns on mortgage-related assets. Goldman shares rose 8.5 percent to $233.04 at 4 p.m. in New York Stock Exchange composite trading, and other financial stocks also climbed.

``We continue to be net short in these markets,'' Blankfein, 53, said in response to a question about the New York-based firm's position.

Financial Shares Rally

Banks and brokerages in the Standard & Poor's 500 Index have rallied 7.6 percent since reaching a two-year low on Nov. 7. Bank of America, based in Charlotte, North Carolina, climbed 5.2 percent today to $46.27. Lehman Brothers Holdings Inc. jumped 9.2 percent to $63.49 after UBS AG analyst Glenn Schorr said the New York-based securities firm's potential CDO losses are ``negligible.''

``I don't know when it's over, but it's not over yet,'' Fink, 55, said. ``The bottom has not been achieved yet.''

The selloff of financial stocks had gained steam after Merrill Lynch announced a record $8.4 billion credit writedown on Oct. 24, which led to the ouster of CEO Stan O'Neal. Deutsche Bank AG yesterday said credit losses may reach $400 billion, while Lehman last week predicted losses would reach $250 billion over the next five years.

At the same time, money managers including Bank of America and Baltimore-based Legg Mason Inc. have collectively set aside almost $500 million to prop up money-market funds that invested in debt issued by structured investment vehicles, known as SIVs.

Money-Fund Trouble

The 10 largest managers of U.S. money funds have about $50 billion in short term debt of SIVs, some issued by vehicles such as Cheyne Finance Plc that defaulted as investors shunned the funds on concerns about losses from securities linked to subprime mortgages, according to reports from the companies.

``You have the SIVs, you have the conduits, you have the money-market funds, you have future losses still in the dealer's balance sheet in the banks,'' Gregory Peters, head of credit strategy at Morgan Stanley said in an interview in New York. ``That's all toppling at once.''

JPMorgan Chase & Co. CEO Jamie Dimon said SIVs, whose assets have dwindled by at least $75 billion since July, will ``go the way of the dinosaur.''

``SIVs don't have a business purpose,'' Dimon, 51, said at the Merrill Lynch conference today.

New York-based JPMorgan joined Citigroup Inc. and Bank of America in forming an $80 billion fund to help revive the market for short-term debt. The banks are pushing to have the fund in place by year-end because SIVs have been unable to get credit as subprime mortgage losses drive investors from all but the safest debt. Their effort has been coordinated by the U.S. Treasury, run by former Goldman CEO Henry Paulson.

BlackRock

BlackRock, the largest U.S. publicly traded asset manager, has been in contact with the Treasury, Fink said. BlackRock will raise ``multibillion dollars'' to invest in distressed securities that are resulting from the ``chaos'' in the market, Fink said. He declined to elaborate.

Fink, who is the most likely candidate to be offered O'Neal's job, said today his firm has had a succession plan in place for at least two years.

``We have taken succession planning very seriously,'' Fink said. ``We have been focusing on it for two or three years; it has been a multi-year process,'' he said, without offering specifics. He did not say whether he has been offered the Merrill Lynch position.

PNC Financial Services Group Inc. CEO James Rohr, who sits on the board of BlackRock, confirmed Fink's earlier comments about succession planning. Rohr said in today's investor conference that he's not familiar with Fink's plans.

``I hope he doesn't leave,'' Rohr said, adding that BlackRock had ``a lot of talent.'' PNC holds 34 percent of BlackRock's stock, according to BlackRock's Web site.

Laurence Fink

Fink, formerly at First Boston Corp., was the youngest-ever managing director there when he got the title at age 29 in 1982. In 1983, while running the fixed-income department, he was one of two bankers to invent a security that repackaged mortgage-backed bonds into new securities with different responses to changes in interest rates, called collateralized mortgage obligations.

The other was Lewis Ranieri, whose tenure overseeing the business at Salomon Brothers is chronicled in Michael Lewis's 1989 book, ``Liar's Poker.''

Fink formed BlackRock as a bond specialist in 1988, with capital from New York-based private-equity firm Blackstone Group LP. Fink led the acquisition of Merrill Lynch's fund unit last year in a $9.4 billion deal. BlackRock's assets have since increased 31 percent to $1.3 trillion.

BlackRock shares rose 3.6 percent to $195.67.

Boar Invade Berlin, Bringing Fences Back to Cold War Barrier

By Leon Mangasarian

Nov. 13 (Bloomberg) -- Clemens von Saldern just erected an electric fence on the site of the Berlin Wall. The organic food distributor isn't rebuilding the Iron Curtain -- he's trying to stop wild boar from tearing up his garden.

Von Saldern, who built a house where the Cold War flashpoint once stood, is battling to hold back an invasion of tusked pigs that are digging up yards and parks throughout Berlin as they root for worms and flower bulbs with their tough, flat snouts.

``One day the builder told me, `That's a big dog you've got back there,''' said von Saldern, 44, who last summer moved with his wife and three children to the house in Potsdam, on the southwest border of Berlin. ``It was a wild boar staking out the garden as if he owned it.''

The animals gained better access to Berlin when the Wall fell in 1989. Now they're thriving thanks to a biogas boom that has fueled planting of the corn they love to eat and global warming, which has boosted survival rates for piglets. Some critics also blame Nazi-era hunting rules for rising numbers of the stiff-furred scavengers.

Berlin now has about 6,000 wild boar, said Thorsten Wiehle, deputy spokesman for the city Forestry Commission.

The population is climbing, as reflected in the number of boar killed by sportsmen. Hunters killed 42,258 last year in Brandenburg state, which surrounds Berlin, up from a low of 9,806 in 1972, according to the state Forestry Agency.

Pigs Attack

Boar have been found sleeping on compost piles in the city's wealthy Dahlem suburb, and are seen during the autumn devouring acorns on the edges of busy roads.

``Several elderly ladies feed the wild pigs so regularly that they've become tame,'' said Christoph Holstein, a Berlin city forester.

At full size, the hogs can be as long as five feet and weigh as much as 300 pounds.

The sharp tusks curling out of the mouths of male boar are two to five inches long and can make the animals more than just a nuisance. Three people were injured in an attack on Sept. 20 in the town of Hannoversch Muenden, the hunting magazine Wild und Hund said in its Nov. 2 issue. Wild boar killed a wolf in eastern Germany, the newspaper Bild reported Aug. 24.

The Berlin Wall, built in 1961 to prevent people in communist East Germany from fleeing to the West, also created a barbed-wire and concrete barrier for pigs. With its collapse, Berlin's 29,000 hectares (71,600 acres) of woods were reconnected to the countryside, giving boar easy access to the whole city.

Corn Explosion

Residents like von Saldern are building stronger fences because boar can push under normal chain-link barriers unless they are anchored to the ground.

The mortality rate among boar, which have few natural predators, is dropping because of milder winters, Holstein said. At the same time, the increased corn crop is providing them with a ready banquet.

``There's too much food,'' said Willi Kuhlmann, 72, a retired forester from Tauer, 60 miles southeast of Berlin, while sitting in his study surrounded by boar tusks and deer antlers. ``The sows now have two litters of piglets a year.''

In Brandenburg, the amount of land planted in corn quadrupled from 1989 to 2006, reaching 509,000 hectares last year, said Jens-Uwe Schade, a spokesman for the state's Ministry for Rural Development and Environment.

Most of the crop supplies Brandenburg's 80 biogas plants, Schade said. In 2004, the federal government passed a law to promote alternative energy, and Brandenburg state has approved construction of 72 more plants.

Nazis' Role

The proliferation of wild boar is also a legacy of the Nazi passion for hunting, said Elisabeth Emmert, federal chairman of the Ecological Hunting Association. The group, based in Roettenbach in central Germany, was set up in 1988 to oppose the policies it says are keeping game populations excessively high.

The 1934 ``Reich Hunting Law'' was sponsored by Hermann Goering, the Nazis' No. 2 man, who also held the title of Reichsjaegermeister, or chief hunter.

Regulations still in effect require that hunters provide game animals with enough food to ensure their survival during exceptionally cold winters. The clause is often abused by hunters who feed the animals too much and too often, Emmert said.

Back in Potsdam, von Saldern often sees boar in the street in front of his house. The fence out back has succeeded in protecting the garden, where a block of steel-reinforced concrete foundation left from the Berlin Wall still sits in one corner.

``I didn't want to rebuild the Wall,'' he said with a grin, while sitting on a half-completed terrace with his dachshund, Pau-Pau. ``Guess I'll just have to keep turning up the voltage of my fence.''

Climate Change Capital's bets on emissions trading

Carbon Traders Create Cheap Credits in China for Sale in Europe

By Stephanie Baker-Said

Nov. 5 (Bloomberg) -- One early October day in London, a financier named James Cameron was poring over a poster-size map of China inside his offices near the River Thames.

Dotting the map were 20 or so sticky labels, similar to small Post-it notes. There were pink ones, blue ones, green ones, yellow ones -- each marking a spot where Cameron's company, Climate Change Capital, is wagering tens of millions of dollars.

Cameron doesn't invest in stocks or bonds. What he invests in is carbon dioxide (CO2), the principal cause of global warming. In return for curbing emissions in, say, China, Cameron can sell the right to pump CO2 into the air in Europe. The going price: about 17 euros ($24) per metric ton.

Since co-founding Climate Change Capital in 2003, Cameron and his business partner, Mark Woodall, have turned their company into a powerhouse in the burgeoning global market in greenhouse gases. Driven by the Kyoto Protocol on global warming, an accord Cameron helped write, this corner of the derivatives arena is growing as never before.

Global warming may present the greatest challenge humans have ever faced. For Cameron, part of a new breed of climate- change capitalists, it also offers something else: a chance to make money. Whether this quest for profit will avert the potentially catastrophic consequences of a warming Earth is, at this point, unknowable. One possible alternative to trading would be to tax emissions, thereby making it costly for companies to keep polluting.

Forerunner: Acid Rain

Al Gore, who won the Nobel Peace Prize on Oct. 12 for his work on climate change, has championed trading as one way to curb emissions of CO2, whose molecular structure traps heat near the Earth's surface. These markets enable power companies, refineries and factories to buy and sell the right to pollute once regulators cap emissions levels. Supporters of trading point to the success of the 12-year-old U.S. market for sulfur dioxide (SO2), a primary cause of acid rain. Since this system began, SO2 emissions from power plants have dropped 41 percent below 1980 levels.

The U.S. has fallen behind Europe in trading CO2 allowances -- ``carbon,'' in trader-speak -- because U.S. President George W. Bush has opted out of the Kyoto Protocol, saying its strict limits on emissions would prove too costly to U.S. companies.

As a result, London rather than New York has become the world capital of carbon finance. As part of the Kyoto accord, the European Union created a single market for CO2 rights on Jan. 1, 2005. Trading has exploded. Last year, the carbon market worldwide grew threefold to $30 billion, according to the World Bank.

$565 Billion Market

Investors have poured about $12 billion into funds devoted to pollution, according to London-based research firm New Carbon Finance. Half of that money is managed from the British capital. In the U.S., where polluters can trade CO2 rights among themselves if they choose, California Governor Arnold Schwarzenegger is pushing to create a market that could one day dwarf Europe's. By 2020, the global carbon market could swell to $565 billion, according to estimates from Oslo-based research firm Point Carbon.

So the great carbon rush is on. In January, Morgan Stanley bought 38 percent of MGM International, a Miami-based company that invests in emissions-reduction projects, as part of a $3 billion push into the carbon market. In June, Credit Suisse Group bought 10 percent of Dublin-based EcoSecurities Group Plc and said it may lend that company 1 billion euros for pollution investments. In August, a unit of London-based hedge fund giant Man Group Plc raised $382 million for a fund specializing in greenhouse gases at Chinese coal plants. And Salt Lake City- based Blue Source LLC, a startup run by two Utah entrepreneurs, has quietly amassed the biggest bank of pollution credits in the U.S.

