Musing about capitalism

Interbank lending woes or...

2008-06-05T10:03:00.000+08:00

Derivatives Traders Signal Bank Woes Likely to Worsen (Update3)

By Liz Capo McCormick

June 4 (Bloomberg) -- Interest-rate derivatives traders are betting banks' difficulties obtaining cash to fund holdings and shore up balance sheets will worsen.

The difference, or spread, between the three-month dollar London interbank offered rate and the overnight index swap rate on contracts beginning in three months and trading now in the forwards market is greater than spreads on those starting this month, according to data tracked by Credit Suisse Holdings Inc.

``The movement in the forward Libor-OIS spreads is telling you that the market is concerned that things can get even worse before they get better,'' said Carl Lantz, an interest-rate strategist in New York at Credit Suisse, one of the 20 primary dealers of U.S. government securities that trade with the Federal Reserve. ``Until all banks' balance sheets are cleaned up and they've re-capitalized, there is going to be funding pressure.''

Derivatives trades show that while global markets have rebounded since March, the worst may not be over for banks after racking up $387 billion of losses and writedowns from mortgage- related securities since the start of last year. Lehman Brothers Holdings Inc. has tumbled about 19 percent this week on concern it needs outside funding to shore up its balance sheet.

The three-month Libor-OIS spread traded forward to June 16, the date the June Eurodollar futures contract expires, is 68.5 basis points, while the forward spread corresponding to the September Eurodollar expiration is 70 basis points, or 0.7 percentage point. Eurodollar futures are priced at expiration to three-month dollar Libor.

Availability of Funds

Overnight indexed swaps are over-the-counter traded derivatives in which one party agrees to pay a fixed rate in exchange for the average of a floating central-bank rate over the life of the swap. For U.S. dollar swaps, the floating rate is the daily effective federal funds rate.

The difference between Libor, which is an average rate based on a daily survey of 16 banks by the British Bankers' Association, and the OIS rate indirectly measures the availability of funds in the money market. Forwards give expectations for the future.

Wider Libor-OIS September spreads may reflect traders exiting ``soon-to-expire'' positions earlier than usual, given potential volatility in Libor amid questions over its veracity, according to Laurence Mutkin, London-based head of European fixed-income strategy at Morgan Stanley, another primary dealer.

Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events, such as changes in the weather.

Widening Forward Spreads

The market has grown more pessimistic since April 30, when the September spread was 6 basis points less than June, according to Credit Suisse.

The spot three-month dollar Libor-OIS spread is 67 basis points today, after ranging from 24 basis points to 90 basis points this year and peaking last year at 106 basis points in December. The spread averaged 11 basis points for the 10 years prior to August, when the global credit crunch began.

Concern institutions are having difficulty accessing financing increased this week after Standard & Poor's lowered credit ratings for Morgan Stanley, Merrill Lynch & Co. and Lehman Brothers on June 2, citing the possibility that the investment banks will have further writedowns on devalued assets.

Lehman Options

Lehman, the fourth-biggest U.S. securities firm, may report this month its first quarterly loss since going public in 1994, increasing pressure on the company to raise capital, according to analysts at Oppenheimer & Co. and Bank of America Corp. Lehman may be forced either to sell all or part of itself to a bigger financial firm or sell a large quantity of new shares to bolster its finances, the Wall Street Journal reported today.

Options trading shows bearish positions on Lehman exceeded bullish ones by 1.6-to-1 yesterday, a two-month high. The cost of protecting debt sold by Lehman from default rose to 240 basis points from 150 basis points in the credit-default swaps market during the past week, data compiled by UniCredit SpA show.

The British Bankers' Association has been under fire since the Bank for International Settlements said in March the banks that set Libor understated their borrowing costs to avoid speculation they were in financial straits as losses in credit markets mounted.

Libor Oversight

The London-based BBA completed a review of Libor on May 30, saying it will strengthen ``oversight'' of the system. Details will be revealed ``in due course,'' it said.

Three-month Libor-OIS forward spreads through December maturities are in line with each other, indicating the problems with Libor will be longer lasting, according Mustafa Chowdhury, head of U.S. interest-rate research in New York at Deutsche Bank AG, also a primary dealer.

``Instead of being an immediate bank-liquidity problem, Libor is now being affected by a longer-term capital problem,'' Chowdhury said. The market ``had previously expected the liquidity problems that had boosted the Libor-OIS spread to dissipate relatively quickly.''

The Libor-OIS forward spread that corresponds with the Dec. 15 Eurodollar futures expiration date was 67.5 basis points.

Getting creative in accounting -- Decrease in expected liabilties --> Gains (booked as profit)

2008-06-03T16:24:00.001+08:00

Wall Street Says -2 + -2 = 4 as Liabilities Get New Bond Math

By Bradley Keoun

June 2 (Bloomberg) -- Leave it to Wall Street to profit from its own distress.

Merrill Lynch & Co., Citigroup Inc. and four other U.S. financial companies have used an accounting rule adopted last year to book almost $12 billion of revenue after a decline in prices of their own bonds. The rule, intended to expand the ``mark-to- market'' accounting that banks use to record profits or losses on trading assets, allows them to report gains when market prices for their liabilities fall.

The new math, while legal, defies common sense. Merrill, the third-biggest U.S. securities firm, added $4 billion of revenue during the past three quarters as the market value of its debt fell. That was the result of higher yields demanded by investors spooked by the New York-based company's $37 billion of writedowns from assets hurt by the collapse of the subprime mortgage market.

``They can post substantial gains as a result of a decline in their own creditworthiness,'' said James Cataldo, a former director of treasury risk management for the Federal Home Loan Bank of Boston and now an assistant professor of accounting at Suffolk University in Boston. ``It's completely legitimate, but it doesn't make sense by any way we currently have of thinking of net income.''

The paper profits have helped offset more than $160 billion of writedowns taken by U.S. financial-services companies during the past year. Now some investors and analysts say the winnings are illusory and may have to be reversed.

``The piper will have to paid eventually,'' said Robert Willens, a former Lehman Brothers Holdings Inc. accounting analyst who left the New York-based firm earlier this year to become an independent consultant.

Statement 159

The debate over what is known as Statement 159 adds to the number of accounting techniques called into question as the U.S. debt market unravels. Investors have criticized banks for booking some writedowns in an accounting category called ``other comprehensive income'' that bypasses their income statements. Accounting rulemakers are now proposing changes to standards that let banks use off-balance-sheet vehicles to juice earnings without tying up precious capital.

Statement 159, formally known as the ``Fair Value Option for Financial Assets and Financial Liabilities,'' was issued in February 2007 by the Financial Accounting Standards Board, or FASB, which sets U.S. accounting rules. It was adopted by most large Wall Street firms in the first quarter of last year and becomes mandatory for all U.S. companies this year, although they have wide latitude in how to apply it, if at all.

Lobbying Effort

The rule was enacted after lobbying by New York-based companies, led by Merrill, Morgan Stanley, Goldman Sachs Group Inc. and Citigroup, which wrote letters to FASB arguing that it wasn't fair to make them mark their assets to market value if they couldn't also mark their liabilities.

``We do not believe it would be appropriate'' to let investors consider creditworthiness when valuing bonds if the issuing company couldn't do the same, wrote Matthew Schroeder, managing director of accounting policy at Goldman, the largest U.S. securities firm by market value, in an April 2006 letter.

Companies are allowed to decide for themselves which of their outstanding bonds, loans and other liabilities will get mark-to- market treatment. That's an unprecedented degree of leeway, said Willens, who is also an adjunct professor at Columbia University in New York.

``It's kind of a dumb rule,'' Willens said. ``In the entire panoply of accounting, this is the most flexible and elective and optional rule that we have.''

The Fed Objects

Here's how it works, according to Richard Bove, an analyst at New York-based Ladenburg Thalmann & Co. A company decides to designate $100 million of its subordinated bonds as subject to mark-to-market accounting. The price of the bonds drops to 80 cents on the dollar from 100 cents. So the firm books $20 million on the ``presumed savings that you have on your liabilities,'' Bove said.

``In the real world you didn't save a dime,'' he said. ``You still owe the $100 million. It's another one of these accounting rules that basically takes you further and further away from reality.''

The Federal Reserve, Federal Deposit Insurance Corp., Office of the Comptroller of the Currency and Office of Thrift Supervision objected to the rule before its passage, saying in a joint 2006 letter to the FASB that it would ``have the contrary effect'' of increasing a bank's net worth at the same time its ``financial condition is deteriorating.''

Split at FASB

The regulators remain so skeptical that they refuse to let banks apply the phantom revenue toward minimum capital requirements, according to reporting rules posted on the Web site of the Federal Financial Institutions Examination Council. Deborah Lagomarsino, a Washington-based spokeswoman for the Federal Reserve, declined to comment.

Not even the FASB was united on the new standard. Two of its seven board members -- Thomas Linsmeier and Donald Young -- voted against it, according to the February 2007 statement. Linsmeier said the rule ``will provide an opportunity for entities to report significantly less earnings volatility than they are exposed to,'' according to the statement.

The FASB tried to limit abuses by forcing companies to designate their ``fair value'' liabilities when they adopt the new standard. Subsequently, they can't change their minds. Liabilities added after adoption can only be designated at inception.

``The statement was thoroughly discussed with users and preparers'' in advance of its publication, said Neal McGarity, a spokesman for Norwalk, Connecticut-based FASB. A March survey by the CFA Institute, a Charlottesville, Virginia-based group that administers a financial-analyst designation program, showed that 74 percent of investors believe the standard ``has improved market integrity,'' he said.

Merrill's Liabilities

Merrill designated about $166 billion of liabilities, or 17 percent of its total, as fair-value instruments subject to mark- to-market accounting at the end of 2007, according to its annual report. Included in the amount were $76.3 billion of long-term borrowings and $89.7 billion of payables under securities- financing transactions.

Prices for the firm's bonds tumbled over the past year: Its floating-rate notes due in January 2015 are trading at about 87 cents on the dollar, compared with about 100 cents last June.

Merrill has said its gains from the liabilities don't add to true earnings power. In a spreadsheet posted on its Web site, Merrill says that investors who want a ``more meaningful period- to-period comparison'' should exclude the $2.1 billion of revenue recorded in the first quarter.

Merrill spokeswoman Jessica Oppenheim declined to comment. The company owns a passive 20 percent stake in Bloomberg LP, the parent of Bloomberg News.

Lehman to Goldman

Lehman, the fourth-biggest securities firm, has reported $1.9 billion of gains related to a widening of its own bond spreads. Citigroup, the largest U.S. bank by assets, has booked $1.7 billion; Morgan Stanley $1.7 billion; JPMorgan Chase & Co., the third-biggest bank, $1.7 billion; and Goldman Sachs $550 million.

There may be more to come, JPMorgan analyst Kenneth Worthington wrote in a May 28 report. Lehman may book $325 million for the second fiscal quarter ended in May, and Morgan Stanley, the second-biggest U.S. securities firm, may report $470 million, Worthington estimates.

Spokesmen for Lehman, Morgan Stanley, Goldman, Citigroup and JPMorgan in New York declined to comment.

`Shell Game'

So far, most banks' writedowns are ``unrealized,'' meaning they've been unwilling or unable to liquidate distressed assets. If prices reversed, the banks would record mark-to-market profits.

The same is true for the liabilities. Companies can't ``realize'' the mark-to-market gains on their debt unless they buy it back at the discounted price. They're unlikely to do so, because the deterioration in creditworthiness means they'd have to replace the debt with higher-cost borrowings, Willens said.

``No one's going out in the market and actually retiring this debt,'' Willens said. ``It's a shell game.''

David Moser, Merrill's managing director for accounting policy, acknowledged that concern in an April 10, 2006, letter to the FASB.

``It seems counterintuitive that when a company's credit spreads are widening, it would recognize a gain in earnings,'' Moser wrote. ``The amounts are typically not realizable and therefore less relevant.''

He nevertheless supported the new accounting standard because it ``mitigates some of the uneconomic volatility in earnings'' that results from marking assets to market without doing the same for liabilities.

Market Reversal

Bear Stearns Cos., which adopted the new standard this year, reported a $305 million windfall in the fiscal first quarter, which ended in February, as bond spreads widened on concerns the company might face a funding shortage. Then in March, after the New York-based securities firm was forced to sell itself to JPMorgan, Bear Stearns's bond spreads tightened, resulting in a $372 million loss, according to a regulatory filing in April.

Worthington estimates that similar tightening of bond spreads at Merrill, Morgan Stanley, Lehman and Goldman Sachs may cause them to reverse $5.96 billion of revenue by the end of the year.

``It could very well hurt earnings,'' said Jeffery Harte, an analyst at Sandler O'Neill & Partners LP in Chicago, in an interview. On the flip side, a recovery may result in asset write- ups, he said.

Standard & Poor's, which relies on banks' financial statements to issue credit ratings, said in April 2006 that the new rule might lead to ``diminished analytical transparency.''

``Equity may be overstated as a result of these illusory gains that may never be realized, hindering the analysis of the equity cushion to absorb losses,'' S&P Chief Accountant Neri Bukspan wrote in a letter to the FASB.

If and when the ``illusory'' revenue is reversed as losses, the banks and brokers may have to work harder to convince investors to ignore them, Willens said.

Lying about LIBOR

2008-06-02T16:10:00.002+08:00

Libor Cracks Widen as Bankers Struggle With Reforms (Update2)

By Gavin Finch and Ben Livesey

May 27 (Bloomberg) -- Few companies have suffered from the subprime mortgage collapse more than UBS AG, which has taken $38 billion of writedowns and losses, replaced its chief executive officer and chairman and saw its stock tumble 60 percent.

Yet on 85 percent of the days between July and mid-April, the Zurich-based bank told the British Bankers' Association that it could borrow in the money markets at lower interest rates than its rivals. Not even the U.K.'s Lloyds TSB Group Plc, which only wrote down $1.4 billion, could obtain the rates UBS said it was able to get, according to data compiled by Bloomberg.

``Even when the market knew UBS was massively exposed and Lloyds wasn't, that was not reflected in Libor,'' said Antony Broadbent, an independent banking consultant and former analyst at Sanford C. Bernstein & Co. in London.

Such discrepancies are creating a crisis of confidence in the London interbank offered rate published daily by the London- based BBA and taken from the contributions of UBS, Lloyds TSB and 14 other banks. Rates on corporate bonds, leveraged buyouts loans, derivatives and even U.S. mortgages are pegged to Libor.

The criticism has prompted the BBA to accelerate a review of the 24-year-old system of setting rates. The findings, due May 30, may determine how fast the banking industry recovers from the credit crisis.

`People Get Hurt'

``You've got to fix Libor,'' said Tim Bond, head of asset allocation strategy in London at Barclays Capital, a unit of Barclays Plc, one of the banks that provide quotes to the BBA. ``You don't ever want to be in a situation like this again, where people can get away with quoting whatever rate they like. Real people get hurt like this.''

Libor is a benchmark for about $350 trillion of debt- related securities and derivatives, according to the Bank for International Settlements in Basel, Switzerland. The rate that San Antonio-based AT&T Inc., the biggest U.S. phone company, pays on $2 billion of notes it sold on March 27 floats at three- month Libor plus 0.45 percentage point.

``Libor is baked into the global financial system,'' analysts at JPMorgan Chase & Co. led by Terry Belton, global head of fixed-income and foreign-exchange research, wrote in a May 16 report. ``The question of whether a benchmark could be designed that is less flawed than Libor is debatable; whether such a benchmark could effectively replace Libor is not.''

Libor Exposed

Every morning the BBA, an unregulated trade group, asks member banks how much it would cost them to borrow from each other for 15 different periods, from overnight to one year, in currencies from dollars to euros and yen. It then calculates averages, throwing out the four highest and lowest quotes, and publishes them at about 11:30 a.m. in London. Three-month dollar Libor was set at 2.64 percent today.

Libor was thrust into the spotlight in August as the subprime-mortgage contagion spread and banks were suddenly wary of lending to each other because of mounting losses that reached $383 billion as of last week, data compiled by Bloomberg show.

Three-month Libor soared to 2.40 percentage points above yields on Treasury bills on Aug. 20, the widest margin since December 1987 and up from 0.39 percentage point a month earlier. The figure was 0.80 percentage point today.

The credit crisis exposed Libor's flaws, according to Peter Hahn, a London-based research fellow for Cass Business School and a former managing director at Citigroup Inc. That's because the BBA publishes the names of contributors and their rates, giving lenders an incentive to underestimate borrowing costs to keep from appearing like they are in financial straits.

Rates `a Lie'

In the first four months of 2007, the difference between the highest and lowest rates for three-month Libor didn't exceed 0.02 percentage point, according to JPMorgan. In the same period this year, it was as wide as 0.17 percentage point.

The BIS said in a March report that some lenders may have ``manipulated'' rates. Strategists such as Bond at Barclays went as far as calling the reported rates a ``lie.''

The BBA said on April 16 that any member deliberately understating rates would be banned. The cost of borrowing in dollars for three months rose 0.18 percentage point to 2.91 percent in the following two days, the biggest increase since the start of the credit squeeze in August.

Lesley McLeod, a BBA spokeswoman in London, would only say the association's review is ``ongoing'' and a ``robust process.''

Libor would be more reliable if banks offered rates anonymously, removing the stigma of appearing like they are having trouble accessing capital, said Bond at Barclays.

More U.S. Banks

For Brian Yelvington, a strategist at bond research firm CreditSights Inc. in New York, the solution is for the BBA to insist on proof that the rates quoted are based on real transactions. That way, there would be ``no way to hide since it goes from being a poll of sorts to a confirmed trade,'' he said.

The discrepancies wouldn't have been so pronounced if Libor were set at 10 a.m. New York time, making it less skewed toward Europe, JPMorgan wrote May 16. Only three U.S. banks contribute rates to the BBA: Citigroup, Bank of America Corp. and JPMorgan.

Any changes may be little more than cosmetic as a wholesale restructuring would disrupt the global financial system, said Barry Moran, a money-market trader at Bank of Ireland in Dublin.

``But the last thing you want to be doing in the middle of a financial crisis is implementing massive changes in the way the world's benchmark rate is set,'' Moran said.

UBS, the world's biggest wealth manager, and Lloyds TSB, the U.K.'s largest provider of checking accounts, underscore the wide range in rates quoted to the BBA since July.

HSBC, RBS

UBS's three-month offered rate in dollars averaged 1.3 basis points less than Libor from July through April 15. By contrast, Lloyds TSB quoted rates that were 0.04 basis point above Libor on average. A basis point is 0.01 percentage point.

In that period UBS ousted Peter Wuffli, 50, as chief executive officer after subprime-related losses at a hedge fund run by the bank, and Chairman Marcel Ospel, 58, who helped form UBS through a merger a decade ago, stepped down. UBS has slumped to 25.84 Swiss francs in Zurich from last year's high of 77.05 francs on Feb. 9, 2007. Dominik von Arx, a UBS spokesman in London, declined to comment.

HSBC Holdings Plc, Europe's largest bank by market value, gave rates that averaged 1.4 basis points less than Libor. The London-based bank has taken $19.5 billion in writedowns and charges. Royal Bank of Scotland Group Plc, the U.K.'s second- biggest bank, submitted rates that averaged 0.9 basis point below Libor. It has reported $15.3 billion in losses and writedowns.

HSBC spokesman Patrick McGuinness in London and RBS spokeswoman Carolyn McAdam in Edinburgh declined to comment.

Older article on appeal of SPACs

2008-04-10T23:09:00.001+08:00

BLANK CHECK COMPANIES
In a chilly IPO market, blank check companies are hot
By Robert Elder
AMERICAN-STATESMAN STAFF
Sunday, March 02, 2008

It's been a rocky year for initial public offerings, but investors can't get enough of companies that have no assets, no operating history and no business plan.

They are called special-purpose acquisition companies —shell companies that aim to acquire a business, usually within two years after it has raised money in an IPO. Investors don't know what kind of business a company will acquire or whether it will complete a deal, that's why they are also called blank-check companies.

Austin media entrepreneur R. Steven Hicks is the latest big-name investor to announce plans for a special-purpose company, joining the likes of his brother Dallas billionaire Thomas Hicks and activist investor Nelson Peltz, each of whom has raised hundreds of millions of dollars in special-purpose company IPOs.

Steven Hicks plans to raise a more modest $186 million for his blank-check company, Austin-based Capstar Acquisition Corp. The IPO was expected to launch this month, but Hicks said Thursday that the offering would be delayed three months until the financial markets settle down.

The delay in Capstar's offering, though, appears to be an anomaly.

