Business Times - 09 Sep 2009
Despite losing an estimated US$25b in 2008, few people on or off Wall St have capitalised on this crisis as deftly as Warren Buffett
(NEW YORK) Warren E Buffett has two cardinal rules of investing. Rule No 1: Never lose money. Rule No 2: Never forget Rule No 1.
Well, a lot of old rules got trashed when the financial crisis struck - even for the Oracle of Omaha.
At 79, Buffett is coming off the worst year of his long, storied career. On paper, he personally lost an estimated US$25 billion in the financial panic of 2008, enough to cost him his title as the world's richest man. (His friend and sometime bridge partner, Bill Gates, holds that honour, according to Forbes.)
And yet, few people on or off Wall Street have capitalised on this crisis as deftly as Buffett. After counselling Washington to rescue the nation's financial industry and publicly urging Americans to buy stocks as the markets reeled, in he swooped.
Buffett positioned himself to profit from the market mayhem - as well as all those taxpayer-financed bailouts - and thus secure his legacy as one of the greatest investors of all time.
When so many others were running scared last autumn, Buffett invested billions in Goldman Sachs - and got a far better deal than Washington. He then staked billions more on General Electric.
While taxpayers never bailed out Buffett, they did bail out some of his stock picks. Goldman, American Express, Bank of America, Wells Fargo, US Bancorp - all of them got public bailouts that ultimately benefited private shareholders like Buffett.
If Buffett picked well - and, so far, it looks as if he did - his payoff could be enormous. But now, only a year after the crisis struck, he seems to be worrying that the broader stock market might falter again.
After boldly buying when so many were selling assets, his conglomerate, Berkshire Hathaway, is pulling back, buying fewer stocks while investing in corporate and government debt. And Buffett is warning that the economy, though on the mend, remains deeply troubled.
'We are not out of problems yet,' Buffett said last week in an interview, in which he reflected on the lessons of the last 12 months.
'We have got to get the sputtering economy back so it is functioning as it should be.'
Still, Buffett hardly sounded shellshocked in the wake of what he once called the financial equivalent of Pearl Harbor. (An estimated net worth of US$37 billion would be a balm to anyone's psyche.)
'It has been an incredibly interesting period in the last year and a half. Just the drama,' Buffett said. 'Watching the movie has been fun, and occasionally participating has been fun too, though not in what it has done to people's lives.'
Investors big and small hang on Buffett's pronouncements, and with good reason: if you had invested US$1,000 in the stock of Berkshire in 1965, you would have amassed millions of dollars by 2007.
Despite that formidable record, the financial crisis dealt him a stinging blow. While he has not changed his value-oriented approach to investing - he says he likes to buy quality merchandise, whether socks or stocks, at bargain prices - Buffettologists wonder what will define the final chapters of his celebrated career.
In doubt, too, is the future of a post-Buffett Berkshire. The sprawling company, whose primary business is insurance, lost about a fifth of its market value during the last year, roughly as much as the broader stock market.
While Berkshire remains a corporate bastion, it lost US$1.53 billion during the first quarter, then its top-flight credit rating. It returned to profit during Q2.
Time is short. While he has no immediate plans to retire, Buffett is believed to be grooming several possible successors, notably David L Sokol, chairman of MidAmerican Energy Holdings at Berkshire and also chairman of NetJets, the private jet company owned by Berkshire.
After searching in vain for good investments during the bull market years, Buffett used last year's rout to make investments that could sow the seeds of future profits.
Justin Fuller, author of the blog Buffettologist and a partner at Midway Capital Research and Management, said the events of the last year, while painful for many, provided Buffett with the opportunity he had been waiting for.
'He put a ton of capital to work,' Fuller said. 'The crisis gave him the ability to put one last and lasting impression on Berkshire Hathaway.'
For the moment, Buffett seems to be retrenching a bit. Like so many people, he was blindsided by the blowup in the housing market and the recession that followed, which hammered his holdings of financial and consumer-related companies.