Expecting `Big Returns'

So much money is pouring into this arena that some investors may not make as much profit as they think, says Martin Whittaker, a director at MissionPoint Capital Partners, a Norwalk, Connecticut-based private equity firm that manages a $335 million growth fund aimed at clean energy and the environment.

``A lot of investors have piled in expecting big returns in a nascent market,'' Whittaker says. ``As in any investment, you get a lot of capital chasing returns and it tends to depress the margins.''

Cameron, 46, and Woodall, 45, run Climate Change Capital out of a glass office tower near the south bank of the Thames, next to the headquarters of London Mayor Ken Livingstone. The company, which has about 120 employees, projects an eco-friendly image. The walls are covered with bamboo and the floors are blanketed with gray carpet made from recycled fabric. The coffee machine is full of fair-trade beans. Tables and worktops are made from recycled plastic yogurt containers. A series of multicolor tiles use English words and Chinese characters to proclaim the company's motto: ``Wealth Worth Having.''

Carbon's Goldman Sachs

Cameron, who is vice chairman, and Woodall, chief executive officer, have big plans for their company. Climate Change Capital is already financing projects that it says will eliminate 70 million metric tons of greenhouse gases. That's roughly equivalent to the amount of CO2 Denmark sends into the sky each year. Cameron and Woodall predict that assets under management will swell to $10 billion within five years. They've pushed Climate Change Capital to manage money, finance clean-air projects and advise on mergers and acquisitions -- in other words, to become a sort of Goldman Sachs of carbon.

In September, the duo flew to New York, where the UN was holding a meeting on global warming, to rub elbows with Gore, former U.S. President Bill Clinton and Hollywood star Brad Pitt. Their latest project is to raise $1 billion for a fund that will invest in low-energy buildings. ``We're just babies,'' Cameron says. ``We've just begun.''

Luring Investors

Climate Change Capital has already lured deep-pocketed investors. In 2005, New York-based Och-Ziff Capital Management LLC, the hedge fund firm founded by former Goldman Sachs Group Inc. trader Daniel Och, bought 20 percent of the company, Woodall says. A unit of Man Group has bought 10 percent. MSM Capital Partners, part of an investment firm started by Priceline.com Inc. co-founder Jesse Fink, also bought in.

MSM recently sold its shares, more than doubling its initial investment, says Whittaker of MissionPoint, which was started by Fink and Mark Schwartz, a former CEO of Soros Fund Management LLC. ``It was a tremendously successful investment,'' Whittaker says, declining to elaborate.

Threat to Crops

The money keeps pouring in. In 2006, Climate Change Capital raised more than 800 million euros for a new carbon investment fund. More than two-thirds of that came from the Dutch pension giants ABP and PGGM, which together manage more than $425 billion. Otto van der Wyck, the founder of BC Partners Ltd., one of Europe's biggest buyout firms, became chairman of Climate Change Capital in 2004 and has helped raise the firm's profile.

For now, Climate Change Capital has the edge in carbon investing, says PGGM money manager Jelle Beenen. ``They represented the first serious strategy in emission rights,'' he says.

There's big money at stake -- for everyone. Nicholas Stern, former chief economist of the World Bank, last year forecast that climate change might cost the global economy $9.6 trillion by 2100. A rise of just 2-3 degrees Celsius in the average world temperature might displace 200 million people, devastate food crops and shave 3 percent off the global economic output, Stern concluded in an October 2006 report prepared for the U.K. Treasury.

Cap-and-Trade

Whatever the scope of the problem, trading in pollution permits may or may not be the solution. So far, trading CO2 rights has done little to curb emissions in Europe, according to Open Europe, a London-based think tank. The group is backed by U.K. executives such as Michael Spencer, CEO of broker-dealer ICAP Plc, and Brian Williamson, former chairman of the London International Financial Futures Exchange, which is now part of Euronext NV.

European emissions rose 0.8 percent from 2005 to '06, according to Open Europe, which has urged the EU to let member countries decide how to reduce emissions on their own.

Europe has adopted a so-called cap-and-trade market similar to the one the U.S. Environmental Protection Agency created in 1995 for SO2. For each year through 2007, EU governments granted about 12,000 factories and power plants the right to emit a total of about 2.2 billion tons of CO2 -- the ``cap'' in cap and trade. The EU also permitted the companies to buy and sell allowances -- the ``trade'' in cap and trade. If companies think they might exceed their annual CO2 allowance, they can buy rights from companies that pollute less. Under the Kyoto accord, the UN has issued similar credits from emission-reduction projects in 49 countries.

Importing Cheap Credits

This dual system enables European corporations to buy indulgences from those in developing countries rather than mend their polluting ways, up to varying limits. It's simply cheaper to reduce emissions in, say, China, than it is in Europe. The EU has allowed European companies to import too many cheap credits, according to the World Wildlife Fund. The result is that some of these companies are doing less than they could to reduce emissions, according to a June WWF report.

``You're sending a signal to companies in Europe that they can carry on investing in high-carbon infrastructure by offsetting reductions,'' says Kirsty Clough, a climate-change policy analyst at the WWF in London. ``That locks us onto a high-carbon path for decades.'' A better approach would be to prevent European companies from using so many credits from developing countries, Clough says.

`Birmingham or Beijing'

Cameron says the system is helping to put China's fast- growing economy on a lower carbon path. ``A ton of carbon is a ton of carbon,'' he says. ``It doesn't matter if you reduce it in Birmingham or Beijing.''

European CO2 trading has enriched big utilities. At recent prices, the allowances that EU governments have granted to companies largely for free for 2008 carried a combined market value of 43.1 billion euros.

For investors such as Climate Change Capital, the potential rewards -- and risks -- have been enormous. The price of 2007 CO2 rights plummeted after traders concluded that the EU had flooded the market with allowances. The plunge prompted the EU to tighten emissions caps from 2008 to '12 and reduce the number of allowances it issues. Carbon investors and traders applaud that decision, and with reason: Fewer credits mean higher prices.

Allowances for 2008 were trading at about 21.65 euros on Oct. 31. Some EU members, including the Czech Republic and Poland, have threatened to sue the European Commission, saying their pollution caps are too stringent.

`A Lost Decade'

The question is, where do prices go from here?

Oslo-based Point Carbon predicts that prices will rise to as much as 30 euros in 2008 and '09 as more utilities start buying allowances in order to comply with Kyoto rules.

Catrinus Jepma, professor of energy and sustainability at the University of Groningen in the Netherlands, says they'll plummet as credits from developing countries deluge the European market. Since 2005, the United Nations Clean Development Mechanism has issued about 85 million Kyoto credits. That number is likely to surge to 2.5 billion by 2012, according to the UN agency.

So far, the European market has been a costly mistake, Jepma says. ``The Kyoto Protocol period is almost a lost decade,'' he says. The idea behind Kyoto credits was to place a high price on polluting. Instead, an oversupply of credits means the price to pollute could stay low, he says.

HFC-23 Gas

Back at Climate Change Capital, Cameron points to a yellow tab affixed to his map of China. The sticker marks chemical maker China Fluoro Technology Co., located in Shandong Province. China Fluoro Technology exemplifies the potential for profit -- and controversy -- in the pollution market. The Chinese company makes refrigerant gases. One byproduct of that process is a potent greenhouse gas called HFC-23. Pound for pound, HFC-23 traps 11,700 times more solar heat in the atmosphere than CO2. Because China doesn't regulate HFC-23 emissions, China Fluoro can belch countless tons of gas into the air with impunity. (The U.S. doesn't regulate HFC-23 emissions, either.)

That's where Climate Change Capital comes in. Cameron and Woodall have helped devise and finance a system that captures the gas and prevents it from swirling into the atmosphere. In return, Climate Change Capital takes a cut of the emissions credits that the UN awards China Fluoro Technology under the Kyoto Protocol.

Factory `Subsidy'

The project will generate 23.5 million tons of carbon- equivalent credits over six years. At current prices, China Fluoro credits are worth as much as 399 million euros. The result is that China Fluoro stands to make more money selling its pollution credits than it does selling its refrigerants. And factories in Europe and Japan can buy the credits from China rather than curbing pollution themselves.

Some investors have steered clear of HFC-23 projects altogether. ``This is supposed to be about clean development,'' says Lionel Fretz, who co-founded Climate Change Capital and now runs London rival Carbon Capital Markets. ``It's not meant to be a subsidy to refrigerant factories in China.''

Cameron says that, over time, the invisible hand of the marketplace will reduce greenhouse gas levels and help head off climate change.

``Right now the market is doing exactly what it should do - -it's going after as many tons as possible at the lowest possible cost and taking them out,'' Cameron says.

Chernobyl Effect

Cameron and Woodall came to the carbon market from different corners. Cameron is the policy brain, Woodall the financial brain. The lanky Cameron, who's half English and half Australian, grew up in Lebanon and Singapore. He studied international law at Cambridge University in the 1980s.

In 1986, he became interested in environmental law after seeing plumes of radioactive smoke billowing across borders from the Chernobyl nuclear accident in Ukraine. That prompted him to help set up the Center for International Environmental Law based in Washington. He used the nonprofit organization to make a name for himself negotiating the Kyoto Protocol on behalf of the Alliance of Small Island States, a 39-nation coalition he helped to build pro bono. He later started the climate change practice at international law firm Baker & McKenzie in London.

Johannesburg Rendezvous

In 2002, Cameron made his first stab at setting up a business to implement Kyoto. He tried to form a sustainable investment group, a coalition of different companies and organizations that would manage funds to invest in the emerging low-carbon economy. He thought he had the European Investment Bank on board to fund his dream. Instead, one of its senior bankers shot down the idea, saying it would be like asking a fish to ride a bicycle.

Cameron didn't give up. At the end of 2002, he bumped into Woodall on the sidelines of the UN's sustainable development summit in Johannesburg. The idea for Climate Change Capital was born.

When he met Cameron, Woodall was a serial entrepreneur who was integrating a technology investment company he founded into Pi Capital, a London private equity firm. Woodall, whose grandfather was the chairman of British Steel during World War II, stumbled onto environmental causes by accident back in the 1980s, when he set up his first company selling products to help factories clean up oil and chemicals. A former British Army officer educated at the elite U.K. boarding school Wellington College, Woodall put his first company into administration when the pound crashed in 1992.

Garden `Hedging'

``I thought hedging was something you did in your garden,'' he says.

After earning a Master of Business Administration from the U.K.'s Cranfield University School of Management, Woodall tried to get a job at a venture capital company. No one would hire him, he says. He decided instead to start what would become Impax Capital Corp., which invested in renewable energy. Woodall exited the business in 2000 when Impax went public. Nowadays, he drives to the office in an electric G-Wiz car, made in India by Reva Electric Car Co., from his home in the south London neighborhood of Stockwell.

From the start, Woodall and Cameron saw opportunity in climate change. They raised 1 million pounds ($2 million) from what Woodall describes as ``friends.'' Cameron remortgaged his house to invest in the venture, and Woodall also dug into his own pockets. They were joined by Gareth Hughes and Anthony White, fellow founding partners who run the firm's corporate development and advisory businesses.

`Terrified' of Failure

``I put my entire life and guts in the business, terrified it was going to go belly up,'' Cameron says.

The pair soon raised more than $100 million for their first carbon fund to invest in rights to emit greenhouse gases. By 2006, Climate Change Capital was readying a fund 10 times that size.

``They've raised the money very swiftly,'' says Nick Wood, head of Man Investments' environmental strategies group in London. ``They've been around the longest in a high-profile sense.''

Cameron says the firm is breaking even. Climate Change Holdings Ltd. reported a loss of 426,100 pounds in the year ended on Aug. 31, 2006, compared with a loss of 1.6 million pounds the previous year, according to the most-recent filings with Companies House.

Focus on China

In September, the firm announced it had raised 200 million euros more for a new private equity fund targeting clean technology, energy efficiency and waste recovery across Europe. Investors included AlpInvest Partners NV, the Dutch private equity firm with 35 billion euros under management, and HSBC Holdings Plc.