"I hate to use the word 'bubble,' but clearly there's a stampede going on to get SPACs to the (IPO) market," said Steven Davidoff, a law professor at Wayne State University who has written extensively on the capital markets.

This year, 11 of the 19 companies that have raised money in IPOs have been special-purpose companies. Overall it's been a down year for IPOs: 19 companies have priced, a 49 percent decline from the same period in 2007.

But 11 of those 19 have been special-purpose companies.

The reason for the stampede by investors is more of a mystery. The structure of a special-purpose company is heavily tilted in favor of its executives, who typically end up with 20 percent of a newly acquired company, essentially for free.

In a new paper, Davidoff says special-purpose companies are part of a surge in what he calls black market capital, investments that "attempt to mimic the characteristics of hedge funds or private equity."

Average investors are effectively shut out of hedge funds and private equity, which are restricted to wealthier individuals. So they instead seek investments such as special-purpose companies they think can provide the outsized returns sometimes earned by private equity.
A special-purpose company, though, doesn't resemble a buyout fund, which may buy dozens of businesses, spreading the risk. A special-purpose company buys one company and usually has two years to do it.

Patience is a virtue in private equity, said Keith Garrison, a private-markets specialist at the Texas Christian University endowment and the former head of private equity at the $107 billion Teacher Retirement System of Texas pension fund.

At the teacher fund, Garrison said, "We had buyout groups that didn't invest capital for two years, just because the market was terrible."
"That was fine with us," he said. "We would not want them to be on a timelime. If they were, they would maybe be compelled to do things that don't make sense."

Davidoff said it's a no-brainer why managers are lining up to form special-purpose companies: They can raise money in a single IPO, rather than through endless fundraising meetings with potential private investors.

There are some protections for shareholders, a result of some blank-check companies failing in the 1980s and losing investors' money.
First, investors must approve the acquisition of a company.

Capstar says it will require 80 percent of shareholders to approve a deal, while other special-purpose companies have put the bar as low as 60 percent.

Second, if a company isn't acquired by the deadline, investors get close to 100 percent of their money returned. The only risk is the money an investor foregoes by having tied up funds in a special-purpose company for two years.

Investors are largely betting on the ability of a management team to find a business.

Someone who buys into Capstar is betting that Hicks can find another hugely profitable deal. Capstar's securities filings say its executives will try to buy a company in the media or entertainment business, but it doesn't have to limit itself to those industries.

Hicks and his brother Tom rode the consolidation wave in the radio industry in the 1990s. With financing from Tom Hicks' buyout firm, Steven Hicks and longtime associate John Cullen built Capstar Broadcasting Corp. into an industry giant.

They sold Capstar to Chancellor Media for $4.1 billion in 1999.

Cullen is president of DMX Inc., a programmed digital music company controlled by Hicks' private investment firm.

Hicks also runs Harden Healthcare, which is acquiring nursing facilities and home health and hospice agencies.

Special-purpose companies as a whole don't have a record investors can judge. Since 2003, about 47 of the 151 companies that have formed have completed deals, according to SPAC Analytics. In the majority of those cases, it's too soon to tell how investors have fared.
As of Feb. 22, there were 25 companies that had deals pending and 73 — with about $13 billion in capital — were looking for deals.
The scramble to make a deal can resemble a scavenger hunt. Endeavor Acquisition Corp., a New York-based special-purpose company, bought American Apparel in 2007, but only after it failed to buy other businesses.

Endeavor said it unsuccessfully tried to acquire two restaurant chains, a national chain of weight-loss centers and an ethanol producer in the Midwest.

So how did Endeavor settle on American Apparel?

In a filing with the U.S. Securities and Exchange Commission, Endeavor said its chairman and chief executive, Jonathan Ledecky, got the idea after he asked a consultant what kinds of products he liked. The consultant, Martin Dolfi, said he liked American Apparel clothes, and based on that Ledecky ordered research into the company, which led to the acquisition.

"Not all of these SPACs are going to work out," Davidoff said. "In the end, you're creating a race for everyone to cash in before it all pops."

Companies' workings
Special purpose acquisition companies, also called blank-check companies, are flooding the market for initial public offerings. Here's how they work:

Directors and executives get stock in the company at vastly discounted prices.

The company raises money from investors in an IPO and places the money in a trust.

It has 24 months to invest the proceeds.

If deadline isn't met, investors receive about 98 percent of their money back.

Stockholders must approve the company's first proposed investment, which must use at least 80 percent of company's capital.
Management ends up with 20 percent of the acquired company — essentially for free.

Investors can exercise their warrants to acquire additional shares in the acquired company.

The Big Mac (New York Times Article)

2008-04-10T23:02:00.004+08:00

The Big MAC
The Deal Professor by Steve M. Davidoff
March 10, 2008, 11:00 am

(Dealbook) We are now a good nine months into the market turmoil that began early last summer. The crisis has left a host of dead deals and tarnished companies in its wake — not to mention scores of scarred merger arbitrageurs who were repeatedly blindsided by cratered transactions.

Material adverse change clauses have played a critical role in these disputes. They have been the lever by which a number of buyers have sought to escape from takeover agreements. In Genesco, HD Supply, SLM and Accredited Home Lenders, among others, buyers have asserted MAC clauses to justify not completing their deals.

That’s a fair number of data points, and so it’s time to take stock of what we’ve learned.

A MAC Invocation is the First Step in a Negotiation
The historical notion of MAC disputes as a renegotiation tool has once again been borne out.

The reason is inherent in the way these clauses are structured. A MAC (also called a material adverse event/effect, or MAE) clause is a way for parties to allocate risk. When a company agrees to be acquired, there will almost always be a period of time between when the original acquisition agreement is executed and the transaction is completed. A MAC clause is a means for the parties to contractually allocate who will bear the risk of adverse events during this interim period. One formulation is “an effect, event, development or change that, individually or in the aggregate, is materially adverse to the business, results of operations or financial condition of the company and its subsidiaries, taken as a whole.” This is a qualitative test and not phrased in dollar terms.

The reason the parties don’t use dollar figures is bargaining leverage. A buyer can invoke a MAC to drive the price of an acquisition down by taking advantage of either changed market conditions or adverse events affecting the company to be purchased. Conversely, even though the buyer may utilize a MAC clause in this manner, a seller may also prefer a qualitative MAC clause to provide it with leeway to argue that an adverse event does not constitute a MAC. In both cases, the MAC clause works for the parties to settle typically at a lower price. The impetus towards settlement is compounded by the lack of substantial case-law on what constitutes a MAC. This is a self-fulfilling loop.
This is what we have seen in the recent wave. All of the MAC cases have been ultimately resolved through settlement rather than a determinative judicial judgment, though one difference has been that only a few deals, such as Accredited Home Lenders/Lone Star, have actually been renegotiated at a lower price; most have settled for a payment by the buyer to the seller, with deal itself being terminated.
And so, despite the relatively large number of MAC disputes, we thus far have only one judicial opinion further defining the scope of a MAC. This was the opinion of the Tennessee Chancery court in Genesco v. Finish Line. Unfortunately, the opinion of that court is not likely to be precedential or particularly useful because of its unique posture under Tennessee law and somewhat flawed reasoning.

Private Equity Buyers Can’t be Trusted with MAC Clauses
The negotiating balance between buyers and sellers that a MAC clause creates has been upset by the structure of private equity transactions.

Private equity deals typically have had a reverse termination fee structure that permits the buyer to exit the deal for any reason by paying a lump sum, typically about three percent of the transaction value. In these circumstances, sellers often rely partially on “soft” factors such as reputation to ensure a deal closing.

The problem with this structure is that it sets an upper bound for maximum damages, and mitigates the risk to a private equity firm in invoking a MAC compared to strategic deals, where the buyer can be forced to complete the deal if no MAC is found. Moreover, a private equity firm may be more incentivized to invoke a MAC to “cover” for the reputational issue.

This is what appeared to happen in a host of deals in the fall. One example is the failed Acxiom transaction. In those deals, a MAC was invoked, but a settlement was reached along the lines of the reverse termination fee, but for slightly less.

So where does that leave us? In private equity deals, parties may want to rethink the inclusion of a MAC clause. Given the continued use of the reverse termination fee structure in private equity deals, the inclusion of a MAC clause provides the private equity firm cover to invoke the MAC clause to “completely” walk from the transaction. Given the damage a MAC claim inflicts on a company, the company will be heavily incentivized in such circumstances to settle out at a lower figure, setting the reverse termination fee as an upper bound of payment.

While we are seeing anecdotal evidence that MAC clauses are getting more seller-friendly, it still does not fully address this issue. If private equity firms are going to obtain the optionality they want, preserving compensation for the seller in a busted deal is an equally worthy goal. This is particularly true since private equity firms are most likely to invoke the reverse termination fee structure in MAC-type situations. Strike a blow for seller rights: Kill the MAC in private equity deals.

The MAC Exclusions Matter
There is also a renewed focus on the carve-outs in every MAC clause. These carve-outs define events that, while materially adverse, are excluded from the definition of a MAC clause. As such, they are the principal place in a MAC clause where buyers and sellers allocate closing risk. The parties can agree any carve-out they wish, but generally parties negotiate carve-outs that allocate market and systemic risk to the buyer and allocate closing risk to the seller for adverse events that particularly and disproportionately affect it.

The SLM and Genesco disputes in particular brought renewed focus on the wording in these carve-outs. There, the parties were seemingly surprised at the exclusions they had negotiated. In SLM’s case it was the scope of the meaning of “disproportional” in a MAC exclusion for changes in laws related to the student lending industry. The Genesco dispute highlighted the potentially wide out an economic industry exclusion could provide a seller in a MAC. The lesson is that these exclusions may be wider than you think and that they are the heart of a MAC clause. Pay attention.

A new MAC strategy has also emerged. In the Genesco case, Finish Line did not initially invoke a MAC. Rather it claimed that the merger agreement among the parties required Genesco to provide Finish Line further information to make such a determination. Despite Genesco’s cries that this was a fishing expedition, the court ordered that Genesco provide such information. Sure enough, Finish Line subsequently claimed a MAC.

Wachovia is following a similar strategy in its litigation to escape financing the Clear Channel/Providence transaction. Wachovia is claiming that it needs further information to make a determination of whether a MAC to the Clear Channel television station business has occurred. This is a claim that, at a minimum, will delay a transaction.

But this strategy is already getting a cold reception in Delaware. Last week, at a hearing on the Clear Channel/Providence/Wachovia litigation, Vice Chancellor Leo Strine Jr. stated to Wachovia’s counsel:

I’m saying is I don’t know what claims you’ve made yet. If what you’re
claiming is that there was some sort of breach of covenant by your client
whereby they were supposed to have been providing certain types of information,
then I understand that there may well be a relationship between that failure to
provide information and your ability to claim an MAE if the information that you
did not get would justify such a call.

But, on the other hand, if you basically already have it, or you really
haven’t been able to call it, then, again, we’re not in that business, and I
don’t think that’s the law of contracts, that you go get to hit and hope.

Translated: Delaware is likely to be less friendly to fishing expeditions or other claims that this is information not in your possession.

And an Example
Let’s conclude by giving an example of an actual MAC clause, the one in the Countrywide’s merger agreement with Bank of America. That agreement defines a material adverse change as:

a material adverse effect on (i) the financial condition, results of operations or business of such party and its Subsidiaries taken as a whole (provided, however, that, with respect to this clause (i), a “Material Adverse Effect” shall not be deemed to include effects to the extent resulting from (A) changes, after the date hereof, in GAAP or regulatory accounting requirements applicable generally to companies in the industries in which such party and its Subsidiaries operate, (B) changes, after the date hereof, in laws, rules or regulations of general applicability to companies in the industries in which such party and its Subsidiaries operate, (C) actions or omissions taken with the prior written consent of the other party, (D) changes, after the date hereof, in global or national political conditions or general economic or market conditions generally affecting other companies in the industries in which such party and its Subsidiaries operate or (E) the public disclosure of this Agreement or the transactions contemplated hereby, except, with respect to clauses (A) and (B), to the extent that the effects of such change are disproportionately adverse to the financial condition, results of operations or business of such party and its Subsidiaries, taken as a whole, as compared to other companies in the industry in which such party and its Subsidiaries operate) or (ii) the ability of such party to timely consummate the transactions contemplated by this Agreement.

This is a middle-of-the-road MAC clause. (For a more seller-friendly one, see the Penn Gaming/Fortress merger agreement.)
Consider recent reports that the FBI is conducting a criminal inquiry into Countrywide: Would that be a MAC, thereby triggering a walk right by Bank of America? Hard to say — a walk right is only triggered if there is a breach of a representation and warranty that rises to the level of a MAC. This investigation certainly might cause such a breach of Countrywide’s representations as to no legal action or compliance with laws.

But to be a MAC, the investigation would have to be something that was not disclosed on the disclosure schedules to the merger agreement that qualify this representation. It would also have to have had or would reasonably be expected to have a MAC on Countrywide.
The disclosure schedules are not public, so we don’t know the answer to the first question. As for the second, a mere investigation is hard to be a MAC; one view is that unless the actual investigation itself causes the MAC, then there is none.

So right now, we just simply don’t know — though it seems not to be one.

Anchoring in auctions

2008-04-10T11:00:00.001+08:00

Why Things Cost $19.95

What are the psychological "rules" of bartering?

By Wray Herbert

(Scientific American) One of Alfred Hitchcock’s most enduring bits of cinematic comedy is the auction scene in the espionage thriller North by Northwest. Cary Grant plays Roger Thornhill, a businessman who has been mistaken for a CIA agent by the ruthless Phillip Vandamm. At a critical juncture, Thornhill is cornered by his enemies inside a Chicago auction house, and the only way he can escape is by drawing attention to himself. When the bidding on an antique reaches $2,250, Thornhill yells out, “Fifteen hundred!” When the auctioneer gently chides him, he loudly changes his bid: “Twelve hundred!” When the bidding on a Louis XIV chaise longue reaches $1,200, Thornhill blurts outs, “Thirteen dollars!” The genteel crowd is outraged, but Thornhill gets precisely what he wants: the auctioneer summons the police, who “escort” him past Vandamm’s henchmen to safety.

Clever thinking and good comedy. It is funny for a lot of reasons, and one is that Thornhill violates every psychological “rule” for how we negotiate price and value with one another. So much of life involves “auctions,” whether it is buying a used car or making health care choices or even choosing a mate. But, unlike Roger Thornhill, most of us are motivated by the desire for a fair deal, and we employ some sophisticated cognitive tools to weigh offers, fashion responses, and so forth—all the to-and-fro in getting to an agreement.

But how does life’s dickering play out in the brain? And is it a trustworthy tool for getting what we want? Psychologists have been studying cognitive bartering for some time, and several basics are well established. For example, an opening “bid” of any sort is usually perceived as a mental anchor, a starting point for the psychological jockeying to follow. If we perceive an opening bid as fundamentally inaccurate or unfair, we reject it by countering with something in another ballpark altogether. But what about less dramatic counter offers? What makes us settle on a response?

University of Florida marketing professors Chris Janiszewski and Dan Uy suspected that something fundamental might be going on, that some characteristic of the opening bid itself might influence the way the brain thinks about value and shapes bidding behavior. In particular, they wanted to see if the degree of precision of the opening bid might be important to how the brain acts at an auction. Or, to put it in more familiar terms: Are we really fooled when storekeepers price something at $19.95 instead of a round 20 bucks?

Janiszewski and Uy ran a series of tests to explore this idea. The experiments used hypothetical scenarios, in which participants were required to make a variety of “educated guesses.” For example, they had subjects think about a scenario in which they were buying a high-definition plasma TV and asked them to guesstimate the wholesale cost. The participants were told the retail price, plus the fact that the retailer had a reputation for pricing TVs competitively.

There were three scenarios involving different retail prices: one group of buyers was given a price of $5,000, another was given a price of $4,988, and the third was told $5,012. When all the buyers were asked to estimate the wholesale price, those with the $5,000 price tag in their head guessed much lower than those contemplating the more precise retail prices. That is, they moved farther away from the mental anchor. What is more, those who started with the round number as their mental anchor were much more likely to guess a wholesale price that was also in round numbers. The scientists ran this experiment again and again with different scenarios and always got the same result.

Why would this happen? As Janiszewski and Uy explain in the February issue of Psychological Science, people appear to create mental measuring sticks that run in increments away from any opening bid, and the size of the increments depends on the opening bid. That is, if we see a $20 toaster, we might wonder whether it is worth $19 or $18 or $21; we are thinking in round numbers. But if the starting point is $19.95, the mental measuring stick would look different. We might still think it is wrongly priced, but in our minds we are thinking about nickels and dimes instead of dollars, so a fair comeback might be $19.75 or $19.50.

The psychologists decided to check these lab findings in the real world. They looked at five years of real estate sales in Alachua County, Florida, comparing list prices and actual sale prices of homes. They found that sellers who listed their homes more precisely—say $494,500 as opposed to $500,000—consistently got closer to their asking price. Put another way, buyers were less likely to negotiate the price down as far when they encountered a precise asking price. Furthermore, houses listed in round numbers lost more value if they sat on the market for a couple of months. So, bottom line: one way to deal with a buyer’s market may be to pick an exact list price to begin with.

This isn’t all about money, however. Medical information, Janiszewski and Uy note, can also be offered in either precise or general terms: a physician might say that your chance of responding to a medication is “good” or that your chance of responding is 80 percent. The percentage is more precise, but many studies have shown that patients prefer vague generalities like “good,” so doctors tend to use them. But remember that life is an auction. In his mind, the patient is dickering with the doctor, so why not negotiate “good” up to “excellent”? When treatment choices are on the line, the auction house can indeed be a perilous place.

Falling public equity markets make SPACs look compelling

2008-03-24T10:29:00.005+08:00

SPAC Attack
Posted on March 20, 2008

(The Deal) The IPO window is all but closed, while the SPAC door looks wide open.

SPACs, or blank-check public offerings, are here to stay, having represented 21% of cash raised in the IPO market in 2007, notes Deal contributor Joseph Bartlett. "The SPACs phenomenon is based on fundamental shifts in the U.S. financial markets, the first being the extended closure (since 2001) of the IPO window in the U.S. for small- and midcap companies."

So what are they, exactly? The Deal's Vyvyan Tenorio offers a primer:

As blind pools, SPACs don't have an operating business when they raise money in public markets. But they have 18 months from an IPO to complete a deal using about 80% of net assets. Up to 95% of the money raised is held in a third-party trust. Once a SPAC has identified a target, it has to notify shareholders and submit documentation to the SEC. Shareholders can approve it and sell or redeem their shares. If the SPAC fails to successfully make an acquisition, the trust is liquidated and the cash returned.

SPACs are an investment favorite of hedge funds (Amaranth Advisors LLC loved 'em before its spectacular implosion) and, of late, large institutional investors like mutual funds. She writes:

Clearly there's an appetite for SPACs among sponsors whose access to capital may be limited, and among hedge funds that hope to profit from arbitrage opportunities. SPACs have also opened avenues for well-heeled financiers such as Texas private equity pioneer Tom Hicks. In June, Hicks filed to raise $400 million through an IPO for a SPAC. [He wound up raising $552 million in October.] Hedge funds, too, are exploiting these vehicles to take themselves public. GLG Partners LP, one of Europe's largest hedge funds, went public in 2006 through a reverse $3.4 billion takeover of Freedom Acquisitions Holdings Inc., which raised $528 million late in the year.

And they're also a popular exit route for private equity firms, notes The Deal's John Morris. (For other ways PE firms can capitalize, see below.) Eleven SPACs have bought private equity-controlled U.S. companies since mid-2006, he says, citing a SPAC tracker.

THE GOOD, THE BAD AND THE FIXES

More generally, SPACs seek to overcome some of the problems involved in the back-door route -- reverse merger into a public shell. It's a two-step process, Sonnenschein Nath & Rosenthal LLP's Bartlett notes: An underwritten IPO followed by an acquisition, effectively a back-door IPO but with built-in safeguards, promising shareholders get a say in choosing the target. He lays out the plusses, particularly when compared to shells, and the minuses:

It affords retail investors access to many advantages of private equity. While hedge funds typically buy the stock, any average investor can too.
Investors buy what the SPAC has set out to do; whereas investors in a shell are bystanders.
And shareholders can vote for a deal or against it and recoup much of their investment, which is far less common with shells.
All told, a SPAC deal is still a reverse IPO, so if a company is to float successfully, why not use the traditional avenue? The road is shorter, cheaper and less risky. But the window, for now, is closed.
Further, many deals involve proceeds that fall short of the amount deemed advisable to escape orphanage, a problem that can be countered with rollups.