He readily concedes he made his share of mistakes. Among his blunders: investing in an energy company around the time oil prices peaked, and in two Irish banks even as that country's financial system trembled.
Buffett declined to predict the short-run course of the stock market. But corporate data from Berkshire shows his company was selling more stocks than it was buying by the end of Q2, according to Bloomberg News.
Its spending on stocks fell to the lowest level in more than five years, although the company is still deftly picking up shares in some companies and buying corporate and government debt.
Among the stocks Buffett has been selling lately is Moody's, the granddaddy of the much-maligned credit ratings industry. Berkshire, Moody's largest shareholder, said last week that it had reduced its stake by 2 per cent\. \-- NYT
Wednesday, September 9, 2009
Wednesday, September 2, 2009
Who will succeed in the coming super-cycle?
Business Times - 01 Sep 2009
Shift of economic power to the East will create huge opportunities for emerging economies
By GERARD LYONS
A PROFOUND change is under way in the world economy. The balance of economic and financial power is shifting from the West to the East.
This shift could usher in a super-cycle of strong, sustained growth for those economies best-positioned to succeed. The successful countries will be those with financial clout or natural resources, or with the ability to adapt and change with the times.
The current crisis, triggered by a systemic failure of the financial system in the West and by an imbalanced world economy, is a sign of this global shift.
Savings flowed 'uphill' from regions running current account surpluses, such as the Middle East and Asia, to deficit countries such as the United States, Spain and the UK.
Some blame the savers, not just the borrowers. This is harsh. The countries that provided the savings to fuel the global boom were not the problem, but are part of the solution. The 1944 Bretton Woods agreement, which has driven thinking since, placed no obligations on savers to correct global imbalances.
The onus was put on countries with deficits to take corrective action. This has to change. A more balanced global economy is needed. The West should spend less and save more, while the Middle East and Asia should do the reverse.
Achieving this will take years, and the implications are huge. The West will become relatively poorer. Money and savings will flow eastwards as multinationals and pension funds invest in markets with higher growth and rising incomes.
Asia will need to change its growth model and boost domestic demand. At this year's Asian Development Bank meeting in Bali, there was a determination to put steps in motion to achieve this, with a focus on social safety nets to discourage saving for a rainy day.
Asia also needs to deepen and broaden its capital markets to allow firms to raise funds, invest and generate jobs. Over the next decade, Asia needs 750 million extra jobs for its young, growing population.
Achieving this would create a huge market for the West to sell into, but at the price of greater global competition. In recent years, the pace and scale of change on the ground in economies as diverse as Brazil, Vietnam and China have been profound.
Furthermore, the catch-up potential of these and others, such as India and Indonesia, is huge. Despite the crisis, the recent infrastructure boom seen in the Middle East continues, particularly in Saudi Arabia and Qatar.
As a result, emerging countries are accounting for an increasing share of global growth. Although the change is widespread, it is China and India that naturally attract attention.
China is still a poor country with huge imbalances, yet its rise over the last three decades has been phenomenal. Now, China is heading into a new development phase, building its infrastructure to compete at every level.
China's US$586 billion stimulus package over this year and next is supplemented by two profound measures - one aimed at building a social safety net and the other at helping farmers to buy consumer goods.
As a result, this year alone the increase in Chinese consumer spending may make up for more than half the shortfall in US consumption. China's growth is forcing others to step up a gear, too.
India's general election this summer saw the government re-elected with a larger majority that could usher in a period of reform, boosting investment and innovation. With 600 million people aged under 25, the potential for India, if it gets this right, is huge.
There are serious implications for commodities, trade and financial flows. Already China accounts for one-third of global demand for metals, and this is rising. India could follow suit, not just in metals, but in food as well.
The outcome will be higher commodity prices, increased investment in countries rich in resources and in water, and a growing need for technological solutions. Regional trade flows are already shifting, with more bilateral deals, rising intra-Asian trade, and greater flows of commodities, goods and investment between Asia and the Middle East, Africa and Latin America.