The bulk of Climate Change Capital's funds are still invested in China, which last year surpassed the U.S. as the biggest emitter of CO2. The firm has been a big player in the market to check HFC-23 emissions.

HFC-23 projects accounted for almost half the credits issued by the UN Clean Development Mechanism through the end of October. Money flowing from the sale of these credits could be up to 10 times higher than the cost to curb the emissions, according to an August UN report.

It would cost about 100 million euros to install incinerators at the 17 refrigerant producers in the developing world, says Michael Wara, a researcher at Stanford University. Yet, at current prices, the 40 million credits issued for HFC-23 projects are worth about 880 million euros. ``These projects have distorted the market,'' Wara says.

Wind, Biomass

Cameron and Woodall defend their work. China taxes profits from HFC-23 projects at 65 percent and puts the receipts into a special fund to finance clean energy, Woodall says. Besides, without Climate Change Capital, the greenhouse gas at China Fluoro Technology would just end up in the atmosphere.

These days, Climate Change Capital is expanding into wind farms, biomass power plants and other sorts of green projects. The challenge will be to keep on delivering high returns.

``There can be no trade-off,'' Cameron says. ``None of this, `We're terribly nice people trying to save the world; therefore, we can perform averagely.''' Cameron and Woodall say they want to do good. They just want to make sure they do well, too

Nouriel Roubini's comment on securitization

The First Crisis of Financial Globalization and Securitization. And the Coming Generalized Credit Crunch

Nouriel Roubini | Oct 22, 2007

The recent turmoil and volatility in U.S. and global financial markets and the sudden and unexpected liquidity and credit crunch suggest the following question: how did some defaulting sub-prime mortgages in California, Nevada, Arizona, Florida lead to a worldwide financial turmoil as far as Australia, France, Germany and parts of Asia? Or more formally, why did systemic risk increase rather than decrease in recent years?

Blame the turmoil on financial globalization and the related phenomenon of securitization. In the past banks that were originating loans and mortgage were keeping these assets on their books and thus holding the credit risk. Then, when a recession occurred – like the housing bust in the US in the late 1980s – many banks that were into mortgage lending (the Savings & Loans Associations) went belly up; this led to a banking-wide crisis and credit crunch and a US recession in 1990-91.

This systemic risk – a financial shock leading to a severe economic contagion and economic damage – was supposed to be reduced by the new phenomenon of securitization: in the new brave world of financial globalization banks now don’t hold such assets in their books but package them in asset backed securities (mortgage backed securities or MBSs for mortgages) and off-load them to investors in capital markets, at home and worldwide. This new “originate and distribute” model was supposed to reduce systemic risk as risks were taken out of the banking system and partly distributed worldwide to a larger set of investors, thus spreading risks previously concentrated in banks. But this summer’s financial turmoil shows that systemic risk has returned with a vengeance in spite of securitization. So what went wrong and what can be done about it?

First of all, notice that this was not just a subprime problem. The same reckless lending practices we observed in subprime – things such as no down-payments, no verification of incomes and assets, interest rate only mortgages, negative amortization, teaser rates – did occur for more than 50% of all mortgage originations in 2005-2007, including many near prime and prime mortgages.

Why then such reckless lending practices? Because the securitization model of “originate and distribute” meant that banks were not carrying the credit risk – they earned fees in the transaction – and thus did not care about the quality of the lending. There is now a whole chain of financial intermediaries there were earning such fees without bearing the credit risk: the mortgage broker was paid a fee and maximized its income by having a larger volume of mortgages; the originating bank was packaging the mortgages into MBS and getting a fee without bearing the credit risk; the investment banks were then re-packaging these MBS in various tranches of Collateralized Debt Obligations or CDOs (and sometimes into CDOs of CDOs, or CDOs of CDOs of CDOs, i.e. CDOs cubed) and getting a fee; the credit rating agencies had serious conflicts of interest - as were giving their blessing and misrating these MBSs and CDOs with higher ratings than warranted - as they were getting a fee from the managers of such instruments; the regulators were asleep at the wheel as the US regulatory philosophy was a free market laissez-faire fundamentalist ideology. Finally, the final investors who were buying these MBS and CDOs – the alleged guardian of market discipline - were greedy and believed the misleading ratings of the rating agencies. So everyone in this credit house of cards chain was getting a fee and not holding the credit risk; while the final investors were greedy and clueless as it was near to impossible to price these new complex exotic illiquid derivative instruments.

Similar reckless lending practices and dangerous levels of leverage were occurring in the LBO markets where private equity firms were taking over public firms and financing such deals with very high debt ratios; and in the leveraged loan market where banks were providing such financing to the private equity firms; and in the asset backed commercial paper market where banks were using off-balance sheet schemes (Structured Investment Vehicles – or SIVs - and conduits) to borrow very short term to invest in such risky MBS, CDOs and other asset backed securities. So no wonder that when the subprime carnage blew up the near prime and prime mortgage markets got a seizure, the CDO market froze, the LBO and leverage markets had a seizure, the asset backed commercial paper market went into a panic and even the interbank market (the market were banks lend to each other liquidity for short term periods) also froze. Since the size of losses was unknown and no one knew who was holding this toxic waste of securities no one trusted counterparties and wanted to hold on its liquidity at the same time that the roll-off of short term debts was leading to a severe liquidity crunch.

While the immediate manifestation of the market turmoil was a liquidity crunch this was not just a liquidity problem; rather a solvency problem. Solvent institutions can be illiquid if they have liabilities that can roll off (such as bank deposits in a bank run, commercial paper rolling off, redemptions from hedge funds) while their assets are illiquid. But the problem in the US today is not only illiquidity, as it was in 1998 in the case of the near collapse of LTCM; it is rather also a problem of solvency. Indeed, you have hundreds of thousands – possible as many as two million – households who are bankrupt and cannot afford their mortgage and will thus default and go into foreclosure; you have already sixty plus subprime lenders who have gone bankrupt; you have many home builders who are near bankrupt; you have many hedge funds and other highly leveraged institutions who have gone bankrupt; and even in the US corporate sector now default will rise as corporate bond spreads are now sharply higher. So this is not just a liquidity crisis. It is also a solvency crisis that easier monetary policy will not resolve. It will take years to clean up the mess of the busting housing bubble and its financial fallout.

The reasons for the market panic, volatility and turmoil have also to do with what economists refer to as unmeasurable “uncertainty” that leads to risk aversion and that is different from priceable “risk”. When phenomena and risks are known you can assign probabilities to them and price this risk correctly. But in this world of financial globalization and securitization we have unmeasurable uncertainty. Why? For two reasons.

First there is massive uncertainty about the size of the losses. Some say subprime alone will be $50 billion or $100 or $200. Nobody knows how much as it will in part depend on the fall in home prices where some estimate a 10% fall, others 20% of more. Moreover, it is real hard to price losses on exotic instruments that are illiquid (i.e. do not have a market price) and are marked-to-model (i.e. priced on a theoretical model based on faulty ratings rather than being priced-to-market value).

Second, no one knows who is holding this toxic waste of dangerous securities. It is like walking blind in a minefield where you have no idea of where the next mine is. In the last few years – thanks to securitization, private equity, hedge funds, over-the-counter markets rather than trading on official exchanges – financial markets have become more opaque with less transparency. And this opacity means that no one knows who is holding what, there is a lack of trust and confidence, there are doubts about your counterparties and, in situation, of market uncertainty, investors panic and become risk averse. Markets are based on trust but trust requires transparency; but in the brave world of financial globalization there is less transparency.

Add to all this investors’ greed, risk spreads that were too low for too long, search for yield and carry trades, high leverage ratios, and poor risk management and you get an explosive mix: when the repricing of risk finally occurred this summer - as the subprime carnage blew up - investors suddenly panicked and rushed to the exits in a liquidity run and a credit strike in an extensive range of financial markets.

This financial market turmoil also brought to the surface the issue of liquidity risk: this liquidity/rollover risk – as well know in emerging market crisis – occurs when there is a mismatch between the maturity of a financial institution assets and the maturity of its liabilities: liquid liability at risk of roll-off and illiquid assets are a dangerous combination. We saw it in the bank run on Northern Rock in the US, in the risk of redemption of hedge fund assets, in the serious liquidity problems of the SIVs and conduits once the asset backed commercial paper funding these assets started to roll-off.

Indeed the problem of the SIVs and conduits is the most serious manifestation of maturity mismatches and liquidity risk in the most recent market episode. And it is also the most serious manifestation of the banks’ gambling for redemption and moral hazard from the lender of last resort role of central banks.

Citigroup alone accounted for 25% of all SIV assets ($400 billion) given its $100 billion (now down to $80 billion given a partial disposal of assets) in seven SIVs. Such banks played a dangerous game of regulatory arbitrage by creating risky off-balance sheet SIVs, loaded with risky assets and funded with the most short term asset backed CP in order to avoid the Basel capital charges for similar on balance sheet assets. The whole point of bank capital regulation is that banks that get the lender of last resort support of the central banks need to have enough capital to avoid the gamble for redemption games of playing at a casino with the money of depositors. But banks first avoided those capital charges by creating the off-balance sheet SIVs with lower capital charges and then, when the roll-off of the liabilities of such SIVs occurred amply relied on the Fed’s lender of last resort lending – and on explicit Fed bending of strict rules on how much the banks could re-lend to their affiliated and SIVs – to avoid the losses that they would have incurred by their reckless creation of illiquid SIVs. Specifically, the Fed played a major role in this SIV mess by providing regulatory forbearance to Citigroup and other banks by allowing them to breach the rule on how much they could relend to their broker dealer and SIV affiliates of the funds lent by the Fed during the August and September liquidity crunch. Formally, Fed's decide to waive Section 23A of the Federal Reserve Act (Reg W) and allow Bank of America, Citigroup, and JPMorgan Chase, Wachovia to make large loans to their broker dealer units. As Chris Whalen clearly put it:

Section 23A is one of the most important parts of the Federal Reserve Act. It prohibits "covered transactions" with any one affiliate of a Fed member bank in excess of 10% of the bank's capital and surplus, and up to 20% in aggregate for all bank affiliates. The purpose of the section is to protect the capital of the bank, even if that means allowing non-bank units or the parent holding company to be decapitalized or even fail in a "market resolution."…. The Fed's August 20, 2007 letter to BAC [Bank of America] allows the lead bank to extend up to $25 billion in collateralized loans to affiliates, an amount equal to 30% of the bank's regulatory capital. The "securities financing transaction" will effectively allow the securities affiliate of BAC to "serve only as a conduit" for the bank to lend to "unaffiliated third parties." The letter notes at the bottom of Page 3 that any such loans will be eligible for excemption from the automatic stay in the US Bankruptcy Code, a comforting legal distinction that may have little impact on the increasing rancid economics of financing CDOs.

This is moral hazard of the first order: avoid capital regulations via off balance sheet dangerous schemes characterized by serious maturity mismatches, high liquidity risk and gambling for redemption by investing in toxic waste securities; and then get free lender of last resort support when the liquidity roll-off occurs.