The remaining issues are tougher, he notes:

How attractive is a company willing to hang around an average of 218 days for a yes vote that may or may not come? "If it is any good, it should be snapped up quickly by financial and/or strategic investors."
And a no vote can be catastropic. "Take a look at the stock price nosedive of targets left at the altar by LBO funds reneging at the last minute." (For more on buyouts gone bust, see a related Dealwatch.)
Further, once proxy materials go out, anyone can take a peek: competitors as well as customers.
The 18-month deadline imposes tremendous pressure to cut a deal.

So what are the fixes?

For SPACs themselves, a team-up with a PE fund may be the best model. (See below.) Potential conflicts of interest surrounding the role of private equity investors in SPACs can also arise, but the shareholders always have the cash-out option.
Meanwhile the SEC needs to regulate to prevent market manipulation (one SEC rule is that SPACs can't predetermine acquisition targets, a contested point because they're often industry-specific) and the average 218-day delay (also aimed at preventing abuse) from sign to close needs to be shortened.
Finally, reliable data on post-closing stock performance is essential, he notes, to help investors decide which SPACs and targets will withstand the after market.

GAME PLAN

SPACs are trying to differentiate from the checkered past of blind pools, note William F. Griffin Jr. and Andrew D. Myers, shareholders with Davis, Malm & D'Agostine PC. There are investor protections: the aforementioned shareholder vote on acquisitions and cash-out option; management and frequently underwriters have skin in the game via stock and warrant purchase agreements and deferred fees, respectively; a relatively small amount of offering proceeds go toward working capital to consummate an acquisition.

So for a private equity investor, there are three ways to go about getting into the SPAC game, notes the SPAC lady herself, Tina Pappas, a managing director with boutique investment bank Morgan Joseph & Co.:

Sponsoring a SPAC as an issuer: PE firms that have done so include: MBF Healthcare Partners LP, Steel Partners, LLM Capital Partners LLC, Camden Partners Holdings LLC and GSC Group, while several others are in registration.
Exits for existing investments: 72 SPACs have more than $12.3 billion in capital looking for acquisitions. She calls a reverse merger one of the most compelling options.
Co-investing in a SPAC acquisition: In an arrangement where an existing consortium of SPACs just need some more cash to complete a transaction, a firm could come in and perhaps be entitled part of the founders' 20% ownership right and warranty options.

A DIFFERENT ANIMAL

And in a then-recent twist, Tenoiro noted in July:

SPACs have now tapped the Rule 144A [under which an issuer can offer a private sale of securities to qualified institutional buyers, or QIBs, without government oversight] market for privately issued, unregistered securities, which coincidentally is an increasingly popular alternative for private equity firms looking to go public.

It affords more flexibility, she writes, as QIBs are perceived as sophisticated institutional buyers who don't need the same protections as individual or smaller investors. They're not subject to the long SEC review process (drawn out to guard against potential abuses). And how many 144A SPACs there have been is hard to say, given that they're private placements, she writes. "Not surprisingly, sources say investors in these offerings are essentially the same community of hedge funds that invest in SPACs."

And after the IPO come the mergers. McDermott Will & Emery LLP's Joel L. Rubinstein and Dennis J. White weighed in on the nuances in September. Unsurprisingly, competition for the listings is fierce. As The Deal's Donna Block noted Feb. 21: Nasdaq's move to institute new listing standards for special purpose acquisition vehicles is an attempt to capture American Stock Exchange listings. - Carolyn Murph

Programmers free thyselves

2008-03-22T21:39:00.003+08:00

You weren't meant to have a boss
March 2008
http://www.paulgraham.com/boss.html

A few days ago I was sitting in a cafe in Palo Alto and a group of programmers came in on some kind of scavenger hunt. It was obviously one of those corporate "team-building" exercises.They looked familiar. I spend nearly all my time working with programmers in their twenties and early thirties. But something seemed wrong about these. There was something missing.And yet the company they worked for is considered a good one, and from what I overheard of their conversation, they seemed smart enough. In fact, they seemed to be from one of the more prestigious groups within the company.So why did it seem there was something odd about them?I have a uniquely warped perspective, because nearly all the programmers I know are startup founders. We've now funded 80 startups with a total of about 200 founders, nearly all of them programmers. I spend a lot of time with them, and not much with other programmers. So my mental image of a young programmer is a startup founder.The guys on the scavenger hunt looked like the programmers I was used to, but they were employees instead of founders. And it was startling how different they seemed.So what, you may say. So I happen to know a subset of programmers who are especially ambitious. Of course less ambitious people will seem different. But the difference between the programmers I saw in the cafe and the ones I was used to wasn't just a difference of degree. Something seemed wrong.I think it's not so much that there's something special about founders as that there's something missing in the lives of employees. I think startup founders, though statistically outliers, are actually living in a way that's more natural for humans.I was in Africa last year and saw a lot of animals in the wild that I'd only seen in zoos before. It was remarkable how different they seemed. Particularly lions. Lions in the wild seem about ten times more alive. They're like different animals. And seeing those guys on their scavenger hunt was like seeing lions in a zoo after spending several years watching them in the wild.TreesWhat's so unnatural about working for a big company? The root of the problem is that humans weren't meant to work in such large groups.Another thing you notice when you see animals in the wild is that each species thrives in groups of a certain size. A herd of impalas might have 100 adults; baboons maybe 20; lions rarely 10. Humans also seem designed to work in groups, and what I've read about hunter-gatherers accords with research on organizations and my own experience to suggest roughly what the ideal size is: groups of 8 work well; by 20 they're getting hard to manage; and a group of 50 is really unwieldy. [1]Whatever the upper limit is, we are clearly not meant to work in groups of several hundred. And yet—for reasons having more to do with technology than human nature—a great many people work for companies with hundreds or thousands of employees.Companies know groups that large wouldn't work, so they divide themselves into units small enough to work together. But to coordinate these they have to introduce something new: bosses.These smaller groups are always arranged in a tree structure. Your boss is the point where your group attaches to the tree. But when you use this trick for dividing a large group into smaller ones, something strange happens that I've never heard anyone mention explicitly. In the group one level up from yours, your boss represents your entire group. A group of 10 managers is not merely a group of 10 people working together in the usual way. It's really a group of groups. Which means for a group of 10 managers to work together as if they were simply a group of 10 individuals, the group working for each manager would have to work as if they were a single person—the workers and manager would each share only one person's worth of freedom between them.In practice a group of people never manage to act as if they were one person. But in a large organization divided into groups in this way, the pressure is always in that direction. Each group tries its best to work as if it were the small group of individuals that humans were designed to work in. That was the point of creating it. And when you propagate that constraint, the result is that each person gets freedom of action in inverse proportion to the size of the entire tree. [2]Anyone who's worked for a large organization has felt this. You can feel the difference between working for a company with 100 employees and one with 10,000, even if your group has only 10 people.Corn SyrupA group of 10 people within a large organization is a kind of fake tribe. The number of people you interact with is about right. But something is missing: individual initiative. Tribes of hunter-gatherers have more freedom. The leaders have a little more power than other members of the tribe, but they don't generally tell them what to do and when the way a boss can.It's not your boss's fault. The real problem is that in the group above you in the hierarchy, your entire group is one virtual person. Your boss is just the way that constraint is imparted to you.So working in a group of 10 people within a large organization feels both right and wrong at the same time. On the surface it feels like the kind of group you're meant to work in, but something major is missing. A job at a big company is like high fructose corn syrup: it has some of the qualities of things you're meant to like, but is disastrously lacking in others.Indeed, food is an excellent metaphor to explain what's wrong with the usual sort of job.For example, working for a big company is the default thing to do, at least for programmers. How bad could it be? Well, food shows that pretty clearly. If you were dropped at a random point in America today, nearly all the food around you would be bad for you. Humans were not designed to eat white flour, refined sugar, high fructose corn syrup, and hydrogenated vegetable oil. And yet if you analyzed the contents of the average grocery store you'd probably find these four ingredients accounted for most of the calories. "Normal" food is terribly bad for you. The only people who eat what humans were actually designed to eat are a few Birkenstock-wearing weirdos in Berkeley.If "normal" food is so bad for us, why is it so common? There are two main reasons. One is that it has more immediate appeal. You may feel lousy an hour after eating that pizza, but eating the first couple bites feels great. The other is economies of scale. Producing junk food scales; producing fresh vegetables doesn't. Which means (a) junk food can be very cheap, and (b) it's worth spending a lot to market it.If people have to choose between something that's cheap, heavily marketed, and appealing in the short term, and something that's expensive, obscure, and appealing in the long term, which do you think most will choose?It's the same with work. The average MIT graduate wants to work at Google or Microsoft, because it's a recognized brand, it's safe, and they'll get paid a good salary right away. It's the job equivalent of the pizza they had for lunch. The drawbacks will only become apparent later, and then only in a vague sense of malaise.And founders and early employees of startups, meanwhile, are like the Birkenstock-wearing weirdos of Berkeley: though a tiny minority of the population, they're the ones living as humans are meant to. In an artificial world, only extremists live naturally.ProgrammersThe restrictiveness of big company jobs is particularly hard on programmers, because the essence of programming is to build new things. Sales people make much the same pitches every day; support people answer much the same questions; but once you've written a piece of code you don't need to write it again. So a programmer working as programmers are meant to is always making new things. And when you're part of an organization whose structure gives each person freedom in inverse proportion to the size of the tree, you're going to face resistance when you do something new.This seems an inevitable consequence of bigness. It's true even in the smartest companies. I was talking recently to a founder who considered starting a startup right out of college, but went to work for Google instead because he thought he'd learn more there. He didn't learn as much as he expected. Programmers learn by doing, and most of the things he wanted to do, he couldn't—sometimes because the company wouldn't let him, but often because the company's code wouldn't let him. Between the drag of legacy code, the overhead of doing development in such a large organization, and the restrictions imposed by interfaces owned by other groups, he could only try a fraction of the things he would have liked to. He said he has learned much more in his own startup, despite the fact that he has to do all the company's errands as well as programming, because at least when he's programming he can do whatever he wants.An obstacle downstream propagates upstream. If you're not allowed to implement new ideas, you stop having them. And vice versa: when you can do whatever you want, you have more ideas about what to do. So working for yourself makes your brain more powerful in the same way a low-restriction exhaust system makes an engine more powerful.Working for yourself doesn't have to mean starting a startup, of course. But a programmer deciding between a regular job at a big company and their own startup is probably going to learn more doing the startup.You can adjust the amount of freedom you get by scaling the size of company you work for. If you start the company, you'll have the most freedom. If you become one of the first 10 employees you'll have almost as much freedom as the founders. Even a company with 100 people will feel different from one with 1000.Working for a small company doesn't ensure freedom. The tree structure of large organizations sets an upper bound on freedom, not a lower bound. The head of a small company may still choose to be a tyrant. The point is that a large organization is compelled by its structure to be one.ConsequencesThat has real consequences for both organizations and individuals. One is that companies will inevitably slow down as they grow larger, no matter how hard they try to keep their startup mojo. It's a consequence of the tree structure that every large organization is forced to adopt.Or rather, a large organization could only avoid slowing down if they avoided tree structure. And since human nature limits the size of group that can work together, the only way I can imagine for larger groups to avoid tree structure would be to have no structure: to have each group actually be independent, and to work together the way components of a market economy do.That might be worth exploring. I suspect there are already some highly partitionable businesses that lean this way. But I don't know any technology companies that have done it.There is one thing companies can do short of structuring themselves as sponges: they can stay small. If I'm right, then it really pays to keep a company as small as it can be at every stage. Particularly a technology company. Which means it's doubly important to hire the best people. Mediocre hires hurt you twice: they get less done, but they also make you big, because you need more of them to solve a given problem.For individuals the upshot is the same: aim small. It will always suck to work for large organizations, and the larger the organization, the more it will suck.In an essay I wrote a couple years ago I advised graduating seniors to work for a couple years for another company before starting their own. I'd modify that now. Work for another company if you want to, but only for a small one, and if you want to start your own startup, go ahead.The reason I suggested college graduates not start startups immediately was that I felt most would fail. And they will. But ambitious programmers are better off doing their own thing and failing than going to work at a big company. Certainly they'll learn more. They might even be better off financially. A lot of people in their early twenties get into debt, because their expenses grow even faster than the salary that seemed so high when they left school. At least if you start a startup and fail your net worth will be zero rather than negative. [3]We've now funded so many different types of founders that we have enough data to see patterns, and there seems to be no benefit from working for a big company. The people who've worked for a few years do seem better than the ones straight out of college, but only because they're that much older.The people who come to us from big companies often seem kind of conservative. It's hard to say how much is because big companies made them that way, and how much is the natural conservatism that made them work for the big companies in the first place. But certainly a large part of it is learned. I know because I've seen it burn off.Having seen that happen so many times is one of the things that convinces me that working for oneself, or at least for a small group, is the natural way for programmers to live. Founders arriving at Y Combinator often have the downtrodden air of refugees. Three months later they're transformed: they have so much more confidence that they seem as if they've grown several inches taller. [4] Strange as this sounds, they seem both more worried and happier at the same time. Which is exactly how I'd describe the way lions seem in the wild.Watching employees get transformed into founders makes it clear that the difference between the two is due mostly to environment—and in particular that the environment in big companies is toxic to programmers. In the first couple weeks of working on their own startup they seem to come to life, because finally they're working the way people are meant to.

Notes[1] When I talk about humans being meant or designed to live a certain way, I mean by evolution.[2] It's not only the leaves who suffer. The constraint propagates up as well as down. So managers are constrained too; instead of just doing things, they have to act through subordinates.[3] Do not finance your startup with credit cards. Financing a startup with debt is usually a stupid move, and credit card debt stupidest of all. Credit card debt is a bad idea, period. It is a trap set by evil companies for the desperate and the foolish.[4] The founders we fund used to be younger (initially we encouraged undergrads to apply), and the first couple times I saw this I used to wonder if they were actually getting physically taller.

Thanks to Trevor Blackwell, Ross Boucher, Aaron Iba, Abby Kirigin, Ivan Kirigin, Jessica Livingston, and Robert Morris for reading drafts of this.

Lower P/Es now may mean... lower P/Es in the future

2008-03-12T17:29:00.002+08:00

MARKET MOVER

Are Low P/Es A Valid Reason To Buy Stocks?

With Earnings Shaky And Inflation Climbing, More Declines Possible

By TOM LAURICELLA
March 10, 2008

(WSJ) With the economy showing clear signs of recession and the credit markets in turmoil, the floor under stock prices seems to be getting thinner. Here is another reason to worry: Stock prices aren't as cheap as they seem, and based on other periods when inflation was accelerating and the economy weak, the market can struggle for prolonged periods.

Some argue stocks are attractively priced after a 17% decline in the Standard & Poor's 500-stock index since October. Based on earnings forecasts for 2008 collected by Reuters Estimates, the S&P 500 is trading at 13.2 times projected earnings, compared with an average of 16.5 times going back to 1989, according to data compiled by Morgan Stanley.

Price-to-earnings ratios reflect the amount investors are willing to pay for future earnings. When these ratios fall below long-term trends, conventional wisdom is that stocks are cheap and it is time to buy.

Until 2000, investors feasted on the combination of rising P/E ratios and rising stock prices. At the end of the 1980-82 bear market, S&P stocks changed hands at a price-to-earnings ratio of 8.7, according to Morgan Stanley's data. In the next 17 years, the ratio moved higher, topping out just shy of 30 in the spring of 1999. During that time, when the S&P rose an average of about 17% a year, roughly one-third of returns on the S&P 500 were the result of rising P/E multiples, according to Ibbotson Associates.

That period also featured a long downtrend in inflation and interest rates, which generally lead directly to higher multiples. Now, inflation is quickening, and interest rates, while heading down, can't fall much further. This suggests an environment less conducive to rising stock multiples.

That was the case in the most recent bull market, when price-to-earnings multiples actually fell even as the market rose. When the bull market began in early October 2002, the S&P 500 had finished the previous month at a P/E ratio of 17.6 when measured against the previous 12 months earnings. This past September, just before the market began its descent, the ratio was 16.8.

It is a similar story when looking at expected earnings, the basis on which stocks currently look cheap. At the end of September 2002, the S&P 500 was priced at 14.5 times the coming 12 months expected earnings, according to Morgan Stanley. This past September, after a five-year run in which the S&P 500 rose an average of more than 15% a year, the P/E on the index was 14.8 times the coming year's expected earnings.

"The growth in stock returns came mostly from earnings growth," says Peng Chen, chief investment officer at Ibbotson Associates.

Morgan Stanley analysts contend that stubborn inflation means investors won't be willing to pay big premiums for future earnings. Goldman Sachs Group strategists say that based on typical declines in P/E ratios in the past four recessions, stock multiples can go much lower.

Nicholas Bohnsack, of Strategas Research Partners, says it is a mistake for investors to assume multiples will head higher. There have been extended periods in which multiples went down or were flat, most recently in the 1970s, he notes. Today, he says, "We're in a secular period of multiple contraction," which features lots of "sideways, grinding of multiples."

Part of the problem is that the earnings side of the equation is looking shaky. Wall Street analysts predict a double-digit increase in corporate profits for 2008, but forecasts have been pared back. As of Friday, S&P 500 stocks are expected to generate $98.25 in earnings a share this year, down from the $101.87 a share predicted at the end of last year, according to Reuters.

Analysts have taken an especially sharp knife to estimates of first-quarter earnings, which now are expected at $22.58 a share, compared with the $23.64 forecast at the end of December. That means instead of rising at a 5.1% rate, first-quarter earnings are expected to be basically flat.

Another problem is inflation. In a number of recent sessions, the stock market has reacted positively to higher commodity prices on the theory that it will boost profits of energy and materials companies. But if inflation stays stubbornly high despite the U.S. economic slowdown, it would be a negative for multiples, because it reduces the value of future earnings.

Abhijit Chakrabortti, Morgan Stanley's chief global and U.S. equity strategist, says inflation is running about 0.8 percentage point above the long-term trend of 3.5%, and value for the S&P 500 should be reduced by the same amount. With that factor taken into consideration, he argues that current fair value for the index is about 17 times trailing earnings, not much above its present reading.

Ed Easterling, president of Crestmont Research, argues that record increases in earnings and profit margins in recent years make prices look artificially cheap. He prefers to look at the 10-year trends in earnings, from which he removes the impact of inflation and smooths out the short-term ups and downs in profit margins. That, he contends, provides a cleaner picture of stock valuations.

Mark-to-market apologist defends regime

2008-03-12T17:26:00.002+08:00

The credit crunch

Mark it and weep

Mar 6th 2008
From The Economist print edition

Mark-to-market accounting hurts, but there is no better way

WITH memories of their drubbing in the dotcom bust still fresh, accountants have kept their noses clean in this financial crisis. Once again, though, they are being dragged into the fray. That is because they are enforcing fair-value accounting, in which assets must be marked regularly to the market price: that is, what they would be expected to fetch right now in a sale. Regulators and bankers fear that this “mark-to-market” approach is helping to turn a liquidity crisis into a solvency one. As holders of mortgage-backed securities and the like revalue their assets at fire-sale prices, they are running short of capital—which can lead to further sales and more write-downs. Are the beancounters ensuring a crash?

All accounting regimes are flawed, and fair-value is no exception. It is timely and transparent, but when markets collapse, prices become less reliable. How do you mark to market when there is barely any market? Some firms rely on credit-derivative indices, but these are far from perfect proxies (see article). Others cling to internal computer models, but their accountants are cracking down on them. Banks are also being asked by their auditors to put more assets into the fair-value regime's lowest bucket (for the most illiquid assets). This adds to their woes, since such assets carry a higher capital charge.

egulators worry that mark-to-market may create a “liquidity black hole”. Nerves jangle at every fire-sale, for fear that this will become the new benchmark for sticky assets. The fear is that value-at-risk systems force investment firms and banks to offload securities, leading to price falls and further sales. The temptation is to sell now, before the next lurch down. The result will be excessive write-downs—as the stable value of assets is above today's distressed level.

That is a damning list of failings. And yet, for all its pain, fair-value accounting is still the best way to value businesses. Especially if investors and regulators treat accounting rules sensibly: as a measuring stick, not a source of universal truth.

On that score the old system of historic-cost accounting was worse. In a crisis prices fall until bottom-fishers start to buy. Yet when assets were booked at their original price, rather than the market one, banks could delude themselves—and investors—that dross was gold. Under historic-cost accounting, the banks had every reason not to restructure assets, because that meant owning up to their losses. Look at Japan, where the economy was sunk for most of the 1990s by stagnant loans to “zombie” companies. Historic-cost left investors in the dark about valuations; it was also prone to fraud and fraught with moral hazard, since sloppy lending went unpunished.