This will continue, and as it does, it will spell problems for the US dollar. There is a slow-burning fuse underneath the US dollar. A decade ago, Asian central banks held one-third of global currency reserves, and this has now risen to two-thirds, the bulk in US dollars.
Although this has been called the 'dollar trap', the reality is that countries do not want to sell the US dollar actively. Instead, passive diversification is under way. As reserves build, fewer are put into the US dollar.
Brazil and China recently discussed paying for each other's trade in their own currencies, not in US dollars, as is the norm. As trade flows change, we expect more countries to manage their exchange rates against baskets of currencies with which they trade.
The shift of economic power from the West to the East will create profound challenges for many economies, not least the US. It will create huge opportunities for emerging economies, especially those which can position themselves to benefit from the new reality.
Regardless of the winners and losers, this shift is inevitable, and it is crucial to correcting the imbalances in the global economy.
The writer is chief economist and group head of global research at Standard Chartered Bank
Shift of economic power to the East will create huge opportunities for emerging economies
By GERARD LYONS
A PROFOUND change is under way in the world economy. The balance of economic and financial power is shifting from the West to the East.
This shift could usher in a super-cycle of strong, sustained growth for those economies best-positioned to succeed. The successful countries will be those with financial clout or natural resources, or with the ability to adapt and change with the times.
The current crisis, triggered by a systemic failure of the financial system in the West and by an imbalanced world economy, is a sign of this global shift.
Savings flowed 'uphill' from regions running current account surpluses, such as the Middle East and Asia, to deficit countries such as the United States, Spain and the UK.
Some blame the savers, not just the borrowers. This is harsh. The countries that provided the savings to fuel the global boom were not the problem, but are part of the solution. The 1944 Bretton Woods agreement, which has driven thinking since, placed no obligations on savers to correct global imbalances.
The onus was put on countries with deficits to take corrective action. This has to change. A more balanced global economy is needed. The West should spend less and save more, while the Middle East and Asia should do the reverse.
Achieving this will take years, and the implications are huge. The West will become relatively poorer. Money and savings will flow eastwards as multinationals and pension funds invest in markets with higher growth and rising incomes.
Asia will need to change its growth model and boost domestic demand. At this year's Asian Development Bank meeting in Bali, there was a determination to put steps in motion to achieve this, with a focus on social safety nets to discourage saving for a rainy day.
Asia also needs to deepen and broaden its capital markets to allow firms to raise funds, invest and generate jobs. Over the next decade, Asia needs 750 million extra jobs for its young, growing population.
Achieving this would create a huge market for the West to sell into, but at the price of greater global competition. In recent years, the pace and scale of change on the ground in economies as diverse as Brazil, Vietnam and China have been profound.
Furthermore, the catch-up potential of these and others, such as India and Indonesia, is huge. Despite the crisis, the recent infrastructure boom seen in the Middle East continues, particularly in Saudi Arabia and Qatar.
As a result, emerging countries are accounting for an increasing share of global growth. Although the change is widespread, it is China and India that naturally attract attention.
China is still a poor country with huge imbalances, yet its rise over the last three decades has been phenomenal. Now, China is heading into a new development phase, building its infrastructure to compete at every level.
China's US$586 billion stimulus package over this year and next is supplemented by two profound measures - one aimed at building a social safety net and the other at helping farmers to buy consumer goods.
As a result, this year alone the increase in Chinese consumer spending may make up for more than half the shortfall in US consumption. China's growth is forcing others to step up a gear, too.
India's general election this summer saw the government re-elected with a larger majority that could usher in a period of reform, boosting investment and innovation. With 600 million people aged under 25, the potential for India, if it gets this right, is huge.
There are serious implications for commodities, trade and financial flows. Already China accounts for one-third of global demand for metals, and this is rising. India could follow suit, not just in metals, but in food as well.