Such SIVs share in the first place many features of reckless Enron-style off-balance special purpose vehicles; and the attempt to avoid the losses from the toxic impaired assets held by such SIVs via a super-conduit is bound to fail. As I more extensively discussed in my “Super-conduit or super-bailout shell game?”:

“…it is not clear what will be the quality of the assets of the new super-conduit. If, as allegedly argued, the new super-conduit would avoid the toxic waste of subprime MBS and CDOs, the better acquired assets would have to be purchased at current market value: and, since those market value today of even better assets are below par because of credit risk and liquidity premium, if Citi and other banks were to dispose of the SIVs assets into the super-conduit at current market values, they would still suffer the same losses as in the case of selling now in the secondary markets the same illiquid assets; thus, their objective of avoiding such losses would not be achieved. Also, if only better assets were to be sold to the super-conduit, the SIVs would be left with only the bad assets (the toxic subprime MBS, CDOs, etc.) and thus the roll-off of the commercial paper backing those assets would accelerate rather than be reduced. It is like stripping a bank that has a run from its best assets and keeping only the bad assets on its balance sheet; the run would accelerate. So, this scheme of shedding only the best assets of the SIVs cannot work. And if the assets to be shed were the lousy ones, of course no one would want to fund such super-conduit as this conduit would be made out of only toxic waste radioactive assets…

The right solution would have been to punish the banks that created these dangerous schemes in the first place by forcing them to take the losses on their illiquid and/or impaired asset; or to bring such asset on balance sheet and take the capital charges or liquidity charges required to do that. Forcing the banks to sell the asset and take the losses would have helped to create secondary markets for these illiquid assets; thus, while losses would have occurred this would have reliquified a frozen market. The super-conduit scheme, instead, is a shell game to prevent the losses to be recognized and, as a by product, it will keep the SIVs asset off the market for a long time and thus avoid the losses to be recognized and the secondary market for such assets to be created and made liquid. But the Fed, instead of letting the market mechanism work, first flooded the banks with liquidity to allow them to have enough liquid assets to deal will roll-off of liabilities and then allowed banks – in an arbitrary regulatory forbearance - to relend such funds to their off-balance sheet affiliates. So the banks avoided the capital charges, avoided the liquidity crunch and got a nice bailout in exchange for their reckless behavior. But since the size of the bailout funds is not sufficient to dispose of all the SIVs liabilities that are being rolled off the current super-conduit scheme can work only if the Fed will provide enough liquidity that banks and creditors can put into this new shell game. Otherwise, as discussed above, the scheme does not add up and does not work. And with lots of SIVs debt coming due in November – for the relatively more thinly capitalized Citigroup but also for other U.S. banks – the urgency of creating this super-conduit becomes clear.”

Given the analysis above, it is clear that severe US and liquidity and credit crunch will get worse rather than better and it will lead to a generalized credit crunch that will trigger – together with a worsening housing recession and a US consumer that is now on the ropes – a severe economic recession in the US in 2008. Expect credit market conditions to tighten sharply over the next few months: the collapse of subprime lending has now led to a severe credit crunch in near prime and prime lending; the increase in credit cards and auto loans delinquencies will then spread the credit crunch to consumer debt; commercial real estate that had excesses similar to housing will be hit next; corporate default rates will start rising as higher junk bond yields and a weakening economy will take a toll on corporate earnings and balance sheets; the current deleveraging of the financial system and the reintermediation into the banking system of off-balances sheet SIV and of mortgages, MBS and leveraged loans will exacerbate the credit crunch in the banking system as banks’ capital is limited and banks’ liquidity also in short supply as banks are hoarding all the central banks’ liquidity injection; the subprime mortgage market is now dead; the CDO issuance market is effectively dead; the CLO and LBO markets are near frozen; the SIVs are unraveling and will be completely collapse and be unwound in a disorderly fashion that will lead to a disorderly sale of illiquid and impaired asset as the Super-conduit shell game will flow; and the liquidity crunch will persist in money markets and interbank markets as everyone is worried about counterparty risk and may need liquidity as the crunch will get worse. In due time even equity markets will realize that the Fed and central bank cannot resolve severe credit problems via liquidity injections: the event of last week prove that a slew of lousy economic news (a worsening housing recession, serious renewed credit problems, fall-off in corporate earnings) will take their toll on equity markets. The conditions described above are thus the factors that will trigger a generalized credit crunch and severe financial and real distress in the US and across the globe.

So what will have to be done – policy-wise and regulation-wise - to avoid the pitfalls of financial globalization after the necessary recession will lead to significant financial damage? Should we reverse financial globalization or try to restrict securitization? The genie of financial liberalization is out of the bottle and it will be hard and not even desirable to reverse it as financial innovation has many benefits. But in order to enjoy its benefits and controls its potential negative side effects – including the vulnerability to greater systemic risk - a series of policy reforms need to be adopted.

First, we need more information and transparency about such complex assets and who is holding them. Second, such complex instruments should be traded on exchanges rather than over the counter markets and be standardized so that liquid secondary markets in such instruments are able to grow. Third, we need better supervision and regulation of the financial system, including some regulation of non-regulated opaque or highly-leveraged financial institutions such as hedge funds and even sovereign wealth funds. Fourth, the role of rating agencies in ratings – and even in Basle II banks’ regulation – needs to be rethought and more regulation and competition introduced in this market. Fifth, liquidity risk should be properly assessed in risk management models and both banks and other financial institutions should better price and manage such liquidity risk; most financial crises are triggered by maturity mismatches. Finally, Enron-style schemes of off-balance sheet SIVs and conduits that avoid ex-ante regulation and receive ex-post bailout should be strictly forbidden. These crucial issues should be put on the agenda of the G7 finance ministries – starting with their meeting on October 19^th - to prevent a serious backlash against financial globalization and the risk that financial turmoil will lead to serious economic damage

New rule to apply to banks

Banks Face $100 Billion of Writedowns on Level 3 Rule

By John GloverNov. 7 (Bloomberg)

-- U.S. banks and brokers face as much as $100 billion of writedowns because of Level 3 accounting rules, in addition to the losses caused by the subprime credit slump, according to Royal Bank of Scotland Group Plc. The Financial Accounting Standards Board's rule 157 will make it harder for companies to avoid putting market prices on securities considered hardest to value, known as Level 3 assets, Royal Bank's chief credit strategist Bob Janjuah in London wrote in a note today. The new rule is effective Nov. 15. ``This credit crisis, when all is out, will see $250 billion to $500 billion of losses,'' Janjuah said. ``The heat is on and it is inevitable that more players will have to revalue at least a decent portion'' of assets they currently value using ``mark- to-make believe.''

Wall Street's biggest firms have written down at least $40 billion as prices of mortgage-related assets dwindle because of record foreclosures. Morgan Stanley, the second-biggest U.S. securities firm, has 251 percent of its equity in Level 3 assets, making it the most vulnerable to writedowns, followed by Goldman Sachs Group Inc. at 185 percent, according to Janjuah. Morgan Stanley fell $3.63, or 6.7 percent, to $50.85 at 2:14 p.m. in New York. The New York-based bank is down 24 percent this month. New York-based Goldman Sachs dropped 3.2 percent to $216.08. Morgan Stanley may write down $6 billion of assets, David Trone, an analyst at Fox-Pitt Kelton Cochran Caronia Waller, said yesterday. Merrill is Healthiest Citigroup Inc., which this week said losses from subprime assets may be $11 billion, has 105 percent of its equity in Level 3 assets, Janjuah wrote. The New York-based bank fell 2.51 percent to $34.20, a four-and-a-half year low. Merrill Lynch & Co., which wrote down $8.4 billion of subprime mortgage debt and other debt securities, has Level 3 assets equal to 38 percent of its equity ``and may well come out of all of this in the best health,'' Janjuah said. Merrill lost 4.36 percent at $53.91.

``If you look at the writedowns just at Citi and Merrill already it's about $20 billion, so $100 billion may be on the conservative side globally,'' said Sajiv Vaid, who manages the equivalent of about $10.5 billion of corporate debt at Royal London Asset Management in London, a unit of the U.K.'s biggest customer-owned insurer.

The losses are likely to hurt shareholders more than bondholders because the banks may be forced to sell stock to raise additional capital, Vaid said. `Unobservable' Inputs Banks may be forced to write down as much as $64 billion on collateralized debt obligations of securities backed by subprime assets, from about $15 billion so far, Citigroup analysts led by Matt King in London wrote in a report e-mailed today. The data excludes Citigroup's own projected writedowns.

Under FASB terminology, Level 1 means mark-to-market, where an asset's worth is based on a real price. Level 2 is mark-to- model, an estimate based on observable inputs and used when there aren't any quoted prices available. Level 3 values are based on ``unobservable'' inputs reflecting companies' ``own assumptions'' about the way assets would be priced. ABX indexes, which investors use to track the subprime-bond market, are showing ``observable levels'' that would wipe out institutions' capital if the benchmark's prices were used to value their Level 3 assets, according to Janjuah.

The indexes have tumbled this year because investors expected rising numbers of borrowers to default on home loans, cutting the cash flowing to the bonds that package the mortgages. Lehman Brothers Holdings Inc. has the equivalent of 159 percent of its equity in Level 3 assets, and Bear Stearns Cos. has 154 percent, according to Janjuah's note, called ``Bob's World: Feast and Famine.''

Why people are miserable at work

Reasons for being miserable at work

By Lucy Kellaway

Published: November 11 2007 14:53 | Last updated: November 11 2007 14:53

(FT) Every unhappy family is unhappy in a different way. Every unhappy worker is unhappy in much the same way.

The first is a dubious generalisation made by the greatest of novelists, Leo Tolstoy. The second is a slightly less dubious one made by a novelist who isn’t great at all. Indeed Patrick Lencioni is a management consultant who has just written a business parable, The Three Signs of a Miserable Job, which, though of no literary merit, is outselling Anna Karenina on Amazon by about 100 to one.

According to this book, we are miserable at work for three reasons. The first is anonymity – we feel no one cares that we are there. The second is immeasurability – we don’t know if we are doing a good job or not, and the third is irrelevance – we feel that our work doesn’t matter much one way or another.

Mr Lencioni argues that all three causes are on the rampage and that we are in the middle of a “misery epidemic” in which three-quarters of all workers hate their jobs. All is not lost, however. Misery, he says, is largely the fault of line managers, and if only they could remember what it felt like to be miserable as a worker they could fix it.

For a start, I don’t accept that we are facing misery on this scale. As a business agony aunt I actively go out touting for misery and so the people who come to me are a skewed sample. But even of these only about half seem genuinely miserable at work.

Even if he were right about the extent of the misery he isn’t quite right about the causes. Last week I had supper with an old friend of mine and we spent a nice hour or two discussing misery. He has done all sorts of jobs and has been miserable in quite a few. I have also had various spells at work where I have felt less happy than Pollyanna, say. We both agreed that our own agony levels peaked long before we ever set foot in an office.

For pure misery, being a first-year undergraduate takes some beating. All three of Mr Lencioni’s conditions were writ large in Oxford in 1978. We were miserable because we were anonymous – nobody cared where we were. We were miserable because we had no way of knowing if we were doing well: we read out our essays to bored dons who would yawn while fellow students fidgeted. And we were miserable because, freed from the compulsion of school, we looked for purpose in our studies and found none. (I think I was also miserable because I had split up with my boyfriend but that was another matter.)

But then we grew up. We no longer really expected meaning and measurement, or at least made do with them in very small doses. We found, when we got our first office jobs, that they had a lot to be said for them. For a start you get paid. This is not only nice in itself, but it does give work a purpose, and one not to be sneezed at.

To search for a deeper meaning beyond this is a dangerous thing. The harder one looks for meaning at work the less likely one is to find it. Is there meaning in writing columns? No, of course there isn’t. But if people quite like reading them and I quite like writing them, that seems reason enough to do it.

As for anonymity, the simple fact of getting paid shows that someone does care you are there. If they didn’t, they wouldn’t pay you to show up. And, as for not knowing how you are doing, this isn’t a problem in most offices. Thanks to endless assessments people are told how they are doing rather too often if anything.

Instead I think the three things that make workers miserable are rather more basic. They are the work, the people and the general environment. The work can be misery-inducing by being too much or too little, too boring, too difficult or too easy.

The people can be wrong in an assortment of ways: lazy, spiteful, bullying or just dull and too depressed themselves to spread much cheer. The environment can be stultifying, unhealthy, too political and so on.

Mr Lencioni reckons one reason managers are bad at making their workers feel better is that they have forgotten what it felt like to be starting out.

I think there is a better reason. Management is one of the most intrinsically miserable jobs there is. Managers find it hard to make the lives of their underlings any better because they are too miserable themselves.

Management is all about getting people to do things that they don’t want to do. So it is difficult, if not well nigh impossible. It is about coming in early and leaving late. The work of a manager is never done. It is one thing after another and another. Being a manager means not minding about being disliked. It means being lonely and having no one inside the company to moan to.