The sticky end

Mark-to-market does not have to be as bad as its critics fear. Not everyone has gorged on toxic assets, and not everyone has to mark to market. This biodiversity means there will be buyers, even in the most strained markets, at the right price. Sovereign-wealth funds have poured money into troubled banks. This week PIMCO, a big fund manager, bought $1.5 billion of American municipal bonds, where yields have jumped as the crisis spread. Warren Buffett is also sniffing around.

The place for regulators to be subtle is not in reporting the figures, but in dealing with the problems they reveal. The task is to make markets resilient when the cycle turns. Central banks could offer more protection against crises in liquidity (see article). Thicker buffers could be built into the Basel II framework for bank capital. Securitised assets could be hauled from murky over-the-counter markets to exchanges, where values are clearer. Models for valuing complex securities will be refined. And regulators and accountants could ease up when banks risk a liquidity spiral—as in Europe in 2002, when insurers faced a solvency crisis over falling share prices.

It would be perverse to ignore market signals when finance is increasingly based on broad capital markets. Fair-value accounting is indeed flawed. To paraphrase Winston Churchill, it is the worst kind of accounting, except for all the others.

The credit fallout continues

2008-03-04T00:11:00.002+08:00

The Federal Reserve's rescue has failed
By Ambrose Evans-Pritchard, International Business Editor
Last Updated: 12:56am GMT 03/03/2008

(Telegraph) Yields on two-year US Treasuries plummeted to 1.63pc on Friday in a flight to safety, foretelling financial winter.

The debt markets are freezing ever deeper, a full eight months into the crunch. Contagion is spreading into the safest pockets of the US credit universe.

It is hard to imagine a more plain-vanilla outfit than the Port Authority of New York and New Jersey, which manages bridges, bus terminals, and airports.

The authority is a public body, backed by the two states. Yet it had to pay 20pc rates in February after the near closure of the $330bn (£166m) "term-auction" market. It had originally expected to pay 4.3pc, but that was aeons ago in financial time.

"I never thought I would see anything like this in my life," said James Steele, an HSBC economist in New York.

No sane mortal needs to know what term-auction means, except that it too became a tool of the US credit alchemists. Banks briefly used the market as laboratory for conjuring long-term loans at Alan Greenspan's giveaway short-term rates. It has come unstuck. Next in line is the $45trillion derivatives market for credit default swaps (CDS).

Last week, the spreads on high-yield US bonds vaulted to 718 basis points. The iTraxx Crossover index measuring corporate default risk in Europe smashed the 600 barrier. We are now far beyond the August spike.

Sub-prime debt is plumbing new depths. A-rated securities issued in early 2007 fell to a record 12.72pc of face value on Friday. The BBB tier fetched 10.42pc. The "toxic" tranches are worthless.

Why won't it end? Because US house prices are in free fall. The Case-Shiller index for the 20 biggest cities dropped 9.1pc year-on-year in December. The annualised rate of fall was 18pc in the fourth quarter, and gathering speed.

As the graph shows below, US households are only halfway through the tsunami of rate resets - 300 basis points upwards - on teaser loans.
The UK hedge fund Peleton Partners misjudged this fresh leg of the crunch. After an 87pc profit last year betting against sub-prime, it switched sides to play the rebound. Last week it had to liquidate a $2bn fund.

Like many, Peleton thought Fed rate cuts from 5.25pc to 3pc (with more to come) would end the panic. But this is not a normal downturn, subject to normal recovery. Leverage is too extreme. Bank capital is too eroded. Monetary traction eludes the Fed. An "Austrian" purge is under way.

Credit Suisse says the cost of the credit debacle will reach $600bn. "Leveraged risk is a cancer in this market."

Try $1trillion, says New York professor Nouriel Roubin. Contagion is moving up the ladder to prime mortgages, commercial property, home equity loans, car loans, credit cards and student loans. We have not even begun Wave Two: the British, Club Med, East European, and Antipodean house busts.

As the once unthinkable unfolds, the leaders of global finance dither. The Europeans are frozen in the headlights: trembling before a false inflation; cowed by an atavistic Bundesbank; waiting passively for the Atlantic storm to hit.

Half the eurozone is grinding to a halt. Italy is slipping into recession. Property prices are flat or falling in Ireland, Spain, France, southern Italy and now Germany. French consumer moral is the lowest in 20 years.

The euro fetches $1.52 (from $0.82 in 2000), beyond the pain threshold for aircraft, cars, luxury goods and textiles. The manufacturing base of southern Europe is largely below water. As Le Figaro wrote last week, the survival of monetary union is in doubt. Yet still, the ECB waits; still the German-bloc governors breathe fire about inflation.

The Fed is now singing from a different hymn book, warning of the "possibility of some very unfavourable outcomes". Inflation is not one of them.

"There probably will be some bank failures," said Ben Bernanke. He knows perfectly well that the US price spike is a bogus scare, the tail-end of a food and fuel shock.

"I expect inflation to come down. I don't think we're anywhere near the situation in the 1970s," he told Congress.

Indeed not. Real wages are being squeezed. Oil and "Ags" are acting as a tax. December unemployment jumped at the fastest rate in a quarter century.

The greater risk is slump, says MIT Professor Paul Krugman. "The Fed is studying the Japanese experience with zero rates very closely. The problem is that if they want to cut rates as aggressively as they did in the early 1990s and 2001, they have to go below zero."

This means "quantitative easing" as it was called in Japan. As Ben Bernanke spelled out in November 2002, the Fed can inject money by purchasing great chunks of the bond market.

Section 13 of the Federal Reserve Act allows the bank - in "exigent circumstances" - to lend money to anybody, and take upon itself the credit risk. It has not done so since the 1930s.

Ultimately the big guns have the means to stop descent into an economic Ice Age. But will they act in time?

"We are becoming increasingly concerned that the authorities in the world do not get it," said Bernard Connolly, global strategist at Banque AIG.

"The extent of de-leveraging involves a wholesale destruction of credit. The risk is that the 'shadow banking system' completely collapses," he said.

For the first time since this Greek tragedy began, I am now really frightened.

Rare display of introspection in structured finance

2008-02-20T10:52:00.003+08:00

Securitisation

Fear and loathing, and a hint of hope

Feb 14th 2008 LAS VEGAS
From The Economist print edition

Not all is lost for the structured-finance business. But it faces further discomfort before it can start to recover some of its past sheen

AS GAGS go, it was cheap. But irresistible. As a banker from Citigroup placed his chips on the roulette table, a watching wise-guy sniggered: “There goes another $15 billion.”

Even though it was held (as usual) in Las Vegas, this year's conference of the American Securitisation Forum (ASF), between February 3rd and 6th, was a subdued affair. First staged only in 2004, the event has become a mecca for those whose job it is to spin mortgages, credit-card debt and other bread-and-butter financial assets into tradable securities. But this time attendance was down—and tension up, as the neck-masseuses in the exhibit hall could attest. Black humour and self-deprecation replaced the self-congratulation of past years. John Devaney, a hedge-fund manager who had to sell his 142-foot yacht, Positive Carry, and his Gulfstream IV after making bad bets on mortgage bonds, told an audience: “I'd like to thank the market for dealing me a direct hit. As a trader if you don't get sucker-punched every once in a while, you don't understand what risk is.”

You might suppose that meeting in America's gambling capital would provide symbolism enough. But the conference Super Bowl party had plenty more. It was hosted by Countrywide, a big, troubled mortgage lender that has had to fall on the charity of Bank of America. And, as the guests digested the dramatic ending of the New England Patriots' long winning streak by the New York Giants, they may have sensed an uncomfortable parallel. After a quarter-century of growth that turned structured finance from a capital-market cog into an engine of growth, their business has been buckled by the crash in subprime mortgages and the successive blows throughout credit markets. Worse, some blame securitisation for causing the pile-up in the first place.

The limits of gonzo finance

Securitisation has greatly enhanced the secondary market for loans, giving originators, mainly banks, more balance-sheet flexibility and investors of all sorts greater access to credit risk. Both have embraced it. By 2006 the volume of outstanding securitised loans had reached $28 trillion (see chart 1). Last year three-fifths of America's mortgages and one-quarter of consumer debt were bundled up and sold on.

Along the way, banks cooked up a simmering alphabet soup. The ingredients included collateralised-debt obligations (CDOs), which repackage asset-backed securities, and collateralised-loan obligations (CLOs), which do the same for corporate loans, as well as structured investment vehicles (SIVs) and conduits, which banks used to keep some of their exposure off their balance sheets.

The breakneck growth of this business went into reverse last summer, when it became clear that defaults would undermine the structures built around America's mortgage markets. So tarnished has the subprime-mortgage market become, because of shoddy loan underwriting and fraud, that investors are likely to shun securities linked to it for months if not years. Securitisation of better-quality “jumbo” mortgages—too big to be bought by government agencies—is also at a near-halt. “Mortgages were traditionally seen as very safe assets. Now all but the very best are stamped with a skull and crossbones,” says Guy Cecala, of Inside Mortgage Finance, a newsletter.

CDOs are unlikely to regain a following in a hurry (see chart 2). Still less popular are CDO-squareds (resliced and repackaged CDOs) and higher powers. CLOs have also been battered as the leveraged loans they are linked to have tumbled in value. However, their collateral is sounder than that backing subprime CDOs, being based on company financials rather than the blandishments of mortgage brokers.

The prospects for SIVs are bleaker still. SIVs borrow short-term to invest in long-dated assets; and investors will no longer tolerate such mismatches in vehicles shielded from standard banking regulation. With the disappearance of the SIVs' funding sources, notably asset-backed commercial paper, banks had to bring over $136 billion-worth onto their books. That comes on top of over $160 billion, so far, of subprime-related write-downs, over a third of which has come at three banks: Citigroup, Merrill Lynch and UBS.

Though few bankers worked in structured finance, it was a huge earner, accounting for 20-30% of big investment banks' profits before the crisis, according to CreditSights, a financial-research firm. Banks such as Bear Stearns, Lehman Brothers and Morgan Stanley, which bought or built mortgage-origination businesses to fuel the securitisation machine, have rushed to close or pare them. Merrill, whose fees from CDOs alone peaked at $700m in 2006, said recently that it would stop packaging mortgages altogether.

Alongside the banks, the “gatekeepers” who were supposed to lend stability and credibility to the new originate-and-distribute model of finance have also been found wanting. Rating agencies' models underplayed the risk that loans from different lenders and regions could turn sour at the same time. Bond insurers, too, misjudged the risks lurking in CDOs. That failing has undermined the worth of their guarantees and strained their own credit ratings—and hence financial markets.

George Miller, the ASF's executive director, accepts that this crisis of confidence will lead to a degree of “re-intermediation” for a time, as some banks go back to balance-sheet lending. But he insists that it highlights the dangers of lax lending standards in a particular market rather than fundamental faults in securitisation itself.

A study by NERA, an economic consultancy, commissioned by the ASF before the crunch, offers some support for this view. Preliminary results, based on data from 1990 to 2006, suggest that increased securitisation leads to lower spreads in consumer credit and softens interest-rate shocks for banks, especially smaller ones. On the other hand, in a recent paper two economists at the University of Chicago's business school conclude that securitisation encouraged mortgage originators to lend to dodgy borrowers.

Stresses and strains

What is not in doubt is that the subprime crisis has exposed four deep flaws in the practice of securitisation. The first is that by severing the link between those who scrutinise borrowers and those who take the hit when they default, securitisation has fostered a lack of accountability.

A debate has been rumbling over how to ensure that lenders have more “skin in the game”. Some think they should set aside a sliver of capital even for loans they sell on. Andrew Davidson, a structured-finance consultant, suggests an “origination certificate”, guaranteeing the quality of the underwriting, issued by the lender and broker, which stays with the loan. Alex Pollock of the American Enterprise Institute thinks that securitisers should be required to guarantee the quality of their loan pools, as are America's government-sponsored mortgage giants, Fannie Mae and Freddie Mac. Others counter that most such exposures can be neutralised these days through derivatives markets.

The second flaw is the sheer lack of understanding of some instruments. Not long ago investors took too much on trust. They are now clamouring for more “transparency”. Some want a central trade-quoting facility for lumpy asset-backed products: regulators have approached the New York Stock Exchange. CME Group, which runs the world's largest futures exchange, is also looking to expand its clearing of over-the-counter securities.

Yet reams of information already accompany mortgage-backed securities sold in public markets. Even SIVs provide a steadier stream of data to investors than most of the banks backing them. So some interpret calls for greater disclosure as whimpering by investors who did not do their homework.

However, more information about the performance of loans after origination would help, particularly those in leveraged structures such as CDOs. This opens up opportunities: fewer banks were at the ASF conference this year, but more data-analytics firms turned up. Clayton, the largest mortgage-surveillance company, unveiled a partnership with Experian, an information-services firm, that will help mortgage-servicers to package subprime loans for modification under a plan backed by the ASF and America's Treasury. Later, it hopes to offer a swathe of data to buyers of structured products.

Understanding the underlying assets is, or should be, at the core of securitisation. Securitisation is really an arbitrage: with surplus collateral, assets can be bundled into an entity with a supercharged credit rating. But if investors fail to spot the jiggery-pokery with credit scores and the outright fraud that permeated the subprime market, that cushion of safety quickly disappears. Witness the speed with which losses have spread into supposedly safe, “super senior” tranches of CDOs.

This points to the third flaw: that some securities were poorly structured, often because their risks were not fully understood. The upper layers of a well-designed securitisation vehicle should be all but impervious to loss. But poorly structured deals, like those stuffed with subprime and marginally less iffy “Alt-A” loans in 2006 and early 2007, have crumbled as the weakness of the collateral becomes clear.

The fourth flaw was the market's over-reliance on ratings as a short cut to assessing risk. In the go-go years, people wrongly assumed that an AAA-rated mortgage bond—even one with a high yield—would never lose value. But the rating agencies, paid for their appraisals by the seller not the buyer, were compromised from the start. Moreover, their quantitative models appear to have ignored “fat-tail” risks—the possibility that large losses are likelier than standard statistical models predict.

Though the agencies do not have to suffer giant write-downs, they have paid a high price. Before the market imploded, almost half the revenue of Moody's, a leading agency, came from structured finance. Now the agencies are revising their rating criteria in a bid to head off tougher regulation. “Either deals get less complex or we have to find a better shorthand for measuring risk,” says Ron Borod of Brown Rudnick, a law firm. The rating agencies say they were never supposed to substitute for investors' own due diligence. That is disingenuous, given their past self-assuredness. Still, wise investors will take future ratings with a pinch of salt, as most hedge funds have long done.

As the market grapples with change, some is likely to be imposed from above. Separately, international regulators and the President's Working Group (comprising America's Treasury, the Federal Reserve and others) are looking into securitisation's part in the crisis. By co-operating over loan modifications, the ASF may have gained favour with the working group.

The industry is more worried about two bills in America's Congress. Securitisers can live with much of the one that has been passed by the House of Representatives. What alarms them is an “assignee liability” provision that would hold them partly responsible for lax lending by originators. This, they say, would send a chill through secondary markets, cutting credit to thousands of worthy borrowers. Precedent is on their side. Georgia introduced assignee liability, only to back-pedal after the state's subprime market started to seize up. Not all bankers are against it: in Las Vegas, Bianca Russo of JPMorgan Chase argued that some form of it was needed to counter the perception, if not the reality, that securitisation was harmful.

The other bill would allow bankruptcy judges to alter the terms of struggling borrowers' mortgages. The industry argues that this would be an intolerable violation of the sanctity of loan-pooling contracts. In addition, securitisers face probes by several state attorneys-general, the Internal Revenue Service, the Federal Bureau of Investigation, the Securities and Exchange Commission and the Justice Department, as well as lawsuits from investors and a rising number of stricken municipalities.

Bankers will tell you that the subprime meltdown was just that: the product of irresponsible lending to, and borrowing by, flaky consumers, not a broader crisis of securitisation. Maybe, but the severity of the credit crunch points to broader pain ahead. More will come from housing: much of the 30-40% of American home-equity loans that have been securitised looks wobbly, as does a growing chunk of the $800 billion of Alt-A paper outstanding. Loans for offices are an even bigger worry. The spread on the AAA tranche of an index tracking bonds backed by commercial mortgages has tripled since the turn of the year. New issuance is frozen.

Trouble is also brewing for securities tied to non-mortgage consumer assets, such as credit-card debt, car loans and student loans, which make up a good slice of the asset-backed market (see chart 3). Credit-card delinquencies are creeping up as the economy turns down. The sharp slowdown in card borrowing, reported recently by the Fed, will mean less raw material for securitisation. Standards for car loans dropped in 2006-07, though not as dramatically as they did for mortgages.

One ominous sign is that structured instruments tied to student loans are coming unstuck, although the loans typically carry a federal guarantee. Recent auctions of such securities by Citigroup, Goldman Sachs and others have failed. Normally the banks would have bought in whatever did not sell. But they have declined, because they dare not cram even more assets onto their already strained balance sheets.

Yet securities of these types should be more resilient than those tied to subprime loans. Their structures are tried and tested, having evolved, along with performance data in their markets, over many years. In contrast, subprime mortgages with only a short record were shoved into many-layered structures that depended on house prices holding up. “They started from the other end entirely, asking how can we create CDOs, backed by mortgage-backed securities, themselves backed by collateral with barely any history, and their stress tests assumed house prices would be stable and the loans in the pools uncorrelated,” says Mr Borod.

Encouragingly, credit-card receivables are still being bundled and sold. There are even shoots of hope in the mortgage market, thanks to a refinancing mini-boom in the wake of interest-rate cuts—though most new deals are backed by the giant agencies, Fannie Mae and Freddie Mac, not Wall Street (see chart 4).

Saunter down the strip

It is also worth remembering that securitisation has not been confined to consumer and corporate loans. In the past decade financial engineers have found ways to package and sell tobacco-settlement and mutual-fund fees, sports and fast-food franchise rights, life-insurance premiums, intellectual property, music royalties and much more. Hollywood studios use securitisation to help finance film-making. With intangible assets accounting for an ever-growing share of corporate value, this trend looks likely to continue.

That may be scant consolation to the banks whose bets have gone so spectacularly wrong. Their fingers are still being singed by mortgage-backed securities and CDOs that continue to burn. Those hoping for a recovery face a long wait, maybe 18 months or more for out-of-favour collateral such as non-agency mortgages. Some once-enthusiastic cheerleaders are turning gloomy: Bear Stearns said recently that its net short position on subprime loans and bonds had risen to $1 billion. Others are redeploying staff and capital to fee businesses that don't put a strain on the balance sheet, such as merger advice.

But it would be a mistake to write the obituary of structured finance. Even its sternest critics accept that securitisation has brought real economic benefits, and that it would be wrong to throw away the whole barrel because of a few subprime apples. Some students of financial innovation think the market will come back even more inventive after scorching its less attractive pastures. “As with past forest fires in the markets, we're likely to see incredible flora and fauna springing up in its wake,” says Andrew Lo, director of the Massachusetts Institute of Technology's Laboratory for Financial Engineering.

So it may just be a matter of hanging on. As any punter in Las Vegas will tell you, every losing streak ends eventually, if you can only stay solvent for long enough.

Should we worry about heavy borrowing from TAF?

2008-02-11T13:44:00.000+08:00

How Non-Borrowed Reserves Became a Sexy Subject: Caroline Baum

Commentary by Caroline Baum

Feb. 8 (Bloomberg) -- Technically insolvent! This has never happened before! Without the Temporary Auction Facility, where would banks be?

When I got the fifth hysterical e-mail on the subject of -- sit down -- the decline in banks' non-borrowed reserves, I thought I was back in the Volcker era.

That would be Paul Volcker, chairman of the Federal Reserve from 1979 to 1987. Volcker knew interest rates had to rise significantly to slay the inflation dragon; he didn't know by how much. So he changed the Fed's operating procedure from targeting a price (the overnight interbank lending rate) to a quantity (the monetary aggregates -- specifically non-borrowed reserves).

``There is no relationship between non-borrowed reserves and anything the Fed cares about, be it inflation, employment or real GDP,'' said Paul Kasriel, chief economist at the Northern Trust Corp. in Chicago.

He said that 20 years ago, when I was just starting out, but I still remember his exact words. They came back to me when I learned of the latest obsession with this irrelevant statistic.

A few basics are in order. I promise not to make this too geeky.

Banks are required to keep a certain amount of funds in reserve -- as vault cash or on deposit at the Fed -- to meet unexpected deposit outflows. These are called required reserves (catchy, isn't it?). Sometimes depository institutions elect to hold more than is required. These are called excess reserves.