The outcome will be higher commodity prices, increased investment in countries rich in resources and in water, and a growing need for technological solutions. Regional trade flows are already shifting, with more bilateral deals, rising intra-Asian trade, and greater flows of commodities, goods and investment between Asia and the Middle East, Africa and Latin America.
This will continue, and as it does, it will spell problems for the US dollar. There is a slow-burning fuse underneath the US dollar. A decade ago, Asian central banks held one-third of global currency reserves, and this has now risen to two-thirds, the bulk in US dollars.
Although this has been called the 'dollar trap', the reality is that countries do not want to sell the US dollar actively. Instead, passive diversification is under way. As reserves build, fewer are put into the US dollar.
Brazil and China recently discussed paying for each other's trade in their own currencies, not in US dollars, as is the norm. As trade flows change, we expect more countries to manage their exchange rates against baskets of currencies with which they trade.
The shift of economic power from the West to the East will create profound challenges for many economies, not least the US. It will create huge opportunities for emerging economies, especially those which can position themselves to benefit from the new reality.
Regardless of the winners and losers, this shift is inevitable, and it is crucial to correcting the imbalances in the global economy.
The writer is chief economist and group head of global research at Standard Chartered Bank
Jamie Oliver to open Italian restaurant chain in Asia
Business Times - 26 Aug 2009
(HONG KONG) Celebrity chef Jamie Oliver is planning to launch 30 Italian family-style restaurants in Asia, with the first one set to open its doors to his gastronomic followers in Hong Kong early next year.
The move marks the first step in taking his chain Jamie's Italian - which now has five eateries in England - outside his hometown, to a region which takes pride in its rich diversity of international cuisine and where the economy is picking up faster than anywhere else in the world.
'Why Asia? Of all the markets, it has by far the fastest-growing economy,' said Edward Pinshow, president of Tranic Franchising, which formed a venture with Jamie's Italian International for the Asia expansion. 'The Chinese have become extremely fond of Italian food. In Japan, Jamie's become a household name,' he said yesterday.
Mr Pinshow told AFP that the first stage of the expansion was to open six restaurants in Hong Kong and Singapore, for which he is now raising about US$200 million.
They plan to roll out another 24 eateries in other parts of the region over the next five years, with China, Japan, Taiwan and Korea among the most likely candidates for location.
Mr Pinshow said they are now working hard to get their first restaurant - a 5,000 sq ft, 180-seat venue in Hong Kong - ready for opening in the second quarter of next year.
He said the menu would offer a full-course meal with antipasti, main dish, dessert, plus a glass of Italian wine, for an average of HK$300 (S$55.70) per head\. \-- AFP
(HONG KONG) Celebrity chef Jamie Oliver is planning to launch 30 Italian family-style restaurants in Asia, with the first one set to open its doors to his gastronomic followers in Hong Kong early next year.
The move marks the first step in taking his chain Jamie's Italian - which now has five eateries in England - outside his hometown, to a region which takes pride in its rich diversity of international cuisine and where the economy is picking up faster than anywhere else in the world.
'Why Asia? Of all the markets, it has by far the fastest-growing economy,' said Edward Pinshow, president of Tranic Franchising, which formed a venture with Jamie's Italian International for the Asia expansion. 'The Chinese have become extremely fond of Italian food. In Japan, Jamie's become a household name,' he said yesterday.
Mr Pinshow told AFP that the first stage of the expansion was to open six restaurants in Hong Kong and Singapore, for which he is now raising about US$200 million.
They plan to roll out another 24 eateries in other parts of the region over the next five years, with China, Japan, Taiwan and Korea among the most likely candidates for location.
Mr Pinshow said they are now working hard to get their first restaurant - a 5,000 sq ft, 180-seat venue in Hong Kong - ready for opening in the second quarter of next year.