Only on the broadest thesis is Mr Lencioni right: the answer to misery may well be better management. Stated thus it is pretty obvious. The hard bit is how to make managers better at managing. If I knew the answer to that I wouldn’t be writing columns like this. I would be out there with my sleeves rolled up making the world happy for office workers.

3i NAV advances

3i Net Asset Value Advances 27% Amid Credit Turmoil (Update5)

By Edward Evans

Nov. 8 (Bloomberg) -- 3i Group Plc, Europe's biggest publicly traded private equity firm, said the net value of its assets rose 27 percent in its fiscal first half even as rising borrowing costs crimped the pace of leveraged buyouts.

Net asset value rose to 1,007 pence a share in the six months to Sept. 30 from 792 pence in the year-earlier period, Chief Executive Officer Philip Yea said on a conference call with reporters today. That beat the 981 pence average forecast of three analysts surveyed by Bloomberg News.

Yea is boosting infrastructure and growth-capital investments to increase returns while allocating less to buyouts as banks struggle to clear, or syndicate, a backlog of leveraged loans. After a record $579 billion of takeovers in the first half, the pace of buyouts has slumped by almost 50 percent, according to data compiled by Bloomberg.

``In terms of summer's dislocation in the leveraged finance markets, the effect on mid-market hasn't been as pronounced as at the large end,'' Yea, 52, said today. ``We weren't as reliant on big underwritten syndications as the top of the market.''

3i reaped 1.04 billion pounds ($2.2 billion) from selling investments including Aibel Ltd., a Norwegian offshore oil and gas service provider, and Care Principals, a chain of British nursing homes it sold to a Qatari fund for 270 million pounds in July. That rate of realizations may now slow, the company said.

Less Debt

The firm spent 1.23 million pounds on new investments in the first half including stakes in Deutz Power Systems, Eltel and Bestinvest, a British investment adviser. That's more than double the 598 million pounds 3i spent in the same period last year. The firm spent more on so-called growth capital investments than buyouts.

The effect of rising U.S. subprime-mortgage defaults on consumer and business confidence is ``yet to be fully played out,'' Yea added. The firm is also using less debt to fund its buyouts.

``Some of the wonderful terms we saw in the first half of last year, like covenant-lite loans, toggles, they're gone,'' 3i's buyout chief Jonathan Russell told analysts on conference call. ``They were lovely at the time. We've returned to a state of reality.''

3i shares were unchanged at 1,016 pence in London, valuing the company at 3.9 billion pounds. The stock has dropped 17 percent since touching a high of 1,236 pence in May as buyouts slowed.

Analyst Ratings

Of the six analysts who rated 3i shares this year, five recommend investors ``buy'' the stock and one advises them to ``hold'' it, according to data compiled by Bloomberg.

3i raised 700 million pounds in a March initial public offering of a fund that targets infrastructure investments. By August, the fund had invested half that money in projects such as oil and chemical storage facilities. 3i is preparing to raise $1 billion for a fund for infrastructure in India.

Growth-capital investments are typically minority investments in companies worth up to 1 billion euros ($1.5 billion). 3i typically invests cash to fund takeovers or boost growth by expanding overseas.

Started after World War II by Prime Minister Clement Attlee to invest in small businesses, 3i looks for undervalued or out- of-favor companies or start-ups that promise rapid growth. The company raised a 5 billion-euro buyout fund last year.

Microcap listings in Singapore

Stamford Law Corporation
Singapore: SGX Revamps SESDAQ Alternative Investment Market (AIM) equivalent listings in Singapore
30 October 2007
Article by Suet Fern Lee

On 23 May 2007, the Singapore Exchange (the “SGX”) released a public consultation paper on changes to its listing rules and its two boards. The proposal is to transform SESDAQ into a sponsor-supervised regime, introducing a model similar to London’s Alternative Investment Market, which has met with significant success. This change is aimed at promoting investor confidence and attracting smaller and fast-growing companies, local as well as foreign, to list on the SGX. Besides the proposed changes to SESDAQ, the SGX will also revise the entry criteria to the Main Board which will focus on the larger and more established companies, creating a clear delineation between the two boards. This is emphasized by a market capitalization limit of S$150 million at the point of the initial public offering (“IPO”) of the listing applicants for the new board.

Under the new board, there is neither a requirement for an operational track record nor any financial entry criteria for all listing aspirants. They will instead be supervised by independent sponsors which will be corporate finance firms or investment banks. These sponsors will decide on the suitability of the company for listing and will review the entire admission and IPO process. Market quality will be maintained by the SGX’s direct regulation over the sponsors via stringent admission and on-going obligatory rules. The additional requirement of continual sponsorship post-listing will help ensure that the companies have guidance in their early years and maintain minimum standards throughout listing.

Another significant change for the new board is that listing aspirants will no longer have to issue a prospectus. Instead, the companies will have to produce an Offer Document, which, as proposed by the SGX, will not have to be registered with the Monetary Authority of Singapore (the “MAS”). In a mirror of the lodgement process for prospectuses with the MAS, the Offer Document will be publicly posted on the SGX website two weeks prior to the listing, for public comment. The disclosure requirements for an Offer Document are proposed to be that of the same as that currently applicable, and the contemplation is for prospectus liability under current securities laws to apply to the Offer Document. The expectation is that this would shorten the listing process and facilitate new IPOs for the new board. It is also believed that handing the admission and IPO process over to sponsors will reduce costs for the IPO aspirant and also minimize the risk of an IPO being aborted.

For existing SESDAQ companies, there will be a transition period of at least two years for them to appoint sponsors and comply with the new rules. The SGX also intends to waive listing fees for three years commencing from the adoption of the new rules by existing SESDAQ companies as an added incentive.

We believe that the new changes signify a bold new direction for the old SESDAQ. We are greatly excited about the potential of this new board and will be looking to actively participate in the development of this new market. The consultation paper is available on www.sgx.com from 23 May 2007 to 20 June 2007.

Change in tax structures for Indian SPVs

India: Venture Capital Funds: End Of An Era
08 November 2007
Article by Sakate Khaitan and Radhika Iyer

The Indian real estate sector has attracted investments from numerous quarters, including offshore jurisdictions. Offshore funds have led the pack of investors by utilising tax efficient structures spanning across jurisdictions. However, as a result of certain changes introduced in the Budget 2007, investors have been compelled to revisit their strategies related to structuring of investments in Indian realty sector. This article examines the impact of these fiscal changes in the long term structural strategy of funds.

Structure
Offshore funds used Indian venture capital funds ("VCF") as their India-based conduits to channel investments into Indian companies engaged in the business of real estate during the last two years. The choice of VCFs as entities for structuring the Indian end of investments was tax-efficient because of the benefit of a "pass-through" status available to VCFs under the Indian tax laws pre 2007. (Indian VCFs, whether existing or newly organized, who wish to avail of the tax benefits available to venture capital funds under the Indian Income Tax Act, must register with the SEBI under the VCF Regulations and comply with the SEBI Venture Capital Fund (Regulations), 1996. )

VCUs were earlier not allowed to invest in real estate sector. Real estate featured in the negative list where VCU were disallowed from making investments. However, in April 2004, amendments were introduced in the SEBI Venture Capital Fund Regulations 1996, which took off the Real Estate from the negative list, thereby allowing the VCUs to make investments into the real estate sector. The pass through benefits were already available to these VCFs. Hence, the offshore funds lapped up the opportunity and began utilizing VCFs as the preferred vehicle for making investments in real estate.

An illustration of a typical offshore fund piggybacking an Indian VCF is as follows:

Investors pool funds together to form a Special Purpose investment vehicle ("SPV") based in an appropriate treaty jurisdiction like Mauritius or Cyprus. The SPV then seeks registration as a Foreign Venture Capital Investor ("FVCI") with the Securities and Exchange Board of India ("SEBI"). Once the SPV is registered as a FVCI the SPV then invests into a SEBI registered Indian VCF, which in turn invests into a Venture Capital Undertaking (VCU) i.e. an Indian operating company engaged in the real estate sector.

The main advantages of this structure was as follows:

The FVCI did not need to meet the minimum capitalisation requirements as prescribed for investments into a non-banking financial company (a VCF is classified as such under existing regulations).

Ease of exit due to non-application of pricing guidelines for sale to resident Indians and lower lock-in requirements if the VCU is seeking listing for FVCIs.

The Indian VCF being a domestic entity had no restrictions in investing into the Indian real estate sector.

Beneficial tax treatment pre 2007 budget.
Though the above structure was for sometime typical in nature it will be necessary to clarify that presently FVCI registrations in India are not easily accorded to real estate focused FVCIs, due to the divergent views taken by SEBI and RBI. According to the RBI, FVCI investments should not be permitted in the real estate sector. Consequently, though the FVCI regulations do not prohibit investments in the real estate sector, the RBI has been slow to approve applications of real estate focused SPV’s for FVCI status. Under such circumstances, in the event the Fund seeks to register itself as FVCI, it is likely that the Fund may not receive FVCI registration until the aforesaid issue is resolved. Further, there is also some debate as to whether or not a simple FVCI structure is tax efficient and can claim all treaty benefits.

Tax treatment of structure:

Pre 2007 budget
As per the provisions of section 115U of the Income Tax Act 1961 ("ITA"), a VCF qualifying for exemption under section 10(23FB) of ITA is not required to withhold any tax in India on the income distributed by it to its investors. Any income distributed by such VCF is chargeable to tax in the hands of the investors in the same manner as if it were the income of the investors, had they made such investments directly in the Indian operating company and for this purpose income received by the investor is deemed to be of the same nature and in the same proportion as it is in the hands of the VCF.

A VCF is typically expected to earn income by way of dividend, interest or capital gains. Tax implications prior to the change in tax code in 2007 was as follows:

Dividend was exempt from tax where the Indian operating company had paid Dividend Distribution Tax ("DDT") on such dividend.
Interest on loan, being a rupee denominated loan, was taxed at the rate of 41.82% while Interest income in respect of borrowings in foreign currency was taxed at the rate of 20.91% (assuming treaty does not provide for lower rate e.g. Mauritius treaty).

Capital gains was exempt from tax as the SPV was usually based in a jurisdiction where treaty benefits is available and care was taken that the gain did not form part of the Permanent Establishment (PE) of the SPV in India.

However, this preferred structure took a hit because of the certain provisions being introduced into the ITA by the Budget of 2007.

Post 2007 budget
As stated above Section 10(23FB) of the ITA exempted any income of a registered VCF from income tax. This tax exemption under section 10(23FB) when read in conjunction with section 115U of the ITA, established the pass-through status of VCFs registered with SEBI. Accordingly, pre-2007 Investors in VCF’s were liable to tax in respect of the income received by them from the VCF in the same manner as it would have been, had the investors invested directly in the VCU.

Thus, under section 115U income from VCFs was taxed in the hands of the investors at the time receipt of distributions from the VCF. However, if the FVCI was based in a territory through which the investor could seek treaty relief, the gains from investments could have been sheltered resulting in an effective tax rate of 0% on capital gains.

In 2007 the Government moved to close this loophole and thorough the Finance Act of 2007 restricted the pass-through status of VCFs to investments in certain specified sectors, namely: biotechnology; information technology relating to software and hardware development; nanotechnology; seed research and development; research and development of new chemical entities in the pharmaceuticals sector; dairy; production of bio-fuels, and hotel-cum-convention centres.

Accordingly, since real estate business is now not a specified business qualifying for tax pass through status, income from investments by the VCF in Indian portfolio companies engaged in real estate business are now taxable as below:

If the VCF is regarded as a determinate trust, its income shall be taxable in the hands of the trustees of the VCF as per section 161 of the ITA and the tax shall be levied upon and recovered from the Trustees in the like manner and to the same extent, as it would be leviable upon and recoverable from the investors (beneficiaries) in the SPV. For this purpose, treaty benefits available to SPV may have to be taken into consideration for computing tax liability of the VCF.