Sources and Uses

Congratulations. You have just completed the introductory course in the uses of reserves. What about the sources?

Reserves can be borrowed (from the Fed's discount window) or non-borrowed (supplied via the Fed's daily open market operations). It matters not one whit to the Fed where the banks acquire the reserves they require. If they borrow directly from the Fed, they don't need to tap the interbank, or fed funds, market.

What's caused the hullabaloo recently is the dive in non- borrowed reserves from $44 billion in early December to minus $8.8 billion at the end of January.

It isn't a mystery what happened. The Fed announced the creation of a Term Auction Facility on Dec. 12, enabling banks to borrow for 28 days versus a wide range of collateral. The minimum bid the Fed accepts is the expected funds rate one month out, which in the current environment means cheaper funding costs than the fed funds market.

So what would you do if you were a bank?

Lower Cost

Loans made through the TAF are categorized as borrowed reserves. The Fed had $50 billion of loans in place at the end of January, which ``caused the borrowed reserves figure to balloon and the non-borrowed figure to decline by a corresponding amount,'' said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey, in a Feb. 6 commentary. (He's on the same e-mail lists I am.)

All of a sudden, people who never glanced at the Fed's H.3 statistical release are now experts on ``Aggregate Reserves of Depository Institutions and the Monetary Base.'' Their e-mails have the same sense of foreboding as the missives put out by the Black Helicopter/Tin-Foil Hat crowd.

``What if the Fed's rate cuts aren't motivated by the desire to stave off recession, rather to prevent a major banking crisis?'' one e-mail read. ``The Fed's not telling anyone what it's up to because it doesn't want to cause panic, but the evidence is there in its own data.'' (Gosh, you'd think it would do a better job of hiding it. Maybe send H.3 to join M3!)

Monopolist Provider

The writer of the e-mail directs his readers to the most recent H.3 report, which shows total reserves ($41.6 billion) less TAF credit ($50 billion) less discount window borrowings ($390 million) equals non-borrowed reserves (minus $8.8 billion). The negative number is really an accounting quirk: If banks borrow more than they need, non-borrowed reserves are a negative number.

This gentleman is overlooking the fact that the Fed is ``a monopoly provider of reserves,'' said Jim Glassman, senior U.S. economist at JPMorgan Chase & Co. ``This is a non-starter. There is no such thing as a banking system short of reserves. The Fed has absolute control over the supply.''

There may be times, such as late last year, when banks are reluctant to lend to one another for a period longer than overnight. ``And any one bank can have a problem'' funding itself, Glassman said. But in a world where ``the Fed can print money, there is no shortage,'' he said. ``The banks get the reserves they want.''

Low Priority Worry

Those hyperventilating over TAF borrowing may want to consider an alternate scenario.

``Suppose the Fed cut the discount rate so that it stood below the funds rate,'' Kasriel said. (He said this yesterday, not two decades ago.) ``Would these folks be upset if banks went to the discount window for funds? What's the difference? It's a difference without a distinction.''

In a commentary this week, Goldman Sachs Group Inc. senior economist Andrew Tilton dismissed the case of the disappearing non-borrowed reserves as ``evidence of the markets' obsession with the health of the financial system.''

Some of the concern is justified, he said, given banks' massive losses and writedowns on subprime loans.

Of all the things to worry about right now, this isn't one of them.

Asset inflation and its place in US economic policy

2008-02-11T13:11:00.000+08:00

The debt delusion

The US economy relies upon asset price inflation and rising indebtedness to fuel growth - and this contradiction has global implications

By Thomas Palley

(Guardian) A second big American interest-rate cut in a fortnight, alongside an economic stimulus plan that united Republicans and Democrats, demonstrates that US policymakers are keen to head off a recession that looks like the consequence of rising mortgage defaults and falling home prices. But there is a deeper problem that has been overlooked: the US economy relies upon asset price inflation and rising indebtedness to fuel growth.

Therein lies a profound contradiction. On one hand, policy must fuel asset bubbles to keep the economy growing. On the other hand, such bubbles inevitably create financial crises when they eventually implode.

This is a contradiction with global implications. Many countries have relied for growth on US consumer spending and investments in outsourcing to supply those consumers. If America's bubble economy is now tapped out, global growth will slow sharply. It is not clear that other countries have the will or capacity to develop alternative engines of growth.

America's economic contradictions are part of a new business cycle that has emerged since 1980. The business cycles of presidents Ronald Reagan, George Bush Sr, Bill Clinton, and George Bush share strong similarities and are different from pre-1980 cycles. The similarities are large trade deficits, manufacturing job loss, asset price inflation, rising debt-to-income ratios, and detachment of wages from productivity growth.

The new cycle rests on financial booms and cheap imports. Financial booms provide collateral that supports debt-financed spending. Borrowing is also supported by an easing of credit standards and new financial products that increase leverage and widen the range of assets that can be borrowed against. Cheap imports ameliorate the effects of wage stagnation.

This structure contrasts with the pre-1980 business cycle, which rested on wage growth tied to productivity growth and full employment. Wage growth, rather than borrowing and financial booms, fuelled demand growth. That encouraged investment spending, which in turn drove productivity gains and output growth.

The differences between the new and old cycle are starkly revealed in attitudes toward the trade deficit. Previously, trade deficits were viewed as a serious problem, being a leakage of demand that undermined employment and output. Since 1980, trade deficits have been dismissed as the outcome of free-market choices. Moreover, the Federal Reserve has viewed trade deficits as a helpful brake on inflation, while politicians now view them as a way to buy off consumers afflicted by wage stagnation.

The new business cycle also embeds a monetary policy that replaces concern with real wages with a focus on asset prices. Whereas pre-1980 monetary policy tacitly aimed at putting a floor under labour markets to preserve employment and wages, it now tacitly puts a floor under asset prices. This is not a matter of the Fed bailing out investors. Rather, the economy has become so vulnerable to declines in asset prices that the Fed is obliged to intervene to prevent them from inflicting broad damage.

All these features have been present in the current economic expansion. Wages have stagnated despite strong productivity growth, while the trade deficit has set new records. Manufacturing has lost 1.8m jobs. Prior to 1980, manufacturing employment increased during every expansion and always exceeded the previous peak level. Between 1980 and 2000, manufacturing employment continued to grow in expansions, but each time it failed to recover the previous peak. This time, manufacturing employment has actually fallen during the expansion, something unprecedented in American history.

The essential role of asset inflation has been especially visible as a result of the housing bubble, which also highlights the role of monetary policy. Despite the massive tax cuts of 2001 and the increase in military and security spending, the US experienced a prolonged jobless recovery. That compelled the Fed to keep interest rates at historic lows for an extended period, and rates were raised only gradually because of fears about the recovery's fragility.

Low interest rates eventually jump-started the expansion through a house price bubble that supported a debt-financed consumer-spending binge and triggered a construction boom. Meanwhile, prolonged low interest rates contributed to a "chase for yield" in the financial sector that resulted in disregard of credit risk.

In this way, the Fed contributed to creating the sub-prime crisis. However, in the Fed's defence, low interest rates were needed to maintain the expansion. In effect, the new cycle locks the Fed into an unstable stance whereby it must prevent asset price declines to avert recession, yet must also promote asset bubbles to sustain expansions.

So, even if the Fed and US treasury now manage to stave off recession, what will fuel future growth? With debt burdens elevated and housing prices significantly above levels warranted by their historical relation to income, the business cycle of the last two decades appears exhausted.

It is not enough to deal only with the crisis of the day. Policy must also chart a stable long-term course, which implies the need to reconsider the paradigm of the past 25 years. That means ending trade deficits that drain spending and jobs, and restoring the link between wages and productivity. That way, wage income, not debt and asset price inflation, can again provide the engine of demand growth.

Exxon returns favour to Hugo Chavez - Sovereign debt swings towards distress

2008-02-09T03:52:00.000+08:00

Exxon Venezuela asset freeze new blow to Chavez
Fri Feb 8, 2008 12:12am GMT

By Brian Ellsworth
CARACAS (Reuters) - Exxon Mobil's move to freeze billions of dollars of Venezuelan oil assets around the globe adds new complications to President Hugo Chavez's crusade toward socialism, which is already facing growing obstacles.

Fresh off a 2007 nationalization drive that led to a takeover of a large Exxon oil project in Venezuela, the leftist leader is struggling with the fallout over a December poll defeat, growing economic problems and discontent among supporters.

Chavez faces a potentially huge legal battle with one of the world's largest companies after Exxon's gambit, which freezes some of Venezuela's cash and blocks it from selling billions of dollars worth of assets.

But paying a settlement to the Texas energy giant could mean sacrificing millions of dollars needed for the social programs and suffering a humiliating defeat to a transnational company the anti-U.S. leader has described as "imperialist."

News of the court ruling prompted a sell-off of Venezuelan debt.

"It makes the actions you took a year ago fairly pricey," said Dino Barajas, an expert in energy law at Paul, Hastings, Janofsky & Walker LLP.

Exxon (XOM.N: Quote, Profile, Research) court filings revealed on Thursday show the company won rulings preventing Venezuelan state oil company PDVSA from selling assets such as refineries while also preventing Venezuela from withdrawing more than $300 million in cash from a U.S. bank account.

It was unclear exactly what the impact would be on the day-to-day operations of PDVSA, which critics say is weakened by government's demands it work on social projects, road repairs and food imports.

"Nobody really knows what is the real reach of these decisions, but it doesn't look good for PDVSA, or for the country, which depends on the company for everything, even importing food," said one Venezuelan investor, who asked not to be named.

Chavez launched a broad energy sector nationalization campaign in 2007 as part of a drive to create a socialist society.

Exxon is suing Venezuela for its takeover of the multibillion-dollar Cerro Negro heavy oil project, arguing the OPEC nation violated its contract and illegally snatched complete control.

Venezuela's Information Ministry said it could not comment on the information.

The news comes only months after Chavez lost a referendum that would have let him run indefinitely for re-election. He is now facing growing criticism over nagging shortages of basic groceries like milk and chicken.

The leftist government is also seeing a growing cash flow crunch at PDVSA, which finances the social programs that keep Chavez popular among the nation's majority poor.

A new obligation to pay billions of dollars in compensation to Exxon would put further strain on the finances of the company, which saw its debt rise by $13 billion in 2007 to reach $16 billion -- largely driven by the nationalization crusade.

Court papers suggest the move came as a surprise to PDVSA.

In the court documents, PDVSA's law firm complained that Exxon's lawyers had been "feigning continued cooperation in good faith while another law firm was working behind the scenes preparing this attachment."

(Additional reporting by Ana Isabel Martinez and Frank Jack Daniel; Editing by Christian Wiessner)

SPAC's rise with fall of LBO financing

2008-01-08T10:23:00.000+08:00

Wall Street Peddles Blank-Check IPOs as Returns Trail S&P 500

By Elizabeth Hester

Jan. 7 (Bloomberg) -- Special-purpose acquisition vehicles, companies with no product, earnings or sales that make takeovers, are Wall Street's growing source of fees now that the market for subprime-mortgage securities has dried up.

The trouble is that investors who have spent $18 billion since 2003 on U.S. initial public offerings by such shell companies would have been better off holding a mutual fund that tracks the Standard & Poor's 500 Index.

While some special-purpose acquisition companies do rise, such as the 98 percent gain last year by the units of Nicolas Berggruen's GLG Partners Inc., the average annual return of the past five years has been 5.8 percent, according to SPAC Analytics, a Turks & Caicos-based independent research service. The S&P 500 advanced 13 percent annually in the same period.

``It seems as if everybody is raising a SPAC,'' David Rubenstein, co-founder of the Washington-based private-equity firm Carlyle Group, said last month at an industry conference in Dubai. ``The jury is still out as to whether these are good things other than for the investment bankers who raise them.''

The securities industry raised $11.7 billion last year for the special-purpose acquisition companies, an almost fourfold increase from 2006, data compiled by Bloomberg show. Billionaire dealmakers Ronald Perelman and Nelson Peltz plan to bring in a combined $1.25 billion before the end of March with SPACs.

Hicks Sale

The surge in SPACs coincides with a decline in leveraged buyouts. LBOs all but disappeared in the second half of 2007 as borrowing costs almost doubled from June to December, Merrill Lynch & Co. data show. U.S. buyouts fell to $103.2 billion in the second half from $322.4 billion in the first six months of the year as the subprime-mortgage market collapsed.

SPACs sell units, usually one share of common stock and one warrant, and use the money to buy a closely held company. They were dubbed blank-check companies because they don't disclose their targets before the IPO. Any takeover must be approved by at least 70 percent of the SPAC's shareholders. If a purchase isn't completed within a set time, usually two years, the money is returned to investors, minus incurred operating costs.

Thomas Hicks, the leveraged buyout pioneer and owner of the Texas Rangers of Major League Baseball, raised $552 million for Hicks Acquisition Co. I in September.

``I plan to use the vehicle to try to build three or four or five significant companies over the next five to 10 years because it's permanent capital,'' Hicks, 61, said in an interview from his office at Hicks Holdings LLC in Dallas. ``Once you make an acquisition, that entity has the ability to continue growing both internally and by acquisitions because it will be very lightly leveraged compared to leveraged buyouts.''

Sluggish Performance

Hicks Acquisition has declined 1 percent in American Stock Exchange composite trading since the IPO. Hicks Acquisition has yet to announce a takeover.

SPAC shares often languish until a deal is disclosed. Returns for blank-check companies that have announced but not completed a purchase have averaged 14.6 percent a year, while those still looking have gained 4.6 percent, according to SPAC Analytics.

After a purchase, the shares trade on the fundamentals of the operating company such as earnings and sales growth. SPACs that have completed their initial transaction rose by an average of 3.7 percent a year.

Services Acquisition Corp. International, sponsored by former Blockbuster Inc. Chief Executive Officer Steven Berrard, raised $138 million in June 2005 in an IPO underwritten by Broadband Capital Management LLC. In March 2006, the SPAC said it would buy juice-smoothie retailer Jamba Juice Co.

Bankers' Fees

Services Acquisition climbed 56 percent from the announcement until the closing date the following November. Since the deal was completed, San Francisco-based Jamba's shares have dropped 77 percent amid rising costs and sales that fell short of forecasts.

Wall Street earned more than $770 million by selling shares of 64 SPACs last year, up from 36 offerings in 2006. The fees helped securities firms offset a 1.2 percent decline in revenue from conventional IPOs, data compiled by Bloomberg show. Underwriting also puts banks in line for advisory business when SPAC clients are ready to pursue takeovers.

Citigroup Inc., the largest U.S. bank by assets, managed its first SPAC IPO in 2005 and ranked No. 1 last year among blank-check underwriters, Bloomberg data show. The New York- based firm earned $302.8 million in fees, ahead of second-ranked Deutsche Bank AG's $92 million. Deutsche Bank is based in Frankfurt.

`Cash Vehicle'

Citigroup probably will report a fourth-quarter loss of $4.2 billion, or 83 cents a share, after writedowns of subprime- related securities, according to a survey of 17 analysts by Bloomberg.

Morgan Stanley, the second-biggest securities firm by market value after Goldman Sachs Group Inc., and No. 5 Bear Stearns Cos. also reported losses during the worst U.S. housing slump since the 1991 recession. All the companies are based in New York.

Citigroup's SPAC clients include Hicks; Jonathan Ledecky, the former CEO of Washington-based U.S. Office Products Co.; and former hedge-fund manager Berggruen.

Berggruen, 46, raised more than $1 billion in the IPO of Liberty Acquisition, the largest SPAC to date. His previous SPAC, the $528 million Freedom Acquisition Holdings Inc., took New York-based hedge-fund manager GLG Partners public on Nov. 2. GLG units rose 31 percent since the deal was announced in June.

``We felt in this environment that having a cash vehicle would really give us a competitive advantage,'' said Jared Bluestein, chief financial officer of New York-based Berggruen Holdings Ltd. ``The ability to do deals without a high degree of leverage will always be an attractive opportunity for both buyers and sellers.''

Blank Checks

Fees for underwriting SPACs are 6.6 percent of assets raised, compared with the 6 percent average for all IPOs in the U.S., Bloomberg data show. SPAC share sales accounted for 21 percent of dollars raised last year in the U.S. IPO market.

Since the start of 2003, 144 blank-check companies have sold shares, raising $18.1 billion with 13 of the deals coming before 2005, according to SPAC Analytics.

As the largest Wall Street firms began underwriting SPACs, it attracted bigger names and prompted investors to pile more money into the vehicles. The average capital raised in 2007 IPOs was $183 million, up from $76.4 million in 2005, SPAC Analytics data show.

Perelman and Peltz

Perelman, the 65-year-old chairman of skin-care company Revlon Inc., has filed to raise $500 million for MAFS Acquisition Corp. The New York-based investor also brokers deals through his closely held holding company, MacAndrews & Forbes Holdings Inc., and M&F Worldwide Corp., which trades publicly.

Peltz, who's known for putting pressure on the managements of companies including ketchup-maker H.J. Heinz Co. to improve shareholder value, is seeking $750 million for New York-based Trian Acquisition I Corp. The IPO is scheduled for Jan. 21. Peltz, 65, separately won clearance from regulators last week to buy a stake of New York-based insurance broker Marsh & McLennan Cos.

Peltz and Perelman declined to comment.

Other newcomers to the SPAC club include Barry Sternlicht, the 47-year-old founder of White Plains, New York-based Starwood Hotels & Resorts Worldwide Inc.; mergers advisory firm Lazard Ltd., run by Bruce Wasserstein, 60; and rival bank Greenhill & Co. Lazard and Greenhill are based in New York.

Different Than LBOs

``We're looking to back proven people,'' said Whitney Tilson, who manages about $160 million at T2 Partners LLC in New York. ``It's a much better deal than investing in your typical LBO fund. In your typical LBO fund you're locked up for 10 years and you can't give thumbs up or thumbs down on a deal by deal basis.''

Buyout firms raise money privately, returning profits from their deals to investors over seven to 10 years. LBO funds range from several hundred million dollars to the record $21.7 billion gathered by New York-based Blackstone Group LP last year.

Since SPACs sell shares with the goal of buying an existing company they haven't yet identified, IPO investors are betting on the ability of the executives to find a suitable target.

Context Capital Management LLC, a hedge-fund firm with about $700 million of assets, is creating a new pool to buy SPACs. The company, which has offices in San Diego and Stamford, Connecticut, aims to raise $300 million, said William Fertig, Context's co-founder and co-chairman.

Credit Risk

``The market opportunity is enormous because the asset class has grown so dramatically,'' he said. ``It could be a billion- dollar opportunity.''

Even if a SPAC can't find a business to buy, investors will most likely break even since almost all the money raised is held in a trust account, Fertig said.

``There is very little credit risk associated with a SPAC because most of the proceeds are held in trust,'' he said.

SPAC founders have much to like about the deals since they'll own part of a publicly traded company once a purchase is completed.

``It's a great deal for the sponsor because they get 20 percent of the company,'' said Steven Kaplan, a finance professor at the University of Chicago Graduate School of Business. ``If a deal doesn't go through, everyone gets their money back. That's pretty good: heads I win, tails I'm even.''

Shortest path vs path of least resistance

2007-12-31T09:31:00.001+08:00

Forget how the crow flies

By John Kay, FT.com site
Published: Jan 16, 2004

If you want to go in one direction, the best route may involve going in the other. Paradoxical as it sounds, goals are more likely to be achieved when pursued indirectly. So the most profitable companies are not the most profit-oriented, and the happiest people are not those who make happiness their main aim. The name of this idea? Obliquity

The American continent separates the Atlantic Ocean in the east from the Pacific Ocean in the west. But the shortest crossing of America follows the route of the Panama Canal, and you arrive at Balboa Port on the Pacific Coast some 30 miles to the east of the Atlantic entrance at Colon.

A map of the isthmus shows how the best route west follows a south-easterly direction. The builders of the Panama Canal had comprehensive maps, and understood the paradoxical character of the best route. But only rarely in life do we have such detailed knowledge. We are lucky even to have a rough outline of the terrain.

Before the canal, anyone looking for the shortest traverse from the Atlantic to the Pacific would naturally have gazed westward. The south-east route was found by Vasco Nunez de Balboa, a Spanish conquistador who was looking for gold, not oceans.

George W. Bush speaks mangled English rather than mangled French because James Wolfe captured Quebec in 1759 and made the British crown the dominant influence in Northern America. Eschewing obvious lines of attack, Wolfe's men scaled the precipitous Heights of Abraham and took the city from the unprepared defenders. There are many such episodes in military history. The Germans defeated the Maginot Line by going round it, while Japanese invaders bicycled through the Malayan jungle to capture Singapore, whose guns faced out to sea. Oblique approaches are most effective in difficult terrain, or where outcomes depend on interactions with other people. Obliquity is the idea that goals are often best achieved when pursued indirectly.