He said the menu would offer a full-course meal with antipasti, main dish, dessert, plus a glass of Italian wine, for an average of HK$300 (S$55.70) per head\. \-- AFP
Hedge your equities portfolio
Business Times - 26 Aug 2009
The six-month stock rally looks likely to continue but the risks have risen sharply along with prices, writes LIM SAY BOON
INVESTORS who have yet to hedge their equities positions - something that is always important to do for long-term portfolios - should look into this pretty quickly. On balance, the stock rally of the past six months should continue. But the risks have risen sharply along with prices.
The recent 20 per cent correction in stock prices on the Shanghai stock exchange might not have marked the end of the rally. But it is a warning shot. More than that, it was probably also a glimpse into the future - at how the cyclical rebound in the equities markets could end.
This has not been a high-quality rally. The underlying recovery in the global economy has been driven by inventory restocking and government fiscal and monetary stimulus. Meanwhile, the markets for risky assets - stocks, corporate debt, and commodities - have been helped along by a huge amount of liquidity sitting on the sidelines, in bank deposits and money market funds. The 'frightened money' appears to have started re-entering the market, with bets in favour of government intervention trumping deflation (see Chart 1).
But what happens after the 'mechanical' business of inventory restocking runs its course? The US consumer has been weakened by a one-third decline in the average home price and frightened by employment approaching 10 per cent. There must be serious questions over the ability of the US consumer to sustain the economic recovery beyond inventory restocking.
And even more importantly, as the panic of the past two weeks over Chinese stocks has shown, this is a monetary stimulus-dependent rally. On speculation that the Chinese government might start pulling back money supply and credit growth, the Shanghai stock market collapsed. This is not surprising given the correlation between money supply growth and the performance of the Shanghai Composite Index (see Chart 2).
But this is not just a Chinese market phenomenon. Monetary stimulus - cheap money and plenty of it - has been crucial in sustaining the 'wassail on Wall Street' (and elsewhere). The markets understand this. So they are closely scrutinising almost every word from central bankers around the world for hints of imminent 'exit'.
Events of the past 12 months have been tagged 'the Great Recession meets the Great Government Intervention'. On many measures, the 'Great Government Intervention' has prevailed. The global economy is already in recovery. Economies from Germany to Japan to Singapore are out of recession. The US is likely to be confirmed in coming months as having emerged from recession in Q3 2009.
Asset price performance
Going forward, three factors will be crucial to the future of the ongoing recovery in risky asset prices. The first relates to the strength of the cyclical rebound in the global economy. The second is about growth drivers beyond inventory restocking. And the third relates to the eventual unwinding of government stimulus.
There is a serious risk of disappointment in the strength of the economic rebound in coming months. To date, the economic data has been weighted in favour of performances beating market consensus. The equities bulls appear to be betting on the continuation of better-than-expected data.
That is, they are counting on a sharp rebound following the deep decline of the past 18 months. They are betting on the mechanical process of recovery from sharp inventory destocking, further supported by aggressive government stimulus.
However, recoveries from recessions associated with financial crises have tended to be weaker than those from simple 'cyclical recessions'.
Meanwhile, in the US, unemployment is approaching 10 per cent, house prices are down by an average of around 33 per cent, and the US household savings rate had surged from almost zero savings to around 6.2 per cent of disposable income at its recent high (before pulling back more recently to 4.6 per cent). If this marks a 'new frugality' among US consumers, the global economy is going to struggle to find new drivers for growth.
And if governments start withdrawing fiscal and monetary stimulus while the world is still fumbling around for a new growth paradigm, that would almost certainly trigger a sharp correction in the rally in stocks, corporate bonds, commodities, and commodity currencies. At this stage of the recovery, the stimulus is the party 'punchbowl'. Take that away and the party ends.
On balance, central bankers are likely to be very circumspect about withdrawing stimulus. In the US, looking back some 40 years, the Federal Reserve has never raised its policy rate until the decline in the unemployment rate has been unambiguously entrenched.