Accordingly, the tax consequences on the income of the VCF proportionate to the share of the SPV in such income would be (on account of the application of the Treaty, read with the provisions of the ITA) as follows:

capital gains resulting from the sale of Indian securities (listed or unlisted) issued by the VCU will not be subject to tax in India;
dividends on shares received from the Indian Portfolio Companies on which dividend distribution tax has been paid will be exempt from tax;

interest income from Indian securities in respect of borrowings in Indian rupees will be taxed at the rate of 42.23% where income of the SPV is more than Rs. 10 million and at 41.2% where income is up to Rs. 10 million (assuming treaty does not provide for lower rate e.g. Mauritius treaty).

If however, treaty benefits are not available, the income of the VCF proportionate to the share of the SPV in such income would be as follows:

Gains earned on the transfer of shares and other listed securities held for a period of 12 months or less are termed as short-term capital gains. The taxation of both long term and short term capital gains under the ITA would be as follows:

Long-term capital gains arising on transfer of listed equity shares on a recognised stock exchange in India will usually be exempt from tax in India;

Short-term capital gains arising on transfer of listed equity shares on a recognised stock exchange in India is taxed at the rate of 10.558% where income of SPV is more than Rs.10 million and 10.3% where income is up to Rs. 10 million.

Short term capital gains arising on a sale of listed equity shares not executed in a recognised stock exchange in India and other Indian listed securities is taxed at the rate of 42.23% where income of the SPV is more than Rs. 10 million and at 41.2% where income is up to Rs. 10 million. In respect of long term capital gains, while the benefit of the indexed cost of acquisition will not be available for computing such gains, it could be contended that such gains will be taxable at the rate of 10.558% or 10.3% as the case may be and not at the rate of 21.115% or 20.6%.

Capital gains arising on sale of unlisted Indian securities is taxed at the rate of 21.115% or 20.6% for long-term gains and at the rate of 42.23% or 41.2% in case of short-term gains.

However, if the VCF is regarded as a discretionary trust or to be carrying on business then the entire income of the VCF would be taxed at the maximum marginal rate i.e. at the rate of 33.99%, and such distribution on which tax has already been paid by the trustees would not be subject to tax in the hands of the SPV.

Impact of change
The change in tax laws has made the typical structure mentioned above inefficient due to the following reasons:

Treaty benefits may be lost because of non-availability of pass through status to the income of VCF.

Effective increase in hurdle rates as distribution from VCF’s are now post tax rather than pre-tax, thereby reducing fund managers carry.
Impact of tax being brought forward as tax is now chargeable in the VCF’s hand rather than in investors’ hand on distribution. This also makes the reinvestment provisions, if any, in placement memorandums in most respects redundant.

Conclusion
Given the above the added administration and transaction costs of a VCF cannot now be justified making the use of VCF’s inefficient. Accordingly, we now see most funds avoiding the VCF route and making investments into the real estate sector directly in compliance with existing foreign direct investment regulations.

Fed signals higher interest rates after 25bps cut

Some BOJ Members Said Low Rates Caused Subprime Rout (Update1)

By Mayumi Otsuma

Nov. 5 (Bloomberg) -- Bank of Japan board members said the U.S. subprime mortgage collapse was caused by keeping interest rates too low, signaling their intention to increase the world's lowest borrowing costs to prevent investment bubbles.

Some of the nine members said a ``long period'' of global monetary easing had led to ``excessive financial behavior'' that resulted in the U.S. home-loan crisis, according to minutes of the Sept. 18-19 board meeting published today in Tokyo.

The Bank of Japan is concerned that keeping its key interest rate at 0.5 percent risks seeding future asset bubbles. The subprime crisis was caused in part by investors who wanted higher returns amid low global interest rates buying securities linked to loans to people with poor credit histories. Defaults on the loans caused a shortage of credit and led to losses at banks including Citigroup Inc. and Merrill Lynch & Co.

The Bank of Japan is saying ```look, the risks we're talking about, that's what hit the U.S.,''' said Jan Lambregts, head of Asia research at Rabobank International in Hong Kong. ``All good central banks are forward-looking but they're caught between the short-term circumstances and long-term risks.''

The central bank last week kept its benchmark rate on hold and cut its forecasts for this year's economic growth and inflation. Governor Toshihiko Fukui said ``downside risks'' for the Japanese economy are rising as U.S. growth slows and financial markets remain volatile.

`Not a Slogan'

Still, Fukui said last week that Japan's ``very low'' rates need to rise gradually as the economy expands. Failure to do so would encourage excessive investment that may lead to swings in economic growth, he said on Oct. 31.

``This is not just a slogan. We're serious about this view,'' he said.

Most members at the September meeting said they're watching the employment situation, home prices and banks' willingness to lend to determine the strength of U.S. consumer spending.

A few members said they need to carefully check whether financial markets and the U.S. economy will affect the bank's outlook for Japan's growth and inflation, the minutes show.

Policy makers at the meeting agreed on their basic view that Japan's interest rates need to be raised gradually according to developments in the economy and prices.

One member said the bank has time to examine the influence of financial-market turmoil and global economic growth on the Japan economy.

Another board member said the bank shouldn't hesitate to raise interest rates as long as it's confident Japan's economy will keep growing in line with policy makers' predictions.

Dollars falling out of favour

Supermodel Bundchen Joins Hedge Fund Managers Dumping Dollars

By Bo Nielsen and Adriana Brasileiro

Nov. 5 (Bloomberg) -- Gisele Bundchen wants to remain the world's richest model and is insisting that she be paid in almost any currency but the U.S. dollar.

Like billionaire investors Warren Buffett and Bill Gross, the Brazilian supermodel, who Forbes magazine says earns more than anyone in her industry, is at the top of a growing list of rich people who have concluded that the currency can only depreciate because Americans led by President George W. Bush are living beyond their means.

Even after the dollar lost 34 percent since 2001, the biggest investors and most accurate forecasters say it will weaken further as home sales fall and the Federal Reserve cuts interest rates. The dollar plummeted to its lowest ever last week against the euro, Canadian dollar, Chinese yuan and the cheapest in 26 years against the British pound.

``We've told all of our clients that if you only had one idea, one investment, it would be to buy an investment in a non- dollar currency,'' said Gross, the chief investment officer of Pacific Investment Management Co. in Newport Beach, California, and manager of the world's biggest bond fund. ``That should be on top of the list,'' said Gross, whose firm is a unit of Munich-based insurer Allianz SE.

The dollar fell 0.8 percent last week to $1.4505, the weakest since the euro started trading in 1999. It lost 2.8 percent against the Canadian dollar to 93.51 cents and 1.8 percent versus the pound to $2.09. The Fed's U.S. Trade Weighted Major Currency Dollar index tumbled to 76.3, from 112.89 in January 2004.

Bundchen's Demands

BNP Paribas chief currency strategist Hans-Guenter Redeker, the most accurate foreign-exchange forecaster last quarter in a Bloomberg survey, said the dollar may drop to $1.50 per euro by year-end. The median estimate of 44 strategists surveyed by Bloomberg is for the currency to end the year at $1.43. Among those surveyed last week, the forecast ranges from $1.42 to $1.50.

When Bundchen, 27, signed a contract in August to represent Pantene hair products for Cincinnati-based Procter & Gamble Co., she demanded payment in euros, according to Veja, Brazil's biggest weekly magazine. She'll also get euros for the deal she reached last October with Dolce & Gabbana SpA in Milan to promote the Italian designer's new fragrance, The One, Veja reported. Bundchen earned $33 million in the year through June, Forbes reported in July.

``Contracts starting now are more attractive in euros because we don't know what will happen to the dollar,'' Patricia Bundchen, the model's twin sister and manager in Brazil, said in a telephone interview in September from Sao Paulo. She declined to discuss details of the arrangements last week, as did Anne Nelson, Bundchen's agent in New York at IMG Models.

Dollar Support

Procter & Gamble's Sao Paulo-based external relations director for Brazil, Andre Quadra, said he couldn't give details of the Pantene contract because of a confidentiality agreement.

Analysts in a Bloomberg survey expect the dollar to strengthen in coming months as stronger-than-forecast reports suggest U.S. consumers will keep the economy out of recession. Payrolls grew by 166,000 in October, double the median forecast of economists in a Bloomberg survey.

The dollar will rise to $1.43 per euro this year and $1.35 by the end of 2008, according to the median estimate in the survey.

``So far the data has shown the U.S. economy may not be slowing to the extent the majority of the market had expected,'' said Omer Esiner, an analyst at currency-trading company Ruesch International Inc. in Washington who expects the U.S. currency to strengthen to as much as $1.38 per euro. ``That could temper policy easing down the road and lend support for the dollar.''

`Moving to Asia'

Buffett, whom Forbes in April ranked as the world's third- richest person behind Bill Gates and Carlos Slim, told reporters in South Korea last month that he is bearish on the U.S. currency.

``We still are negative on the dollar relative to most major currencies, so we bought stocks in companies that earn their money in other currencies,'' Buffett said Oct. 25. Buffett, 77, is chairman of Omaha, Nebraska-based Berkshire Hathaway Inc.

Jim Rogers, a former partner of investor George Soros, said last month he's selling his house and all his possessions in the U.S. currency to buy China's yuan.

``The dollar is collapsing,'' Rogers said last week in an interview. ``I'm moving to Asia because moving to Asia now is like moving to New York in 1907 or London in 1807. It's the wave of the future.''

Better Returns

The dollar is falling as investors seek better returns outside the U.S. Developing Asian nations including China and India will grow 9.8 percent this year, compared with 1.9 percent for the U.S., the International Monetary Fund said last month.

China, India and Russia accounted for half the global expansion over the past year, and the euro region will expand 2.5 percent in 2007, outpacing the U.S. for the first time since 2001, the Washington-based IMF estimates.

``The world has learned to live with a weak dollar,'' said Jay Bryson, a former Fed analyst who is now a global economist in Charlotte, North Carolina, at Wachovia Corp., the fourth- largest U.S. bank. ``It's not worried. it doesn't rely on the U.S. as much as it once did.''

Bryson forecasts the dollar will weaken to $1.50 per euro by the end of June.

The U.S. currency dropped in the past two months as the Fed cut its target rate for overnight loans between banks twice to keep a decline in home sales from starting a recession. The rate was reduced by three quarters of a percentage point to 4.5 percent, including a quarter-point last week. The National Association of Realtors trade group in Washington said on Oct. 10 that existing home sales may fall 11 percent this year.

Housing Recession

Lower rates have made yields on U.S. debt less attractive. At 3.36 percent, U.S. two-year Treasuries yield 0.26 percentage point less than German government bonds of similar maturity. The last time Treasuries yielded less than bunds was 2004.

The weaker currency has cushioned the U.S. economy during the worst housing recession in 16 years. Gross domestic product grew at an annual rate of 3.9 percent in the third quarter, the most in more than a year, the Commerce Department said Oct. 31 in Washington.

The five-year, 67 percent drop against the Canadian dollar has made it cheaper for fans from Toronto to drive the 110 miles (177 kilometers) to Orchard Park, New York, to watch the Buffalo Bills play football.

Canada Day

Canadians account for 11 percent of the team's season tickets this year, up from 6.5 percent in 2005, according to Scott Berchtold, the Bills' vice president of communications. At yesterday's annual Canada Day game, a record 23 percent of the sellout crowd of 73,967 fans were from Canada, he estimated.

``When the Canadian dollar was down around 65 cents, we didn't get anybody,'' Ralph Wilson Jr., the team's owner, said in an interview. ``When the dollar fell, we starting getting some people.'' The Canadian dollar bought 61.76 U.S. cents in 2002.

The dollar's drop also makes American goods cheaper abroad. U.S. exports were a record $138.2 billion in August, government data show. Net exports added 0.93 percentage point to U.S. gross domestic product last quarter, offsetting a 1.05 percentage point drag from housing, government data show.

``As long as the dollar's decline doesn't trigger inflation, it's a good thing, helping the U.S. economy to stay out of recession,'' said Robert Mundell, a professor at Columbia University in New York who won the Nobel Prize for economics in 1999.