Obliquity is characteristic of systems that are complex, imperfectly understood, and change their nature as we engage with them. Forests have all these features. Fire is the greatest enemy of the forest. From the late 19th century, the policy of the US National Parks Service was of zero tolerance towards fire. Every outbreak, however small, would be extinguished. But the incidence of fire did not fall: it increased.

Computer simulation of fire control policies suggests the explanation. Most forest fires are small, and burn themselves out. In doing so, they remove combustible undergrowth, and create firebreaks that limit the spread of future fires. In 1972, the National Park Service determined a new policy: it would put out man-made fires, but allow natural ones to burn.

Sixteen years later, the largest fire known swept through Yellowstone National Park. In extremely dry conditions, several fires - some sparked by lightning, some by arsonists - joined together. The blaze was fought by 25,000 firefighters at a cost of $120m; more than a third of the park's vegetation was destroyed.

Today's guidelines allow forest rangers to use their judgment in deciding which fires should be tackled and which left to burn. Experience has shown that too much effort devoted to fire extinction is counterproductive. Time demonstrates, but only slowly, whether policy has gone too far in one direction, or the other. Forest management illustrates obliquity: the preservation of the forest is not best pursued directly, but managed through a holistic approach that considers and balances multiple objectives.

Forests are not the only systems structured in this way. Obliquity is equally relevant to our businesses and our bodies, to the management of our lives and our national economies. We do not maximise shareholder value or the length of our lives, our happiness or the gross national product, for the simple but fundamental reason that we do not know how to and never will. No one will ever be buried with the epitaph "He maximised shareholder value". Not just because it is a less than inspiring objective, but because even with hindsight there is no way of recognising whether the objective has been achieved.

For most of the 20th century, ICI was Britain's largest and most successful manufacturing company. In 1987, ICI described its business purpose thus: "ICI aims to be the world's leading chemical company, serving customers internationally through the innovative and responsible application of chemistry and related science.

"Through achievement of our aim, we will enhance the wealth and well-being of our shareholders, our employees, our customers and the communities which we serve and in which we operate."

ICI's corporate portfolio had evolved over the decades - the company's traditional strengths had been dyes and explosives, but its chemical expertise had taken it into other industrial feedstocks and agricultural fertilisers. After the second world war, the management of ICI concluded that in future "the responsible application of chemistry" was most likely to be found in pharmaceuticals. ICI recruited a team of able, young, academic scientists but the team was slow to bring returns.

The pharmaceutical division was a drain of ICI resources until, in the 1960s, the discovery of beta-blockers gave the company the first effective drug for controlling hypertension. More discoveries followed and, by the 1980s, pharmaceuticals had become the growth engine of the company.

In 1991, Hanson, the predatory UK conglomerate that had successfully acquired and reorganised sluggish British manufacturing businesses such as Ever Ready and Imperial Tobacco, bought a modest stake in ICI. While the threat to the company's independence did not last long, the effects were galvanising. ICI restructured its operations and floated the pharmaceutical division as a separate business, Zeneca. The rump business of ICI declared a new mission statement: "Our objective is to maximise value for our shareholders by focusing on businesses where we have market leadership, a technological edge and a world competitive cost base."

While the National Parks Service had moved from a narrow, focused objective to a broader holistic view of forest management. ICI made the opposite shift - from a grand vision of the responsible application of chemistry to a narrow concentration on established, successful activities. The aim of bringing benefit to a wide range of stakeholders was replaced by the specific objective of creating shareholder value from narrowly focused operations. The company translated this into an operational strategy by disposing of the company's interests in bulk chemicals to acquire a niche group of speciality businesses: ICI, once the main supplier of chemical products to one third of the world, was reinvented as a smells company.

The outcome was not successful in any terms, including those of creating shareholder value. The share price peaked in 1998, soon after the new strategy was announced. The decline since then has been relentless. After two successive dividend cuts the company was ejected in early 2003 from the FTSE 100 index, the transition from industrial giant to mid-cap corporation had taken only 12 years.

ICI is not the only company for whom greater emphasis on corporate financial goals led to less success in achieving them. I once said that Boeing's grip on the world civil aviation market made it the most powerful market leader in world business. Bill Allen was chief executive from 1945 to 1968, as the company created its dominant position. He said that his spirit and that of his colleagues was to eat, breathe, and sleep the world of aeronautics. "The greatest pleasure life has to offer is the satisfaction that flows from participating in a difficult and constructive undertaking," he explained.

Boeing's 737, with almost 4,000 aircraft in the air, is the most successful commercial airliner in history. But the company's largest and riskiest project was the development of the 747 jumbo jet. When a non-executive director asked about the expected return on investment, he was brushed off: there had been some studies, he was told, but the manager concerned couldn't remember the results.

It took only 10 years for Boeing to prove me wrong in asserting that its market position in civil aviation was impregnable. The decisive shift in corporate culture followed the acquisition of its principal US rival, McDonnell Douglas, in 1997. The transformation was exemplified by the CEO, Phil Condit. The company's previous preoccupation with meeting "technological challenges of supreme magnitude" would, he told Business Week, now have to change. "We are going into a value-based environment where unit cost, return on investment and shareholder return are the measures by which you'll be judged. That's a big shift."

The company's senior executives agreed to move from Seattle, where the main production facilities were located, to Chicago. More importantly, the more focused business reviewed risky investments in new civil projects with much greater scepticism. The strategic decision was to redirect resources towards projects for the US military that involved low financial risk. Chicago had the advantage of being nearer to Washington, where government funds were dispensed.

So Boeing's civil orderbook today lags that of Airbus, the European consortium whose aims were not initially commercial but which has, almost by chance, become a profitable business. And the strategy of getting close to the Pentagon proved counter- productive: the company got too close to the Pentagon, and faced allegations of corruption. And what was the market's verdict on the company's performance in terms of unit cost, return on investment and shareholder return? Boeing stock, $48 when Condit took over, rose to $70 as he affirmed the commitment to shareholder value; by the time of his enforced resignation in December 2003 it had fallen to $38.

In Yellowstone National Park, at ICI and at Boeing, the attempt to focus on simple, well defined objectives proved less successful than management with a broader, more comprehensive conception of objectives.

The 20th century saw the rise and fall of modernist rationalism in many activities. Nowhere was the change more visible, or the results more disastrous, than in architecture and town planning. In the modernist vision, technology emancipated builders from tradition and accumulated knowledge. Twentieth- century planners could redesign our environment from first principles.

Charles Jencks, the architectural commentator, announced that modernism ended at 3.32pm on July 15 1972, when demolition contractors detonated the fuses to blow up the Pruitt-Igoe housing project in St Louis, Missouri. Less than two decades earlier, the scheme had won awards for its pioneering, visionary architecture. Tower blocks were the supreme expression of Le Corbusier's view that "a house is a machine for living in". Corbusier himself designed the first such buildings, the Unite d'Habitation on the edge of Marseilles.

But a house is not simply a machine for living in. There is a difference between a house and a home. The functions of a home are complex and the utility of a building depends not only on its design but on the reactions of those who live in it. The occupants of the Pruitt-Igoe scheme, like those of similar buildings, were alienated by the isolation of a living environment that saw no need for accidental, unplanned social interactions. They showed no respect for its public spaces. The functionality of the blocks proved, in the end, not to be functional.

Communities are complex organisms, imperfectly understood, and their functioning depends on their social relations. Great architects implicitly understand obliquity, but obliquity is so important to the design of towns that the most successful towns have no designer at all. The planned city was conceived in the late 19th century. Baron Hausmann swept away the jumble of Paris streets that had developed over the centuries to create grand boulevards. From the 1920s to 1968, the powerful, autocratic Robert Moses controlled the physical environment of New York, driving expressways through apartments, offices and factories.

The zenith of these ideas was reached in planned cities such as the designed capitals of Brasilia, Canberra and Chandigarh. But all these cities are dull. They lack the vitality of real communities. As with tower blocks, their very functionality is dysfunctional.

The National Park officials who thought they could eliminate fire; the managers who thought they could reinvent ICI and Boeing; the architects who believed they could discard thousands of years of experience and redesign buildings on purely functional lines; the planners who attempted to rationalise the patchwork evolution of historic cities: all made the same mistake of underestimating the complexity of the system with which they dealt and the value of the traditional knowledge they inherited. And the answer to their problem is not better analysis and more sophisticated modelling, but more humility.

Such humility is not commonly found in the business world. Re-engineering the Corporation by Michael Hammer and James Champy became a New York Times bestseller in 1993. Hammer and Champy are as radical in aspiration as Le Corbusier: "Re-engineering means asking the question `If I were re-creating this company today, given what I know and given current technology, what would it look like?' Re-engineering a company means tossing aside old systems and starting over. It involves going back to the beginning and inventing a better way of doing work."

Obliquity gives rise to the profit-seeking paradox: the most profitable companies are not the most profit-oriented. ICI and Boeing illustrate how a greater focus on shareholder returns was self-defeating in its own narrow terms. Comparisons of the same companies over time are mirrored in contrasts between different companies in the same industries. In their 2002 book, Built to Last: Successful Habits of Visionary Companies, Jim Collins and Jerry Porras compared outstanding companies with adequate but less remarkable companies with similar operations.

Merck and Pfizer was one such comparison. Collins and Porras compared the philosophy of George Merck ("We try never to forget that medicine is for the people. It is not for the profits. The profits follow, and if we have remembered that, they have never failed to appear. The better we have remembered it, the larger they have been") with that of John McKeen of Pfizer ("So far as humanly possible, we aim to get profit out of everything we do").

Collins and Porras also paired Hewlett Packard with Texas Instruments, Procter & Gamble with Colgate, Marriott with Howard Johnson, and found the same result in each case: the company that put more emphasis on profit in its declaration of objectives was the less profitable in its financial statements.

Similarly the richest men are not the most materialistic. Sam Walton, founder and principal shareholder of Wal-Mart, the world's largest retailer, drove himself around in a pick-up truck. "I have concentrated all along on building the finest retailing company that we possibly could. Period. Creating a huge personal fortune was never particularly a goal of mine," Walton said. Still, five of the top 10 places in the Forbes rich list are occupied by members of the Walton family.

Henry Ford was sued by stockholders who resented his determination to expand his automotive business rather than distribute the profits. When they won their case, most of the dividend that the court required the Ford Motor Company to pay went to Henry himself. He used the money to buy back stock and regain freedom of operations. The dissatisfied stockholders would have done better to keep quiet.

Warren Buffett, the most successful investor in history, still lives in the Omaha bungalow he bought almost 50 years ago and continues to take pleasure in a Nebraskan steak washed down with cherry Coke. For Buffett: "It's not that I want money. It's the fun of making money and watching it grow."

The individuals who are most successful at making money are not those who are most interested in making money. This is not surprising. The principal route to great wealth is the creation of a successful business, and building a successful business demands exceptional talents and hard work. There is no reason to think these characteristics are associated with greed and materialism: rather the opposite. People who are obsessively interested in money are drawn to get-rich-quick schemes rather than to business opportunities, and when these schemes come off, as occasionally they do, they retire to their villas in the sun.

And so, the greatest happiness is rarely achieved by those who set out to be happy. The development of psychology and neurophysiology gives us more insight into the real determinants of happiness. Author and psychologist Mihaly Csikszentmihalyi explores the nature of happiness by listening to what people say about their activities through what he calls experience sampling. He pages people frequently to write down structured reports of exactly how they feel about what they are doing at that moment.

Although we crave time for passive leisure, people engaged in watching television reported low levels of contentment. Csikszentmihalyi's systematic finding is that the activities that yield the highest for satisfaction with life require the successful performance of challenging tasks. These moments are encountered as frequently in work as outside it, and they constitute the state of mind which Csikszentmihalyi describes as flow. "Flow tends to occur when a person's skills are fully involved in overcoming a challenge that is just about manageable."

Csikszentmihalyi's formulation exactly parallels that of Boeing's Bill Allen - "the greatest pleasure that life has to offer is the satisfaction that flows from participating in a difficult and challenging undertaking." Flow is as characteristic of the successful business as of the contented individual.

Yet there are fundamental differences. While the quest for happiness is complementary - by achieving it we make it easier, not harder, for others to achieve the same goal - the development of business is competitive. Tolstoy claimed in Anna Karenina that "All happy families resemble one another, but each unhappy family is unhappy in its own way."

However, the opposite is true in commercial life. Unhappy businesses resemble one another: each successful company is successful in its own way. Business achievement depends on doing things that others cannot do - and still find difficult to do even after others have seen the benefits they bring to the imitators. So the most profitable companies are those that are successful with major challenges - like Boeing's creation of the jumbo jet or ICI's development of a pharmaceutical division. For Csikszentmihalyi, flow is the accomplishment of a difficult task, involving the successful match of capabilities to environment. In the less elegant language of business gurus, Collins and Porras describe the same phenomenon in business as the achievement of "big hairy audacious goals".

Companies that succeed in such challenges are disproportionately represented in the case studies of business schools. We don't hear much about business innovators who adopted big hairy audacious goals and failed, although failure, not success is the norm. For every Bill Gates, Sam Walton and Warren Buffett, there are a hundred people with similar ambitions, and not necessarily much less talent, whose pictures will never be seen on the front cover of Fortune magazine.

Success through obliquity is a product of natural selection in an uncertain, but competitive, environment. It is almost certainly true that, on average, profit-oriented companies are more profitable than less profit-oriented companies. It is very likely that on average people who are interested in money are richer than people who are not. But at the same time that the most profitable companies are not the most profit-oriented, the richest people are not those most interested in money. Outstanding success is the product of obliquity.

This oblique relationship between intention and outcome is the subtle, but frequently misunderstood, message contained in Richard Dawkins' metaphor of the selfish gene. The gene is not actually selfish: the gene has no motive at all, in the sense in which we normally talk about motive. Genes that survive the processes of selection are those well adapted to their environment, and such adaptation was not the product of any conscious design. And this is also true of the forests we travel thousands of miles to see, the great capital cities of history, the traditions of classical architecture, and the development of great businesses. All of them are the product of evolution in a universe too complex and unpredictable for any of us fully to understand. All of them survive and prosper because they are well adapted to their environment.

The University of Sheffield Sports Engineering Research Group, after analysing David Beckham's performance on the football field, announced in 2002 that they had discovered a physics genius. The scientists had identified the complex differential equations that need to be solved to bend it like Beckham. No doubt their computers are already crunching numbers to tell Jonny Wilkinson how to drop a goal.

But little research is needed to confirm that Beckham is not a physics genius. Solving equations of motion is a means of understanding what happens, but is not a means of making it happen. Similarly, the financial returns of a business record what it achieves but are not the means by which it is achieved. Successful companies do maximise long-term shareholder value, or at least create large quantities of it. But that does not imply they were any more capable of formally calculating the results of their activities than Beckham can. Still less can we infer that such calculations were the basis of their achievement.

Would Boeing really have benefited from careful analyses in the mid-1960s of the prospective return on investment from development of the 747? An analyst would have had to anticipate the oil shock, the globalisation of world markets and the development of the aviation industry through to the end of the century. Anyone who has built models of these kinds, or scrutinised them carefully, knows that the range of possible assumptions is always wide enough to allow the analyst to come up with whatever answer the person commissioning the assessment wants to hear.

ICI might have made calculations in the 1950s that estimated the market capitalisation Zeneca would have achieved in the year 2000. Their strategists could then have put that number into a discounted cash flow calculation to estimate a return on the company's early investment in its pharmaceutical business. But no one would or should have taken such a calculation seriously.

The distinction between intent and outcome is central to obliquity. Wealth, family relationships, employment all contribute to happiness but these activities are not best conducted with happiness as their goal. The pursuit of happiness is a strange phrase in the US constitution because happiness is not best achieved when pursued. A satisfying life depends above all on building good personal relationships with other people - but we entirely miss the point if we seek to develop these relationships with our personal happiness as a primary goal.

Humans have well developed capacities to detect purely instrumental behaviour. The actions of the man who buys us a drink in the hope that we will buy his mutual funds are formally the same as those of the friend who buys us a drink because he likes our company, but it is usually not too difficult to spot the difference. And the difference matters to us. "Honesty is the best policy, but he who is governed by that maxim is not an honest man," wrote Archbishop Whately three centuries ago. If we deal with someone for whom honesty is the best policy, we can never be sure that this is not the occasion on which he will conclude that honesty is no longer the best policy. Such experiences have been frequent in financial markets in the last decade. We do better to rely on people who are honest by character rather than honest by choice.

In a similar way, the statement "we look after employees because we care" is not the same as the statement "we have introduced new compensation arrangements because, having calculated the relative costs of benefits enhancements and staff turnover, and commissioned a consultant's report on the policies of competitors, we believe it will produce a net enhancement of earnings per share". Even if the pensions and healthcare benefits are the same, the response from those affected is different. That is why companies that put the second statement in their board papers and investor presentations typically put the first statement in their press releases and communications to employees. But people who work in a business generally know its nature well enough to see the instrumentality at work.

Marks and Spencer was famous for decades for the breadth of its staff welfare programme. In particular, the company pioneered the provision of high-quality meals at nominal prices. The policy did not originate in any nice calculation of costs and benefits. It was adopted when a shop assistant fainted as Simon Marks was making one of his legendary store visits. Marks discovered that her husband was unemployed and the family did not have enough to eat. Marks was not engaged in philanthropy - he did not offer to feed his employee's family. Nor was his purpose the creation of shareholder value. Marks was making a sincerely felt statement about the kind of business he wanted his company to be. Such statements about the nature of the business defined the iconic company Marks and Spencer became. As at ICI and Boeing, Marks and Spencer was to sacrifice that status in the rationalist 1990s in the ultimately unsuccessful pursuit of growth in earnings per share.

You don't prolong life much by adopting long life as your goal. Nor do you learn much about the sources of longevity by asking very old people how they did it. Medical interventions don't have a large overall impact on life expectancy - medicine is to health what fire control is to forest management. The most important influences on life expectancy are environment and general health. We extend our lives most effectively, not through hypochondria, but by caring for our bodies and ourselves in a comprehensive, holistic manner.

Happiness is achieved in the same way. As John Stuart Mill said: "Those only are happy who have their minds fixed on some object other than their own happiness... aiming thus at something else, they find happiness by the way."

The great cities of the world lift our spirits, not because some great designer set out to achieve that effect, but because of their lack of planning, their diversity and vitality, their unexpected encounters and conjunctions. And they evolve, not through conservative preservation or planned change, but by a process in which undistinguished buildings are torn down and only the best examples of each era are preserved.

Forest management is unexpectedly complex. The regimented plantation proved as unsuccessful as the planned city, and ecologists today are tearing such plantations down. Monocultural forests are not only dull to look at, but vulnerable to disease and fire. Managed woodlands are economically and environmentally superior. But no one knows the best way to manage a forest, or even what "best" means in this context. Our objective in a complex system is not to find the optimum, because no one can know before or after whether such an optimum has been achieved. We can and should be satisfied with an outcome that is good enough.

What is true of forests is equally true of businesses. The great corporations of the modern world were not built by people whose overriding interest was wealth, profit, or shareholder value. To paraphrase Mill: their focus was on business followed not as a means, but as itself an ideal end. Aiming thus at something else, they found profit by the way.

This is how Hewlett Packard described it: "Profit is a cornerstone of what we do... but it has never been the point in and of itself. The point, in fact, is to win, and winning is judged in the eyes of the customer and by doing something you can be proud of."

Obliquity is relevant whenever complex systems evolve in an uncertain environment, and whenever the effect of our actions depends on the ways in which others respond to them. There is a role for carrots and sticks, but to rely on carrots and sticks alone is effective only when we employ donkeys and when goals are simple. Directness is appropriate. When the environment is stable, objectives are one dimensional and transparent, and it is possible to determine when and whether goals have been achieved. Obliquity is inevitable when the environment is complex and changing, purposes are multiple and conflicting, and when we cannot tell, even with hindsight, whether they have been fulfilled.

Balboa made the first transit of the American continent. The last great crossing was the completion of the Canadian Pacific Railroad, which runs almost 3,000 miles from Toronto to Vancouver. The most impenetrable stretch of the Rockies was the Selkirk Mountains. The builders of the railroad, faced with a costly detour, offered $5,000 and naming rights to anyone who discovered a pass. These incentives worked. On the Trans-Canada Highway today you cross the Selkirks through the pass named for the ambitious and intrepid Major A.B. Rogers. But even here, obliquity kicks in. The Rogers Pass is more or less parallel to the Panama Canal, and your westward journey across Canada is best accomplished by veering south-east to traverse it. But sometimes directness is the best solution. In the 1910s, after struggling to keep the Rogers Pass open in an area that often gets 100 metres of snow per year, Canadian Pacific bored a tunnel that runs straight as an arrow through Mount Macdonald.