That has meant a lag of months, even a year, after the peaking of unemployment. In China, there has been a tendency by the Chinese government over recent cycles to pull in money supply growth only during peaks or close to peaks of industrial production and export growth.
Currently, US unemployment has only just shown very early signs of peaking. Meanwhile, in China, exports are still in deep year-on-year contraction. And with prices in deflation, there is little incentive at this stage for the Chinese government to reverse course on monetary policy.
So money is likely to continue to be plentiful and cheap. Low interest rates are likely to continue forcing investors into the risky asset markets in search of higher returns. And late-comers to the rally could push the markets into an overshoot of fundamentals.
For example, the Shanghai Composite prior to the recent correction was trading at 3.8 times book value. And even with the correction, it is still trading at around 3.6 times book. Eventually, when earnings growth kicks back in, the focus will turn to price-earnings valuations and high returns on equity will eventually justify the high price-to-book valuations. But this has not happened yet - hence the 'overshoot' of fundamentals.
Prices for risky assets are likely to push higher, notwithstanding all the unresolved fundamental problems. But the easy money has been made. Prepare for a rougher ride from here. Volatility - measured by the S&P 500 volatility index VIX - recently hit a low of around 23 per cent. It is still trading around 25 per cent, a far cry from its crisis peak of 90 per cent. Volatility is cheap. Investors should consider buying a proxy for VIX (see Chart 3).
The less aggressive investor might want to start taking profits off the table while continuing to ride this liquidity rally. They might put those profits into VIX to hedge their equities portfolios. They might also want to consider low correlation plays such as gold.
Lim Say Boon is the chief investment strategist for Standard Chartered Group Wealth Management and Standard Chartered Private Bank
The six-month stock rally looks likely to continue but the risks have risen sharply along with prices, writes LIM SAY BOON
INVESTORS who have yet to hedge their equities positions - something that is always important to do for long-term portfolios - should look into this pretty quickly. On balance, the stock rally of the past six months should continue. But the risks have risen sharply along with prices.
The recent 20 per cent correction in stock prices on the Shanghai stock exchange might not have marked the end of the rally. But it is a warning shot. More than that, it was probably also a glimpse into the future - at how the cyclical rebound in the equities markets could end.
This has not been a high-quality rally. The underlying recovery in the global economy has been driven by inventory restocking and government fiscal and monetary stimulus. Meanwhile, the markets for risky assets - stocks, corporate debt, and commodities - have been helped along by a huge amount of liquidity sitting on the sidelines, in bank deposits and money market funds. The 'frightened money' appears to have started re-entering the market, with bets in favour of government intervention trumping deflation (see Chart 1).
But what happens after the 'mechanical' business of inventory restocking runs its course? The US consumer has been weakened by a one-third decline in the average home price and frightened by employment approaching 10 per cent. There must be serious questions over the ability of the US consumer to sustain the economic recovery beyond inventory restocking.
And even more importantly, as the panic of the past two weeks over Chinese stocks has shown, this is a monetary stimulus-dependent rally. On speculation that the Chinese government might start pulling back money supply and credit growth, the Shanghai stock market collapsed. This is not surprising given the correlation between money supply growth and the performance of the Shanghai Composite Index (see Chart 2).
But this is not just a Chinese market phenomenon. Monetary stimulus - cheap money and plenty of it - has been crucial in sustaining the 'wassail on Wall Street' (and elsewhere). The markets understand this. So they are closely scrutinising almost every word from central bankers around the world for hints of imminent 'exit'.
Events of the past 12 months have been tagged 'the Great Recession meets the Great Government Intervention'. On many measures, the 'Great Government Intervention' has prevailed. The global economy is already in recovery. Economies from Germany to Japan to Singapore are out of recession. The US is likely to be confirmed in coming months as having emerged from recession in Q3 2009.
Asset price performance
Going forward, three factors will be crucial to the future of the ongoing recovery in risky asset prices. The first relates to the strength of the cyclical rebound in the global economy. The second is about growth drivers beyond inventory restocking. And the third relates to the eventual unwinding of government stimulus.