Wealthy Clients

The Commerce Department's price index for personal consumption expenditures excluding food and energy rose 1.8 percent in September from a year earlier, the same as in August. The Fed forecasts the index will increase 1.75 percent to 2 percent next year.

Wealthy clients at San Francisco-based Union Bank of California have doubled their deposits in foreign currencies to $60 million the past two months as a hedge against a decline, said Bradley Shairson, head of currency and derivatives at the bank.

U.S. investors bought $198 billion in foreign securities this year through August, 72 percent more than in the same period last year, Treasury Department data show.

That's the same strategy as sovereign wealth funds run by the largest exporters and oil producers, including China, Singapore and Qatar, said Stephen Jen, head of currency research at New York-based Morgan Stanley.

The funds may grow to $17.5 trillion by 2017 from $2.5 trillion now and shift more than $500 billion out of the dollar in the next three years in search of better returns, he said.

``We're all thinking about diversifying out of the dollar,'' said Jen, who is based in London. ``It's a very logical thing.''

Dated article on roll-ups

High Rollers
A new generation of financial hot-shots are making their fortunes on roll-ups -- risky consolidations of IPOs. The risks are even greater for the CFO in the middle.
Joseph McCafferty
CFO Magazine
April 01, 1998

The day before last Thanksgiving, then-39-year-old financial whiz Jonathan Ledecky pulled off a bold deal. He went to the public equity markets and raised half a billion dollars for his company, Consolidation Capital Corp., in an initial public offering. What made this deal so brazen was not just that Consolidation had yet to earn a dime. In fact it had no revenues, no assets, no operating history, and no identity. Ledecky hadn't even settled on an industry for his new venture. He raised the capital in a blind pool on the strength of his reputation alone.
That reputation rests on his ability to build so-called roll-ups. These are companies created to consolidate fragmented industries by gobbling up small mom-and-pop businesses. But unlike regular consolidations, in which strong industry leaders buy up weaker rivals, roll-ups are started from scratch.

Here's how it works: A promoter like Ledecky finds between 5 and 10 private companies in the same industry that agree to sell their businesses for cash and stock from the proceeds of an IPO that has yet to occur. The IPO and the merger of the founding companies occur simultaneously. Using its stock as currency, the new company continues the acquisition binge in the hope of eventually creating a national power-house that will dominate the industry.

Roll-ups are red hot on Wall Street. At last count, about 90 roll-ups had gone public since one of the first, U.S. Delivery Systems Inc., debuted in 1994, including 50 in 1997 alone. And the frenzy continues, with an average of 5 coming to market each week.
Also called "poof" companies because of the way they seem to materialize out of thin air, roll-ups are consolidating such industries as funeral homes, dry cleaners, flower wholesalers, bus lines, home builders, and air-conditioning repair services. In fact, roll-ups have popped up in every fragmented industry.

But the risks in these deals are as great as the rewards. "There are so many hurdles to overcome that it is very difficult to pull these deals off," says Patrick Sullivan, partner in charge of acquisition advisory services for Coopers & Lybrand LLP in Los Angeles.
That hasn't stopped Ledecky and those like him from trying. They are financial cowboys, '90s style. But unlike 1980s' corporate raiders T. Boone Pickens and Carl Icahn, who made a killing preying on conglomerates and selling off their pieces, these cowboys make money by putting the pieces together. In that sense, roll-ups are the reverse of the leveraged buyouts of the '80s. Sullivan calls them "leveraged buildups," because they leverage equity to build the company.

The king of consolidators is H. Wayne Huizenga, owner of the Florida Marlins baseball team. Huizenga pioneered the technique by rolling up garbage-truck businesses to create Waste Management Inc., the nation's largest waste company. He went on to create the largest video chain, Blockbuster Video, and is trying to work his magic on the auto retail industry through Republic Industries Inc.
Now promoters have taken the concept to the next level, with roll-up IPOs. Ledecky, who created one of the earliest and now largest roll-ups, U.S. Office Products Co. (USOP), has since created three more--USA Floral Products Inc., a flower distributor; Consolidation Capital; and UniCapital Corp., a consolidator of commercial leasing firms that filed to go public in February. These three were all done in the past year, while Huizenga took 25 years to get to his third.

The man with the most notches on his belt, though, is Steve Harter, chairman of Notre Capital Ventures II, a Houston-based investment bank. Harter has six bronze bulls, awarded by the New York Stock Exchange when a company is listed there, to prove it. He sharpened his skills doing M&A work for Arthur Andersen LLP and, later, analyzing acquisition candidates for Allwaste Inc., a Houston environmental-waste company. After orchestrating the U.S. Delivery roll-up, he completed five more, including some of the most successful yet. Coach USA Inc., a roll-up in the motor coach industry, went public in May 1996 at $14 a share and has more than doubled to a recent close of $38. Another of Harter's creations, Metals USA, is up 60 percent, to a recent high of $16 since its initial offering last July.

Harter also started Comfort Systems USA Inc., which is out to consolidate the air conditioning and heating industry; Physicians Resource Group Inc., a consolidator of ophthalmology practices; and his most recent IPO, Home USA Inc., a consolidator of mobile-home retailers that went public last November.

FEES THAT MATCH THE P/EsClearly, the success stories are alluring. But roll-ups have their critics. Among them, oddly enough, are the stronger players, who take aim at less-scrupulous copycats. "There is a tremendous amount of financial alchemy going on," says Harter. What concerns them is that roll-ups can be a house of cards. After the IPO, the roll-up continues to acquire companies, using equity it raised at high P/E ratios to buy smaller private companies that trade at lower multiples. This arbitrage helps maintain the roll-up's high ratio and the acquisition binge; it's a machine that feeds itself.

But P/Es are as much about investors' perceptions as about earnings. If investors come to doubt that earnings can be sustained, the multiple will come down, throwing sand into the gears. And it's virtually a foregone conclusion that every industry will ultimately run out of suitable acquisition candidates. Yet consolidators almost always cite the arbitrage as the key to their strategy. "It is the concept," says Ledecky. "It's a gerbil wheel." At that point, investors in roll-ups will have to worry whether their company can effectively manage what it owns.

Trouble is, roll-ups often lack experienced management teams. "Roll-ups tend to be headed by executives who have experience in roll-ups, but not in the industry," says Samuel Hayes, a finance professor at Harvard Business School. That, he says, can be a recipe for disaster. Indeed, some observers contend that once traditional measures of performance are applied, like comparison of same-store sales or other measures of operational growth, lofty P/E ratios will fall back to earth even before a roll-up runs out of potential targets.

"Fueling growth by buying companies with lower P/E ratios has long been discredited as a strategy that has no rationale," says Geoffrey Brooks, an assistant professor at the University of Pennsylvania's Wharton School. He cites the failure of diversification in the 1960s as a prime example. Jeffrey Evans, vice president of research at Credit Lyonnais Securities (U.S.A.) Inc., agrees. "It's the greater-fool theory. At some point it has to stop, and someone is left holding the bag." Often that includes the CFO.

Consider Fine Host Corp. The Greenwich, Connecticut-based food-service firm set out to consolidate small players that run concessions and cafeterias at universities, corporations, and sports arenas. It went public in the summer of 1996 at $12 a share and shot up to $43 by the fall, buoyed by a flurry of acquisitions. But in April 1997, the CFO, Nelson A. Barber, was suddenly demoted to treasurer, and by October analysts were complaining about a lack of information. In December, the stock fell 64 percent when the company removed Barber and its CEO, Richard E. Kerley. The company later admitted it had recognized some income before it was earned and incorrectly capitalized certain expenses, and restated earnings back to 1994, incurring losses instead of profits. The Securities and Exchange Commission is conducting an informal investigation.

In many cases, though, the promoters and underwriters make a killing whether the roll-ups bear fruit or not. "The people who financially engineer these deals make an enormous amount of money," says Patrick Hurley, partner and M&A director at Howard, Lawson & Co., a Philadelphia investment bank. He says that the promoters get a large equity stake for a very small up-front investment. "If they have been able to sell stock, they've made money whether the roll-up succeeded or not." (Often they are locked into agreements that prevent them from selling for 12 to 18 months.) Up-front fees for underwriting, accounting, and legal services are also high due to the complexity of the deals. Hurley estimates that total managers' fees related to completed roll-ups, including the management fee, underwriting fee, and selling concession, are about 50 percent higher than for normal IPOs.

When roll-ups do go wrong, the underlying problem is most often a focus on the financial engineering at the expense of improving operating efficiencies. "The biggest risk in this whole phenomenon is that acquirers lose sight of the nuts and bolts," says Evans. "They just buy things to buy them." Perhaps this point is best illustrated by the title of the keynote presentation, "It's Easier to Buy 'Em Than to Run 'Em," at the upcoming second annual Industry Roll-Ups Conference, a how-to course on the strategy.

CONFLICT-RIDDEN?Some roll-up cowboys seem to have problems handling the conflicts of interest that can arise. Consider Ledecky. One of the companies he merged into USOP as it went public was Sharp Pencil, of which he himself was majority owner. Although he used $17.6 million of the February 1995 IPO proceeds to, in effect, buy himself out, Ledecky did not think it necessary to get an independent appraisal of Sharp's value, according to USOP's prospectus. Ledecky, who denies any conflict of interest, says he got the same multiple for Sharp Pencil as the other founding companies. "They were all valued in the same way. Everyone negotiated the deal together." Still, investors had little way of knowing whether the price was fair, because none of the financial information about Sharp in USOP's prospectus was audited, according to the filing.

Ledecky's conflicts of interest didn't end once he paid himself for Sharp. He took Consolidation Capital public even while serving as chairman of USOP and USA Floral. That raised the risk that he would make acquisitions for Consoli-dation Capital that might have as easily served USOP's and USA Floral's interests. "[Management] may have conflicts of interest in determining to which entity a particular business opportunity should be presented," says Consolidation Capi-tal's prospectus. And even if USOP, USA Floral, and Consolidation Capital weren't competing for the same businesses, Ledecky's time and attention could not be fully devoted to the interests of either or any of the companies, a factor that was also noted in the prospectus. Ledecky announced his resignation as chairman of USOP in January, effective this month.

MRI UNDER SIEGELedecky isn't the only roll-up artist to have engaged in questionable self-dealing. Gary Siegler, chairman of Medical Resources Inc. (MRI), a consolidator of medical imaging centers that went public in 1993, is also accused of indiscretions. The company is facing lawsuits related to questionable payments it made to 712 Advisory Services, a company Siegler controlled. Former managers allege that the advisory firm didn't earn the $1.5 million it was paid in cash and securities to advise on a number of MRI's acquisitions in 1997. Also, the ex-managers contend that Siegler arranged for MRI to take a $3 million stake in a private plane, which they claim was unnecessary. They allege that Siegler, who earned his wings working for Carl Icahn in the 1980s, wanted the plane for private use.

In early November, CFO John O'Malley was fired, and two other executives, chief operating officer William Farrell and general counsel Gary Fields, resigned after they raised the matter with the board and called for Siegler's ouster. They have since filed whistle-blower lawsuits. The company disclosed the departure of its CFO in a press release that also warned of earnings shortfalls, causing the stock to tumble to 83/4 from a high of 205/8 just a month earlier.

The company has launched an internal investigation, and is also being investigated by the New Jersey Attorney General's office, according to company filings.

WHY STOP AT OFFICE SUPPLIES?If Ledecky and Harter are the two founding fathers of roll-ups, their strategies couldn't be more different. Ledecky is a hands-on manager, often taking the position of chairman, while Harter builds the roll-ups and lets others with more experience in the industry run them. Harter likes to move slowly, focusing on integration of the acquired companies; Ledecky moves fast to build up a big organization as quickly as possible. Perhaps nowhere is that more evident than at USOP.

Sharp Pencil was one of six privately owned office-supply companies that Ledecky put together. But he didn't stop there. Two years and 220 acquisitions later, USOP was a member of the Fortune 500, with $3.8 billion in revenues. The stock had gone from $7.50 at the offering to a high of $27 in the summer of 1996. "It was crazy," says Donald Platt, senior vice president and CFO of the Washington, D.C., company. Of course, Platt relied heavily on outside resources, including a team of lawyers and accountants, to get the deals done.