John Kay is an FT columnist and the author of `The Truth About Markets' (Allen Lane)

Mezzanine funds gain an edge in credit market turmoils

2007-12-14T09:48:00.000+08:00

LBOs Find Cash as Goldman, TCW Raise Mezzanine Funds (Update1)

By Sree Vidya Bhaktavatsalam and Jason Kelly

Dec. 13 (Bloomberg) -- Goldman Sachs Group Inc., TCW Group Inc. and New York Life Capital Partners are raising more than $30 billion to increase their investments in leveraged buyouts.

At least 32 firms are starting mezzanine debt funds as investors shun bonds and loans used to finance LBOs out of concern that the collapse of prices for subprime-mortgage securities will spread. Mezzanine funds make loans to companies at higher rates than banks and buy their preferred stock. They earn returns from interest payments and the eventual sale of the equity interest.

``Today, virtually no one is willing to finance LBOs and it's created an opportunity for mezzanine providers,'' said John Morris, managing director at Boston-based HarbourVest Partners LLC, which oversees $24 billion of private-equity investments for institutions.

Goldman, the world's most profitable securities firm, is gathering $20 billion for the biggest mezzanine fund, said two people with knowledge of the matter. TCW, which manages more than $150 billion, is raising $4.5 billion to split between two funds, said the people, who declined to be identified because the companies haven't disclosed their plans.

Officials at New York-based Goldman and TCW in Los Angeles declined to comment.

New York Life Capital, the investment unit of New York Life Insurance Co., raised $800 million last month for its second mezzanine fund, $200 million more than originally sought. The fund will provide financing for acquisitions as large as $4 billion, said Thomas Haubenstricker, a senior managing principal at the firm.

Funding Backlog

``We have the opportunity in this market to work on deals that are larger than what would typically come to our market,'' Haubenstricker said.

With financing readily available, LBO firms announced a record $582.6 billion of deals in the first half of 2007, data compiled by Bloomberg show. That fell to $171 billion in the past five months as lenders were left with $370 billion of debt that they couldn't sell to investors, according to a Sept. 24 note by analysts at Bank of America Corp. in New York.

``When the big commercial banks move, they go far in both directions,'' said Rick Rickertsen, managing partner of Washington-based private-equity firm Pine Creek Partners.

While the banks have reduced some of the backlog, they are still sitting on $230 billion of debt, according to a Dec. 4 report by JPMorgan Chase & Co. analysts in New York.

Taking More Risk

Private-equity firms use funds raised from investors to finance as much as 30 percent of their acquisitions. They borrow the rest against the assets of the companies they buy, using the business's cash flow to pay down the debt.

As much as 50 percent of the funding comes from senior debt, which banks package and sell to investors. The remainder is financed using high-yield loans and mezzanine debt, which is unsecured, high-yield borrowing that ranks last for repayment in the event of default.

``The ability to access the high-yield markets, which is a very important component of all buyouts, has if not disappeared, become very tough,'' said Scott Sperling, co-president of buyout firm Thomas H. Lee Partners LP in Boston, said today in a Bloomberg TV interview. ``That makes mezzanine financing a more attractive alternative and sometimes the only alternative to help finance buyouts.''

Mezzanine funds also acquire equity in some buyouts to generate higher returns for investors. They take the added risk to earn annual returns of as much as 20 percent before fees, said Patrick Campbell, a principal at New York-based Benedetto Gartland & Co., which raises money for mezzanine-fund managers.

By contrast, junk bonds, often sold as part of LBOs, returned an average 6.97 percent from 1997 to 2006, according to indexes compiled by Merrill Lynch & Co.

``Investors have a much greater appetite for mezzanine funds because the risk-return rewards are so much better,'' Campbell said.

The following is a list of the 10 largest mezzanine funds being
raised:

Fund                            Target     Manager
GS Mezzanine Partners V         $20B       Goldman Sachs
TCW/Crescent Mezzanine Fund V   $2.5B      Trust Co. of the
West
TCW Energy Fund XIV             $2B        Trust Co. of the
West
N.Y. Life Mezz. Partners II     $800M*     N.Y. Life Capital
Capzanine II                    $368M**    Capzanine
CapitalSouth Partners Fund II   $300M      CapitalSouth
Partners
Darby Asia Mezzanine Fund II    $300M      Darby Overseas Ltd.
Darby Latin Am. Mezz. Fund II   $300M      Darby Overseas Ltd.
MidWest Mezzanine Fund IV       $200M      Midwest Mezzanine
BNY Mezzanine Partners          $200M      Bank of N.Y./Mellon

*Closed
**250 million euros

Some asset backed loans are better than others

2007-12-06T13:25:00.000+08:00

Despite Credit Woes, Asset-backed Loan Funds Enjoy Steady Returns

By David Price
November 21, 2007

With Wall Street’s giants taking billion-dollar write-downs from subprime-linked losses following this summer’s spate of hedge fund closures, mortgage lending has become the black sheep of the investment family. But a small number of hedge funds have carved out a niche for themselves in this market, and the results are eye-opening.

Even at the height of the credit meltdown this summer, the Ambit Bridge Loan Fund was clicking along, turning out roughly the same 1% return it has produced each month since its March 2005 launch. Contrast that with the shellacking many other funds took at the same time and Ambit's strategy of asset-backed lending looks positively stellar.

Ambit originates and services short-term real-estate loans, writing checks for up to $25 million to developers seeking to get commercial projects off the ground. The loans are secured at a maximum of 70% of the property's value. Interest, which is typically 12% to 15% per year, is pre-paid and held in escrow, creating a sure-fire revenue stream to support fund returns. Through the end of October, the domestic Ambit fund and an affiliated offshore fund, Ambit Bridge Loan International, are up 9.84% net this year. Over the past 12 months, both funds were ahead 12.72%.

"During the past few months, our strategies have held up very well," Ambit Managing Director Ben Shoval says, adding that the recent upheaval in the credit markets may actually be working to Ambit's advantage by expanding the pool of potential borrowers.

Meanwhile, Jonathan Kanterman, managing director at hedge fund firm Stillwater Capital Partners, estimates that dealflow for his New York-based firm has tripled in recent months, with traditional bank lenders pulling back as the sub-prime credit crisis spreads. Like Ambit, Stillwater is enjoying significant improvement in the collateral offered by would-be borrowers as well as a favorable swing in the loan terms it can command.

But perhaps most noticeably, Kanterman says, there has been a big jump in investor interest. He explains that in the past, the lack of volatility in ABL fund returns was often a fund’s own worst enemy, because many institutional investors were willing to take on more risk in return for the potential for much bigger returns. Then, the credit and equity markets began to sink, "and all of a sudden, the steady-eddy hedges like us were getting a lot more attention," he says.

Both Ambit and Stillwater are currently open to new investors, and Stillwater also recently partnered with U.K.-based Matrix Group to market a new fund of ABL funds. The firms have weathered the recent financial turmoil relatively unscathed, although Ambit did have a $5 million redemption earlier this year when a pair of limited partners with their own cash needs¬ pulled out of its fund.

Shoval, who managed three funds of hedge funds for several years before locking in on an ABL strategy in 2005, says his investors now include at least one "major" investment bank, a few insurance companies and a family office. Assets under management across both the domestic and offshore funds by the Wilkes-Barre, Pa.-based firm total about $210 million.

According to Gregg Winter, president and founder of Winter & Co. Commercial Real Estate Finance, a commercial mortgage brokerage and advisory firm in New York, hedge funds are a more efficient vehicle to source, originate and service short-term loans, compared with pulling together investors for each deal. He launched the W Financial Mortgage Fund in June 2003 and now manages nearly $30 million, all from accredited individuals. The fund makes close to $80 million in loans, and net returns for investors have been just under 11% per year since inception.

"This is a progression of hard-money lending," Winter says, adding that investors benefit by gaining greater diversification and a more reliable income stream under the hedge fund model. "It's the same philosophy behind investing in a mutual fund—there's a lot less risk in spreading out investments across a portfolio of stocks rather in than a single company." Looking to capitalize on the booming interest in asset-based lending, Winter plans to open up the fund to institutional investors in early 2008.

As with any asset-backed vehicle, the biggest downside risk for ABL funds would be a precipitous decline in the value of the underlying asset. But while residential property values have fallen in many parts of the country, commercial real estate prices have so far held strong. The short time frame, along with the low loan-to-value ratio typical for bridge loans, also provides a substantial financial cushion for fund managers if a borrower falls behind or defaults on a loan. A sudden glut of similar properties on the market could whittle away some of those gains, Kanterman says, although "it's pretty unlikely that the commercial real estate market is going to drop 25% or 30% in only a year or two.”

Because of their stringent due diligence, however, most ABL fund managers say that foreclosures are extremely rare in their business. At Ambit, Shoval said he has only had one loan get into trouble, while Winter says W Financial has yet to experience a single default or foreclosure.

As a rule, ABL funds are also relatively conservative in their own use of leverage. Many, like Ambit, don't borrow at all, although some of its limited partners have levered positions to boost their earnings potential. Winter, on the other hand, said he occasionally will take on debt—either to keep the fund fully deployed or to swing slightly larger deals.

And despite the growing interest by institutions and the resulting tide of new money, Winter said he doesn't anticipate the eventual rise of huge ABL mega-funds. Real estate is a very local business, he explains, making it tough for a firm to expand much beyond the markets it already knows intimately.

"This is a niche strategy, and to do it well, you really have to understand the territory. That's probably going to keep most firms from getting too big or going national," he says. "I'd think it would be difficult to ramp up to $1 billion or more in size.

Old feature article on CDO recovery rates

2007-12-06T11:35:00.000+08:00

May 2004 | Feature

CDO guide: recovery rates

Severity of default is key

(Credit Magazine) For investors to feel comfortable with investing in CDOs they must feel confident about the circumstances under which they will win and lose. Here the recovery rate of the underlying assets is the key to performance

For investors in the CDO market, it is important to distinguish between default and recovery rates. A default is defined as occurring at the moment that a promised payment on a bond is missed by the issuer, or the time at which an announcement of a missed payment is made regardless of the allowable grace period. For example, the way that Moody’s rates bonds means: “If issuer ABC misses an interest payment on the due date but makes the payment during the grace period, Moody’s treats ABC as a defaulted issuer at the time of the missed payment.”

For CDO investors, therefore, the severity of loss rather than the severity of default is the key. Clearly, recovery rates in the event of liquidation of assets will vary widely across various claims in the capital structure. S&P’s recovery assumptions, for example, range from highs of 50% to 60% in the case of senior secured bank loans through to lows of 15% to 28% for subordinated debt and just 15% for emerging market corporates. For individual distressed credits, therefore, recovery rates can also vary dramatically. For example, according to figures published by S&P, recovery rates have varied from as low as 9–12% for WorldCom and 11–24% for Enron through to as high as 78–90% in the case of Railtrack in the UK.

Aside from the specific circumstances of default, a number of other factors can and do influence recovery rates. For example, on average, the longer collateral managers hold on to defaulted securities, the greater their recovery values become. That does not necessarily mean that collateral managers will usually aim to retain ownership of defaulted securities, because in most cases the terms of their contracts will make them forced sellers in a default scenario.

The important differences between default and recovery rates mean that calculating historical recovery levels and therefore extrapolating likely future trends is far from straightforward. A complication in the European market is that information on recovery rates has historically been kept private by banks in the loan market, forcing rating agencies and other analysts to apply a so-called ‘haircut’ to recovery rate data from the US, where much broader information on recovery rates for bonds and loans is available.

An added complication, especially for CDO investors tutored in the bankruptcy laws that apply in the US, is that insolvency regimes continue to differ throughout Europe. France, for example, is notorious for being highly protective of borrowers while Germany is regarded as being much more pro-secured creditors. Furthermore, as the Credit Guide to CDOs published in 2002 observed: “In many European jurisdictions, bond investors have no control over any work-out process: this is in stark contrast to the situation in the US, where both loan and bond investors get a seat at the table. As a result of these structural features, European high-yield bonds are proving to have abysmal recovery rates.”

Those poor European recovery rates, however, are not confined to the high-yield market. According to Moody’s, while the default rate in the European corporate bond market plunged from 20.1% in 2002 to 6.9% in 2003, the average recovery rate was almost unchanged at 19.9% in 2003 compared with 20% the previous year. Recovery rates in Europe, Moody’s advises, continue to be roughly half the North American average.

Structuring and constructing a CDO

The financial press will often make its first mention of a ‘new’ CDO on or around the time of its closing – with the closing date generally the day on which the CDO issues tranches of debt and equity to investors. Prior to that day, however, there will have been a so-called pre-closing or ‘warehousing’ period, typically lasting between three and six months. During that period the asset manager will have acquired (or ‘warehoused’) assets to act as collateral for the securities to be issued by the CDO via a special-purpose vehicle (SPV – see box) on the closing day. Closing of a fund usually occurs when a CDO has acquired between 40% and 60% of its targeted assets.

Clearly, however, given that the proceeds of the CDO notes will only become available following their sale on closing day, CDO managers will often need a bridging loan facility (or ‘warehouse facility’) during the warehousing period.

Following the issuance of notes on closing day, the CDO will have a period usually lasting between 60 and 360 days – although the period can also be much longer – in which to complete the process of buying the assets backing the CDO. This important phase is commonly known as the ramp-up period, and the year in which the ramping-up takes place is referred to as the CDO’s vintage. The final investment amount amassed following the ramp-up is sometimes known as the target par amount, which is the total size of the fund less its start-up costs. A portfolio that has been ramped-up with a relatively large number of small exposures is described as being granular, whereas a more concentrated portfolio with a small number of exposures is known as a lumpy fund.

After completion of the ramp-up, there is usually a reinvestment (or revolving) phase lasting up to five years, during which any cashflows arising from amortisation, maturity, prepayment or the sale of assets can be reinvested, as long as a number of basic performance objectives have been maintained.

Finally, during the amortisation phase, which can last for between five and 30 years depending on the underlying assets of the CDO, cashflows earned by the fund are used to pay down its liabilities.

CDO repackaging (repacks)

The repackaging of CDOs (known as CDO repacks) is a relatively recent phenomenon arising from the poor performance of a number of CDOs in 2002 and 2003, and another good example of the flexibility and adaptability of the market to respond to fluctuations in credit quality and economic volatility. Repacks are considered to be ‘first derivatives’ of CDOs and, as Moody’s explains: “In a typical repack, the terms of the existing CDO are restructured, with changes in seniority, notional amount, coupon, maturity and waterfall priority. The cashflows of the existing debt are used to support restructured debt securities to achieve the desired ratings.”

Moody’s adds that repackaged structures, 45 of which were rated by the agency in 2003 compared with just 11 in 2002, will be able to achieve a higher rating due to an increased subordination and the support of extra interest. “After the restructuring of the existing CDO structure, the new bond will be more appealing to the investors who are seeking higher credit quality,” Moody’s notes.

The role of the SPV

ABS (including CDOs) are generally issued by SPVs or special-purpose entities set up to allow for the transfer of risk from the originator to an entity that is generally thinly capitalised, bankruptcy-remote and isolated from any credit risk associated with the originator.

According to a JP Morgan handbook: “To limit the universe of an SPV’s potential creditors, it is usually a newly established entity, with no operating history that could give rise to prior liabilities. The SPV’s business purpose and activities are limited to only those necessary to effect the particular transaction for which the SPV has been established (for example, issuing its securities and purchasing and holding its assets), thereby reducing the likelihood of the SPV incurring post-closing liabilities that are in addition or unrelated to those anticipated by rating agencies and investors.”

Securitization as an option for Project Financing depends on timing

2007-12-04T15:55:00.000+08:00

PPP/PFI

Project finance securitisation
03 October 2007

Banks which arrange and participate in project finance debt are building significant risk concentrations around this asset class. As margins fall and maturities extend, it is expected that there will be fewer participant banks active in the syndicated loan market. Mark Gordon, Head of Securitisation, Structuring and Placement at SMBC Europe, examines how project finance debt arrangers have turned to the securitisation market to manage their loan portfolios more efficiently

Global demand for infrastructure and the project financing that supports it is at an all time high, with investors financing US$129bn worth of infrastructure projects in H1 2007, US$114bn in H2 2006, US$111bn in H1 2006 and US$104bn and US$66bn in the second and first halves of 2005 (these figures do not include so-called 'Alternative Investments')1.

However the knock-on effects of the US sub-prime crisis have adversely impacted the wider securitisation market. Issuers, arrangers and rating agencies continue to structure project finance securitisations in anticipation of the market returning gradually over the next few months.

Issuer Motivations

For the banks that have issued synthetic securitisations of portfolios of project finance loans and bonds, the prime motivation to date has been regulatory capital release. Under Basle I, drawn project finance loans are risk weighted at 100%. Under Basel II, these loans (which are a category of Specialised Lending) are risk weighted at 70% at best under Foundation IRB. Under Advanced IRB, this risk weighting may be reduced to a much lower level. Most of the structures we have seen are Basel I compliant and incorporate call features on the super senior swap, reflecting the low risk weighting for retained super senior under the new capital accord. The release of regulatory and economic capital around a specific portfolio improves both return on equity and return on risk asset.

These deals are generally replenishable and as such are used as ongoing portfolio management tools. During the pre-agreed replenishment period, as loans amortize, prepay or cancel, the originating bank may replenish with new loans. These new loans must meet the replenishment criteria set out in the offering circular. The replenishment criteria are set to protect the interests of the note investors.

A secondary motivation for issuing banks is the arbitrage between the margin income on the loan portfolio and the cost of buying protection via the securitisation. Despite falling margins in the loan market, the arbitrage case is quite compelling given the alternatives i.e asset sales or monoline wraps, both of which can have a negative impact on a lending bank's relationship with project borrowers/sponsors. The arbitrage is improved by the expected maturity mismatch between the underlying assets and the credit-linked notes.

For an originator to achieve full regulatory capital release from the securitisation, the legal maturity of the hedge must equal or exceed the legal maturity of the underlying assets. The final legal maturity of SMBCE's SMART PFI 2007 transaction is March 2044. This reflects the maturity of the longest dated asset in the reference portfolio. As you can imagine, ABS investors have little interest in 37 year PFI risk.

Therefore synthetic securitisations are normally structured to incorporate a call feature at the originator's option. In the case of SMART PFI 2007 the call is at year 7. The note investors are comfortable that the originator will call the deal at this time, as the securitisation starts to become less efficient once the replenishment period has ended. This is due to the effect of scheduled amortisation and prepayments on the reference portfolio when set against certain fixed costs of securitisation.

Typical Structures / Deal History

Between 1999 and 2001 there were a small number of cash CLOs of project finance loans. Since 2004, there have been five bank balance sheet project finance synthetic CLOs.

Originating banks tend to prefer synthetic structures over cash structures (where a portfolio of loans is transferred by means of a true sale to an SPV). The synthetic transfers part of the risk associated with a portfolio of loans, but not the loans themselves. As such the originating bank continues to service the loans in the normal way and preserves it relationship with the borrower.

As far as the project borrowers and sponsors are concerned, the fact that its loan is included in the reference pool of a synthetic securitisation does not change the operation of that loan in any way or under any circumstances. Given the additional liquidity that securitisation brings to the project finance market and the effect it can have on margins (this is most notable in the UK PFI market) most project borrowers and sponsors are active supporters of the synthetic securitisation process.

Given the long term nature of project finance debt, cash deals do provide a funding advantage. We understand that at least one project finance cash deal is currently at the structuring stage, however we expect the market to remain predominantly synthetic for the foreseeable future.

A summary of the main features of the synthetic deals is given in Figure 1

You will note from Figure 1 that four out of the five deals closed since November 2004 have involved the intermediation of KfW. KfW benefits from a guarantee from the Federal Republic of Germany and as such is zero risk weighted under Basel I and II. KfW will intermediate only on certain asset classes. PFI/PPP loans and bonds originated by European banks are one such asset class (the others being SMEs and certain property related assets). The fact that banks can achieve a zero risk weighting on the whole reference portfolio above the first loss/threshold amount provides a significant advantage in terms of risk asset release. This is one of the main reasons that PFI/PPP has featured so heavily in recent issuance. A typical KfW intermediated Basle I structure is given in Figure 2

In the example depicted above, the asset originating bank (the "originator") buys credit default swap protection from KfW for realised losses that occur in the reference portfolio which exceed the threshold amount. KfW in turn buys protection from a super senior investor (typically an unfunded CDS from a AAA rated monoline). The SPV (the "Issuer") issues rated notes, linked to the performance of the reference portfolio. The Issuer uses the proceeds of the notes to purchase KfW certificates ("Collateral") which are credit linked to the reference loans. KfW is then fully hedged via the super senior swap and the cash collateral from the sale of the credit linked certificates of indebtedness to the SPV.