Within these 220 acquisitions, are there no bad apples? "Not yet," says Platt. "We restricted them to well-managed, profitable companies. At worst, we would still be making money."

The trouble was, after grabbing that many companies, USOP had a patchwork of firms in six different businesses, including office supplies, travel, coffee sales, printing, and even educational supplies. The idea was to focus on the customer and provide one-stop shopping for corporate purchasers, rather than a tight industry niche.

At the pace Ledecky was moving, however, it was nearly impossible to attain significant economies of scale. Little integration was accomplished. Once purchased, in fact, a company was pretty much left alone. Ledecky not only kept existing management teams intact; he insisted they remain, locking them in with long-term agreements. Even the names of the companies were unchanged. And in only a few cases were warehouses and other overhead shared. "If you start to consolidate too quickly, you make the wrong decisions," says Platt. And buying well-run businesses left little room for improvement. Any integration they did do failed to increase margins. As a percentage of revenues, gross profit actually decreased from 28.1 percent for the nine months ended January 25, 1997, to 27.9 percent for the nine months ended January 24, 1998.

Without improving efficiency, USOP needed to keep up the acquisition pace to continue growing and keep the P/E ratio high. "Stock value is important. If you don't trade at a healthy multiple, using your stock as currency has less value," says Platt. "It absolutely feeds on itself. Success breeds success."

Until something finally gives. Without enough acquisitions or internal growth to drive earnings, USOP started to stumble. The stock fell to $16 at the end of 1997 from a high of $27.

In January, the company conceded that it could no longer sustain the current strategy, and reversed course. It decided to spin off four of the units--travel services, printing, educational supplies, and technology--and focus on its core businesses of office supplies, furniture, and beverages. And the executive who replaced Ledecky at the helm, Thomas Morgan, plans to do exactly what his predecessor couldn't: integrate with the aim of increasing efficiency through economies of scale. Just to be safe, the company also tapped the debt market for an additional $800 million to help fund a $1 billion stock buyback.

HELP WANTEDHarter has taken a different approach. In contrast to Ledecky, he intensely scrutinizes each acquisition and integrates each purchase completely into the organization. And he focuses on industries that have much to gain from better management, increased purchasing power, and increased efficiency. "If the customer doesn't benefit at the end of the day, you haven't created value," says Harter.
But he, too, has stumbled on occasion. Take, for instance, Physicians Resource Group (PRG), which Harter established as a roll-up in June 1995 to consolidate ophthalmology practices nationwide. It quickly grew from 10 practices at the outset to 177 by the fall of 1997. But costs grew even more rapidly. In the third quarter of 1997, the company reported a loss of $18.4 million, even though revenues grew to more than $100 million from $60 million a year earlier. Harter refused to comment on PRG's problems, but Richard D'Amico, PRG's chief administrative officer, admitted to the Dallas Morning News, "We grew too fast." Last November the company, now the largest eye-care group of practices in the nation, announced it was holding off on any more acquisitions, closing 14 of its troubled practices.

It is a common occurrence in roll-ups, says George Koo, an analyst with Burnham Securities Inc., in New York. "They move too quickly, projections aren't conservative enough, and costs get out of control." That's created plenty of opportunities for acquisition-minded CFOs. "In a roll-up, each of the things a CFO focuses on--raising capital, making acquisitions, improving operations, and talking to Wall Street--is at a fever pitch all the time," says Mike Kirksey, senior vice president and CFO at Metals USA, a Houston-based consolidator of metals processing firms. Perhaps the consolidation trail wouldn't have been so rough for PRG if it had had a strong CFO. For the two and a half years the company has been public, there have been no less than three finance chiefs.

"The CFO is crucial to the success of a roll-up," adds Kirksey. "The complexity requires someone with the skill to do the deals, but also to make them work, operationally."

Harter turned to Kirksey, former vice president of strategic planning at Keystone International Inc., a publicly traded valves and controls manufacturer in Houston, when he wanted to consolidate the metals-processing industry. Along with CEO Arthur French, also from Keystone, they created Metals USA. In any roll-up he starts, Harter has used professionals from the industry to run the business, though he has sat on four of his six companies' boards. "My ego doesn't need to be called 'chairman,'" he says.

THE GOLDEN GOOSEHarter at least has learned from his mistakes. Has Ledecky? He claims so. "One of the things I learned from U.S. Office Products is to focus," he says. But he already may be forgetting that lesson. In January, just days after USOP announced it was reversing its consolidation strategy and instead spinning off four separate roll-ups, Ledecky announced his plans for Consolidation Capital. The company will provide a variety of services to retail and office-building owners, including pest control, landscaping, and equipment maintenance. In February, it announced plans to acquire seven electrical contractors for $138 million, half of which would come in Consolidation Capital stock. When the acquisition is completed, Consolidation will be the fourth-largest electrical contractor in the United States. In a time when focusing on a niche is the standard, that will be a hard sell on Wall Street.

Eventually, many roll-ups will go the way of the LBO. When the stock market turns down, they will have a harder time using equity for acquisitions no matter how profitable they are. The cowboys themselves fear that day will come even sooner, as their corporate cattle drives fall victim to their own success.

"I have seen guys try to put these things together with mass mailings and Internet sites," says Harter. Fair warning for CFOs tempted to saddle up.

Chinese shipbuilders raising more equity - anticipating slower order books?

Chinese shipbuilders plan IPOs
By Raphael Minder in Hong Kong and Jamil Anderlini in Beijing
Published: October 31 2007 22:03 Last updated: October 31 2007 22:03

(FT) At least seven Chinese shipbuilders are planning share offerings, underlining China's efforts to build up its domestic fleet and branch out into the construction of more advanced vessels. The largest of the anticipated initial public offerings is likely to come from state-owned China Shipbuilding Industry Corporation (CSIC), which wants to raise about $900m on the Chinese mainland A-share market, according to bankers familiar with the situation. The other major state-owned shipbuilder, China State Shipbuilding Corporation (CSSC), is considering a share sale in Hong Kong. The companies refused to comment.
Meanwhile, five privately owned shipbuilders – Jiangsu Rongsheng Heavy Industries, Sinopacific, Mingde Nantong, Yantai Raffles Shipbuilding and JES International – are also looking to sell equity in order to fund their expansion, according to people familiar with the situation. Sinopacific and Mingde confirmed they have IPO plans but refused to give details.
Chinese shipbuilders want to raise capital at a time when shipping activity is close to an all-time high. The Baltic Dry Index, a key measure of commodity shipping costs, has more than doubled in the past year. Gilbert Feng, assistant director of the Hong Kong Shipowners' Association, who visited China's two major state-owned shipbuilders, said: “New building orders are already full until 2010, so their executives certainly sound very confident.”
JES will begin its roadshow next week and is set to float in Singapore as early as the end of November, trying to raise as much as $300m from a share sale managed by ABN Amro. Sinopacific is hoping to raise about $660m next year in an IPO managed by Citic. Meanwhile, Chen Qiang, president of Rongsheng, said in April his company was planning to sell as much as 25 per cent of its equity in an IPO. However, Rongsheng is now in talks with private investors about selling a stake ahead of a IPO. Finally, Mingde has selected Deutsche Bank and Morgan Stanley to manage a listing in either Singapore or Hong Kong. The banks involved in the plans would not comment.
China recently overtook Korea, the world's leading shipbuilding nation, for the first time in terms of one specific measure – first-half ship orders in terms of deadweight tonnage. CSSC's goal is to double its shipbuilding output over the five years to 2010.

Baron bets on US infrastructure spending

Baron Turns to Road, Bridge Investments After Casinos (Update3)
By Nick Baker and Rhonda Schaffler

Oct. 31 (Bloomberg) -- Ron Baron, the investor whose stakes in casinos helped make his Baron Partners Fund the top performer among his peers, said U.S. spending on bridges and roads are creating some of the best investment opportunities in the world.

``For years America has underinvested by trillions of dollars in infrastructure,'' Baron, manager of $22 billion at Baron Capital Management Inc. in New York, said during an interview today. ``There is a tremendous amount of spending that has to be done.''

The 64-year-old investor said New Orleans flooding caused by broken levees in 2005 and Minnesota's bridge collapse in August will lead to more spending on public projects. That trend has already helped Baron holdings including Fastenal Co., the largest U.S. retailer of nuts and bolts, and MSC Industrial Direct Co., a marketer of repair supplies.

The $3.2 billion Baron Partners Fund has returned 21 percent this year, more than double the gain of the Standard & Poor's 500 Index. It's the No. 1 performer among 40 U.S. market- neutral funds, which aim to profit whether stocks rise or fall, according to data tracked by Bloomberg. Baron converted Partners from a hedge fund into a mutual fund four years ago.

The American Society of Civil Engineers said in 2005 that $1.6 trillion should be spent over five years to shore up the nation's infrastructure. Rehabilitation or replacement of the Tappan Zee Bridge north of New York City may cost as much as $14.5 billion, according to a report released in May by the Urban Land Institute and Ernst & Young LLP.

AIG Fund

American International Group Inc., the world's biggest insurer, said this week it raised $3.5 billion to take stakes in power plants, waste-treatment facilities and shipping terminals. Most of the firm's holdings are in North American infrastructure companies, including Ports America, the terminal operator Dubai- owned DP World sold under pressure from U.S. lawmakers in March.

Baron, whose office overlooks New York's Central Park, holds this bullish view of America even though he expects the U.S. to be surpassed. ``I'm sure China will be largest economy in 50 years,'' he said. ``As long as they don't screw up.''

U.S. economic growth unexpectedly accelerated last quarter, expanding at a 3.9 percent annual rate, the Commerce Department reported today. China, which contributes a tenth of global growth, has expanded more than 11 percent for three quarters. The Asian nation is the fastest growing among the world's major economies.

Fastenal, MSC

Shares of Fastenal, based in Winona, Minnesota, and MSC of Melville, New York, have each gained 24 percent so far this year. The S&P 500 has advanced 8.7 percent. The Morgan Stanley Capital International World Index of developed markets gained 13 percent, and MSCI's gauge of emerging markets surged 47 percent.

``America is a land of opportunity,'' Baron said. ``People come here to escape religious persecution, to own a home, for freedom. There's no other place in the world like it. In China, you say something bad about the government and they beat you up. In Russia, they put you in jail.''

That hasn't dissuaded Baron from investing in China. His biggest holding is Wynn Resorts Ltd., which runs a casino in Macau. The Las Vegas-based company yesterday reported a 94 percent plunge in third-quarter earnings even as revenue doubled from the Chinese resort opened last year. The company had a gain in the year-earlier period that inflated profit.

Wynn Investment

Wynn shares lost as much as 7.7 percent to $155 today in Nasdaq Stock Market composite trading. That trimmed the stock's increase this year to 65 percent.

Baron's firm has a 5.6 percent stake valued at more than $950 million, according to Bloomberg data. Baron paid about $15 a share on average, including stock acquired before Wynn's 2002 initial public offering, to accumulate that position. He anticipates Wynn shares will reach $300.

Wynn's chief executive officer, billionaire Steve Wynn, ``builds properties that attract people,'' Baron said. ``We are less focused on short-term earnings because we do not believe that matters. We believe that creating a sustainable competitive advantage is more important.''

Baron's $6.9 billion Growth Fund hasn't fared as well as the Partners Fund this year. Its 11.7 percent return was enough to beat only half of its peers.

WellCare Health Plans Inc. was among the fund's laggards. The Tampa, Florida-based health insurer's shares have tumbled more than 80 percent since Oct. 23 after Federal Bureau of Investigation agents and investigators from a Florida Medicaid fraud unit searched WellCare's headquarters.

Baron was the eighth-largest WellCare shareholder, regulatory filings show. The money manager said he sold his stake after the stock started dropping.

``Our faith in management was apparently misplaced,'' he said. ``We did not make any money, although we think the idea of being able to provide health care, provide access to older people who do not have access to health care is a good idea.''