We understand the rating agencies are currently working on six new project finance securitisations and that a number of these are not PFI/PPP related.

For example, SMBCE will securitise a portfolio of project finance loans totalling $1bn that it has originated in the 6 countries of the GCC (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and UAE). These assets will be representative of the sort of project finance that is prevalent in the region, i.e. LNG, petrochemical, refinery, power/water, etc. This will be the first securitisation of such assets and one of the very few non-property related securitisations of Middle East assets. This type of portfolio would not be eligible for KfW intermediation. As such, and as SMBCE is now operating under Basle II, the structure of this and other non intermediated transactions is as per Figure 3.

You will note that in this example the originator retains the first loss and also the super senior portion of the capital structure. This reflects a Basle II scenario where banks can risk weight retained super senior at 6/7 per cent (depending on regulatory jurisdiction).

Rating Agency Approach

All three major rating agencies have invested considerable resources in understanding project finance; they have recruited heavily from the banking sector and developed well published rating methodologies around project finance. That said, significant differences of opinion can exist between agencies with regard to the credit quality of a particular loan.

Typically, each project within the reference pool will be separately rated on a "shadow" (non-public) basis. Each asset will be assigned a recovery rate and a correlation matrix (if one loan defaults, the probability that other loans in he pool will also default) will be established for the pool. In general terms, the recovery assumptions around project finance are relatively high. The pools that have been securitised in recent years have been predominantly investment grade and correlation has generally been assessed as low.

S&P published its "Project Finance Default and Recovery Study" in December 20063.The report highlights key findings of the aggregated data experience of Standard & Poor's analysis of the historical project finance loan default and recovery rates. 32 banks participated in the study. The data comprises 4,029 projects from the period January 1st, 1990 to December 31st 2005. The data showed that project finance loans had a ten year cumulative average historical default rate of 11.34 per cent. The average recovery rate based on widely defined defaults is 72.1%. This recovery rate varies from region to region. The combined effect of strong ratings, high recovery and low correlation assumptions means that from an originators perspective, project finance debt, in general terms, lends itself to securitisation.

Practical Issues

Of course, if the rating agencies are to analyse each project separately, they require detailed information on each project. To complete the shadow rating process, the rating agencies require the level of information that would be released to a potential participant in a syndicated loan, e.g. project legal bible, due diligence reports, financial close model and depending upon the status of the project, updated project information e.g. construction and compliance certificates, construction or operation reports, updated financial model, waiver requests, etc.

Most project finance loan facility agreements prohibit the disclosure of such information to third parties. As such, we at SMBCE seek specific consent to release information to the rating agencies from each project company and where necessary, the project sponsors.

The second category of information that will be released around a securitisation is that which is released in investors. The majority of this information relates to the characteristics of the pool as a whole rather than specific data on each project e.g. portfolio breakdown by sector, geography and shadow rating, average DSCR/LLCR etc.

As a large number of project finance borrowers and sponsors are unfamiliar with securitisation and/or the rating agencies, it is worth investing some time to get all parties comfortable with the process. From the perspective of the sponsors, synthetic securitisation is preferable to a sale of the loan as it preserves the lending relationship with a bank and keeps bank syndicate size at a minimum. It also introduces a new pocket of liquidity to the project finance market. In our experience, those institutions which purchase the CLNs that come out of project finance securitisations are generally non-bank investors.

In the Middle East alone, the predicted requirement for project financing over the next 3 to 5 years is considered to be far in excess of what can be absorbed by the bank market. It is essential for borrowers and lenders alike, that originating banks develop the synthetic risk market to allow them to efficiently manage their portfolios. With regard to the PFI sector in the UK, securitisation is frequently credited with allowing certain debt providers to lend at lower margins than would have otherwise been possible.

It is worth noting that the existence of a small number of project finance securitisation programmes can not in itself cause a reduction in debt pricing across the board. The main market for the distribution of project debt is still the syndicated loan market. As such, margins can only fall to a level which is acceptable to the participant banks.

Other issues to consider from an originators perspective are the not insignificant up front and on going costs associated with securitisation e.g. legal fees, rating agency fees, trustees, accountants, arrangement and distribution fees etc. The upfront component of these costs can usually be amortised over the expected life of the deal.

Given the cost component and the requirement for a certain level of diversity in the reference pool, a portfolio of a certain type and size is necessary for the securitisation to be efficient. You will note from Figure 3 that the minimum amounts are around £400m and 24 assets. In addition to those assets included in the original reference pool it is prudent to hold an amount of eligible assets for replenishment purposes.

For these reasons a number of banks have attempted to pool portfolios and securitise on a joint basis. Given structural and regulatory issues this is very difficult to achieve.

Future

World-wide demand for infrastructure projects is growing at a tremendous rate. Our expectation is that the number of active arrangers and participants in the project finance debt market will decrease due to the effects of Basle II, margin reduction and longer tenors on the underlying loans.

Those banks which remain will need to manage their risk synthetically and recycle capital through securitisation. Investors are drawn to this asset class by the strong cash flows, low defaults and high recoveries of the underlying assets. Market permitting, we expect project finance to become an established asset class within the securitisation market within the next 12 months.

Large forces in the global capital markets

2007-12-04T11:27:00.000+08:00

The world’s new financial power brokers

Four rising players will continue to grow in wealth and importance, even if interest rates rise and oil prices drop.

Diana Farrell and Susan Lund

December 2007

One glance at the distribution of wealth around the world and the shift is obvious: financial power, so long concentrated in the developed economies, is dispersing. Oil-rich countries and Asian central banks are now among the world’s largest sources of capital. What’s more, the influx of liquidity these players have brought is enabling hedge funds and private-equity firms to soar in the pecking order of financial intermediation.

New research from the McKinsey Global Institute shows that the assets of these four groups of investors—the new power brokers—have nearly tripled since 2000, reaching roughly $8.5 trillion at the end of 2006 (Exhibit 1).¹ This sum is equivalent to about 5 percent of total global financial assets ($167 trillion) at the end of 2006, an impressive number for players that lay on the fringes of global financial markets just five years ago.

The impact and visibility of this quartet exceed its relative size, despite the discreet way its members operate. Among other things, they have helped lower the cost of capital for borrowers around the world. In the United States, we estimate, long-term interest rates are as much as 0.75 of a percentage point lower thanks to purchases of US fixed-income securities by Asian central banks and petrodollar investors—$435 billion of net purchases in 2006 alone. Meanwhile, investors from the Middle East, pursuing returns they believe will exceed those generated by fixed-income instruments or equities in developed economies, are fueling investment in Asia and other emerging markets. Hedge funds have added to global liquidity through high trading turnovers and investments in credit derivatives, which allow banks to shift credit risk off their balance sheets and to originate more loans. Private-equity firms are having a disproportionate impact on corporate governance through leverage-fueled takeovers and subsequent restructurings.

And over the next five years, the size and impact of the four new power brokers will continue to expand.²

Oil rises to the top

In 2006 oil-exporting countries became the world’s largest source of global capital flows, surpassing Asia for the first time since the 1970s (Exhibit 2). These investors—from Indonesia, the Middle East, Nigeria, Norway, Russia, and Venezuela—include sovereign wealth funds, government-investment companies, state-owned enterprises, and wealthy individuals.

This flood of petrodollars comes from the tripling of world oil prices since 2002 and the steady growth in exports of crude oil, particularly to emerging markets. A large part of the higher prices paid by consumers ends up in the investment funds and private portfolios of investors in oil-exporting countries. They then invest most of it in global financial markets, adding liquidity that helps to explain what US Federal Reserve Board of Governors chairman Ben Bernanke described as a "global savings glut" that has kept interest rates down over the past few years. In 2006 alone, we estimate at least $200 billion of petrodollars went to global equity markets, more than $100 billion to global fixed-income markets, and perhaps $40 billion to global hedge funds, private-equity firms, and other alternative investments. This capital is invested chiefly in Europe and the United States, but regions such as Asia, the Middle East, and other emerging markets are also significant beneficiaries.

Although the added liquidity from petrodollars has helped buttress global financial markets, it may also be creating inflationary pressure in illiquid markets, such as those for real estate and art. The unanswered question is whether the world economy will continue to accommodate higher oil prices without a notable rise in inflation or an economic slowdown.

Where the wealth is . . .

The Gulf Cooperation Council (GCC) states—Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates (UAE)—are the largest oil exporters. Together, we estimate, they had foreign assets of $1.6 trillion to $2 trillion by the end of 2006 (Exhibit 3). Other states in the region, including Algeria, Iran, Libya, Syria, and Yemen, held an estimated $330 billion; the other oil exporters combined, about $1.5 billion. At the end of 2006, the oil exporters collectively owned $3.4 trillion to $3.8 trillion in foreign financial assets.

Much attention around the world has recently been devoted to the oil exporters’ sovereign wealth funds, which are indeed large. By some estimates, the Abu Dhabi Investment Authority (ADIA) holds nearly $875 billion in foreign assets, Norway’s Government Pension Fund $300 billion, Russia’s Oil Stabilization Fund $100 billion, and the Kuwait Investment Authority $200 billion. But oil investors as a whole are a more diverse group, with hundreds of individual players. We calculate that private individuals who actively invest in global financial markets hold at least 40 percent of the foreign wealth purchased with petrodollars. Also important are the oil-exporting states’ central banks (such as the Saudi Arabian Monetary Agency) and private-equity-like funds, including Dubai International Capital.

. . . and where it’s going

Compared with traditional players such as pension funds and mutual funds, the assets of petrodollar investors are relatively modest. Still, they have been growing at an impressive rate of 19 percent a year since 2000 and will continue to increase their impact on world financial markets because of escalating energy demand from China, India, and other emerging markets. Even in a base case with oil prices reverting to $50 a barrel,⁴ the oil-exporting countries would have net capital outflows⁵ of $387 billion a year through 2012—an infusion of more than $1 billion a day of capital into global financial markets. Over the next five years, we estimate, this flow would generate investments of $1.4 trillion in equities, $800 billion in fixed-income securities, and $300 billion for private-equity firms, hedge funds, and real estate. The oil exporters’ total foreign assets would grow to at least $5.9 trillion in 2012.

If oil prices remained at $70 a barrel until 2012—and they neared $100 in November 2007 as this article went to press—foreign assets purchased with petrodollars would grow to $6.9 trillion by then. This figure implies an inflow of almost $2 billion a day into global financial markets. Even if oil prices declined to $30 a barrel, foreign assets purchased with petrodollars would grow robustly (Exhibit 4). This enormous pool will continue to provide liquidity for capital markets but may also cut investment returns and create inflationary pressures in areas such as real estate.

Reserves: Asia’s opportunity cost

Second in size to petrodollars are the reserves of Asia’s central banks—reserves that have grown rapidly as a result of rising trade surpluses, foreign-investment inflows, and exchange rate policies. In 2006, Asia’s central banks held $3.1 trillion in foreign-reserve assets, 64 percent of the global total and nearly three times the amount they held in 2000. Compared with petrodollars, these assets are concentrated in just a handful of institutions. China alone had amassed around $1.4 trillion in reserves by mid-2007.

Unlike investors with petrodollars, Asia’s central banks have channeled their funds into conservative investments, such as US treasury bills. We estimate that by the end of 2006, these institutions had $1.9 trillion more in foreign reserves than they needed for exchange rate and monetary stability.⁶ Because they could have invested that sum in higher-yielding opportunities, the forgone returns represent a significant opportunity cost (Exhibit 5). On the relatively conservative assumption that alternative investments in a higher-yielding capital market portfolio might yield 5 percent more than US Treasury bills, that cost for Asia’s major economies, in 2006 alone, was almost $100 billion—1.1 percent of their total GDP.

What to do with growing reserves?

As trade surpluses accumulate, the opportunity cost of Asia’s reserves will become even greater. If recent growth continues, they will reach $7.3 trillion in 2012. Even if China’s current-account surplus declined dramatically over the next five years and Japan’s remained the same, Asia’s reserve assets would grow to $5.1 trillion by 2012 (Exhibit 6).

n a quest for higher returns, some Asian governments have begun to diversify their assets by channeling some of their reserves to sovereign wealth funds similar to those of oil-exporting nations. The Government of Singapore Investment Corporation (GIC), established in 1981, now has an estimated $150 billion to $200 billion in assets and according to public statements has plans to increase them to $300 billion. Korea Investment Corporation (KIC) has $20 billion in assets, the new China Investment Corporation (CIC) $200 billion. The assets of Asia’s sovereign wealth funds could collectively reach $700 billion in the next few years, with the potential for even more growth.

Such a shift will benefit Asian nations through higher investment returns and spread the "Asian liquidity bonus" beyond the US fixed-income market. Given the large and rapidly growing amounts of reserves used to purchase assets, however, US interest rates won’t necessarily rise as a result. Over time, a greater share of the investments made by the sovereign wealth funds may stay within Asia, spurring the development of its financial markets.

Beneficiaries of liquidity

Hedge funds and private-equity funds are among the beneficiaries of the added liquidity that Asian and oil-rich countries bring to global markets. Assets under management in hedge funds totaled $1.7 trillion by the middle of 2007. But after taking into account leverage, we estimate that their gross investment assets could amount to as much as $6 trillion, more than the foreign assets of investors from oil-producing countries or Asia’s central banks.⁸

Although the failure of several multibillion-dollar hedge funds in mid-2007 may slow the sector’s growth, investors usually look to the long term; it would take several years of low returns before these vehicles lost their appeal. What’s more, oil investors are big clients of hedge funds and private-equity funds, with around $350 billion committed today, and high oil prices could more than double that sum over the next five years. Even if the growth of the hedge funds’ assets were to slow significantly—say, to 5 percent a year—by 2012 they could still reach $3.5 trillion (Exhibit 7). Taking into account leverage, hedge funds would then have gross investments of $9 trillion to $12 trillion, about a third of the assets that mutual funds around the world will have in that year.

Hedge funds as financial engines

Thanks to the size and active-trading styles of hedge funds, they play an increasingly significant role in global financial markets: in 2006 they accounted for 30 to 60 percent of trading volumes in the US and UK equity and debt markets, and in some higher-risk asset classes, such as derivatives and distressed debt, they are the largest type of player (Exhibit 8). Although petrodollar investors and Asia’s central banks add liquidity by bringing in new capital, hedge funds do so by trading actively and playing a large role in credit derivative markets. In this way, they increase the number of financing options available to borrowers (including private-equity firms) that might have found it hard to attract financing in the past, and their active trading improves the pricing efficiency of financial markets.

How risky?

Worries persist that the hedge funds’ growing size and heavy borrowing could destabilize financial markets. But our research finds that over the past ten years several developments have reduced—though certainly not eliminated—the risk of a broader crisis if one or more funds collapsed.

For one thing, their investment strategies are becoming more diverse (Exhibit 9). Ten years ago more than 60 percent of their assets were invested in directional bets on macroeconomic indicators. That share has shrunk to just 15 percent today. Arbitrage and other market-neutral strategies have become more common, thereby reducing herd behavior—one reason most hedge funds withstood the US subprime turmoil in 2007. Several large quantitative-equity arbitrage funds simultaneously suffered large losses, indicating that their trading models were more similar than previously thought. But, overall, the sector emerged relatively unscathed.

In addition, banks now manage risk more capably; the largest appear to have enough equity and collateral to cover losses from their hedge fund investments. Our analysis indicates that the top ten banks’ total exposure to credit and derivatives risk from hedge funds is 2.4 times equity—a relatively high capital adequacy ratio of 42 percent.

Private equity: small but powerful

Private equity has gained prominence less because of its size than its impact on corporate governance. Although assets under management rose 2.5 times, to $710 billion, from 2000 to 2006, the private-equity industry is roughly half the size of the hedge funds, smaller than the largest petrodollar fund (the ADIA), and growing more slowly than either.

Even so, thanks to typical investment horizons of four to five years, concentrated ownership positions, and seats on the board of directors, private-equity funds can embark upon longer-term, and therefore potentially more effective, corporate-restructuring efforts. Not all private-equity firms live up to that billing, however. Our research shows that only the top-performing ones sustainably improve the operations of the companies in their portfolios and generate high returns.

The growing size of individual firms—and "club deals" combining the muscle of several firms or investors—have enabled them to buy ever-larger companies. Private-equity investors accounted for one-third of all US mergers and acquisitions in 2006 and for nearly 20 percent in Europe (Exhibit 10). This wave of buyouts has prompted CEOs and boards at some companies to find new ways of strengthening their performance.

Size limits risk

Private-equity firms may also amplify the risks in financial markets—particularly credit risk—because they like to finance takeovers with leveraged loans and use their growing clout to extract looser lending covenants and better terms from banks. The credit market correction of mid-2007, however, jeopardized the financing for many private-equity deals.

Even if private-equity defaults rose sharply, they would not be likely to have broader implications for financial markets. In 2006 private-equity firms accounted for just 11 percent of overall corporate borrowing in Europe and the United States. If their default rates rose to 15 percent of all deals—the previous high was 10 percent—the implied losses would equal only 3 and 7 percent, respectively, of 2006 syndicated-lending issuance in Europe and the United States (Exhibit 11).

Growth signals a structural shift

Despite the difficult experience of some recent buyout deals, we believe that global private-equity assets under management will double to $1.4 trillion by 2012. Our projection assumes that fund-raising remains at its 2006 level in Europe and the United States and grows at half its previous rate in Asia and the rest of the world. If current growth rates in fund-raising continued, private-equity assets would reach $2.6 trillion in 2012 (Exhibit 12).

Either way, that kind of growth represents a fundamental shift in the development of financial markets. For the past 25 years, financial intermediation in mature economies has migrated steadily from bank lending to the public-equity and debt markets. The rise of private equity and the private pools of capital in sovereign wealth funds herald the resurgence of private forms of financing.

The road ahead

Regardless of whether interest rates rise or oil prices drop, the four new power brokers will continue to grow and shape the future development of capital markets. To ease the transition to the coming financial order, the players can take some useful steps.

Because capital markets function on the free flow of information, sovereign wealth funds and other types of government-investment units⁹ in Asia and in oil-exporting nations should consider disclosing more information about their investment strategies, target portfolio allocations, internal risk-management procedures, and governance structures. (Norway’s Government Pension Fund is a model in this respect.) Funds can allay concerns that politics will play a role in their decisions—and reduce the likelihood that regulators will act too aggressively—by publicly stating their investment goals.

Policy makers in Europe and the United States should base any regulatory response to the activities of the new power brokers on an objective appraisal of the facts. In particular, they ought to distinguish between direct foreign acquisitions of companies and passive investments by diversified players in financial markets.

Banks must protect themselves against the risks posed by hedge funds and private-equity funds. In particular, they need tools and incentives to measure and monitor their exposure accurately and to maintain enough capital and collateral to cover these risks. Currently, it is difficult to assess the dangers stemming from illiquid collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs). Ratings agencies and investors alike must raise their risk-assessment game.

With the growth of credit derivatives and collateralized debt obligations, banks have in many cases removed themselves from the consequences of poorly underwritten lending. As institutions originate more and more loans without putting their own capital at risk for the long-term performance of those loans, regulators should find ways to check a decline in standards. Concerns about the rise of the four power brokers are rational. But we find cause for qualified optimism that the benefits of liquidity, innovation, and diversification they bring will outweigh the risks.

Babcock faces off adversarial investors

2007-11-29T13:42:00.000+08:00

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

2007-11-27T19:39:00.000+08:00

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

2007-11-26T22:50:00.000+08:00

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

2007-11-22T08:58:00.000+08:00

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

2007-11-22T08:53:00.000+08:00

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

2007-11-22T08:49:00.000+08:00

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?

2007-11-20T10:16:00.000+08:00

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

2007-11-20T10:11:00.000+08:00

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

2007-11-19T17:15:00.000+08:00

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

2007-11-19T17:05:00.000+08:00

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

2007-11-19T13:38:00.000+08:00

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

2007-11-16T09:57:00.000+08:00

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

2007-11-15T15:23:00.000+08:00

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

2007-11-15T15:19:00.000+08:00

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

2007-11-14T10:41:00.000+08:00

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

2007-11-14T10:34:00.000+08:00

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

2007-11-14T10:22:00.000+08:00

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.

2007-11-14T10:13:00.000+08:00

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.''