There is a serious risk of disappointment in the strength of the economic rebound in coming months. To date, the economic data has been weighted in favour of performances beating market consensus. The equities bulls appear to be betting on the continuation of better-than-expected data.
That is, they are counting on a sharp rebound following the deep decline of the past 18 months. They are betting on the mechanical process of recovery from sharp inventory destocking, further supported by aggressive government stimulus.
However, recoveries from recessions associated with financial crises have tended to be weaker than those from simple 'cyclical recessions'.
Meanwhile, in the US, unemployment is approaching 10 per cent, house prices are down by an average of around 33 per cent, and the US household savings rate had surged from almost zero savings to around 6.2 per cent of disposable income at its recent high (before pulling back more recently to 4.6 per cent). If this marks a 'new frugality' among US consumers, the global economy is going to struggle to find new drivers for growth.
And if governments start withdrawing fiscal and monetary stimulus while the world is still fumbling around for a new growth paradigm, that would almost certainly trigger a sharp correction in the rally in stocks, corporate bonds, commodities, and commodity currencies. At this stage of the recovery, the stimulus is the party 'punchbowl'. Take that away and the party ends.
On balance, central bankers are likely to be very circumspect about withdrawing stimulus. In the US, looking back some 40 years, the Federal Reserve has never raised its policy rate until the decline in the unemployment rate has been unambiguously entrenched.
That has meant a lag of months, even a year, after the peaking of unemployment. In China, there has been a tendency by the Chinese government over recent cycles to pull in money supply growth only during peaks or close to peaks of industrial production and export growth.
Currently, US unemployment has only just shown very early signs of peaking. Meanwhile, in China, exports are still in deep year-on-year contraction. And with prices in deflation, there is little incentive at this stage for the Chinese government to reverse course on monetary policy.
So money is likely to continue to be plentiful and cheap. Low interest rates are likely to continue forcing investors into the risky asset markets in search of higher returns. And late-comers to the rally could push the markets into an overshoot of fundamentals.
For example, the Shanghai Composite prior to the recent correction was trading at 3.8 times book value. And even with the correction, it is still trading at around 3.6 times book. Eventually, when earnings growth kicks back in, the focus will turn to price-earnings valuations and high returns on equity will eventually justify the high price-to-book valuations. But this has not happened yet - hence the 'overshoot' of fundamentals.
Prices for risky assets are likely to push higher, notwithstanding all the unresolved fundamental problems. But the easy money has been made. Prepare for a rougher ride from here. Volatility - measured by the S&P 500 volatility index VIX - recently hit a low of around 23 per cent. It is still trading around 25 per cent, a far cry from its crisis peak of 90 per cent. Volatility is cheap. Investors should consider buying a proxy for VIX (see Chart 3).
The less aggressive investor might want to start taking profits off the table while continuing to ride this liquidity rally. They might put those profits into VIX to hedge their equities portfolios. They might also want to consider low correlation plays such as gold.
Lim Say Boon is the chief investment strategist for Standard Chartered Group Wealth Management and Standard Chartered Private Bank
Should shareholders own companies?
Business Times - 02 Sep 2009
BREAKINGVIEWS.COM
By EDWARD HADAS
SHAREHOLDERS own companies. That is what the law says, but when it comes to big listed corporations, most of these owners don't take much care over their property. Lord Myners, the UK City minister, is the latest to complain about this cavalier approach.
Mr Myners' previous suggestions for reform - selling votes, and offering extra votes to long-term holders - don't address the main problem: Most shareholders these days can't or won't think like owners. But his latest proposal - to have more non-voting shares for apathetic investors - is a sensible acknowledgement of the reality that most equity investors make bad owners.
Small private investors generally don't know enough about business and finance. The professional portfolio investor looks only a year or two ahead, and the constant struggle to outperform peers leaves almost no time to worry about individual holdings. Pure traders rarely look more than a few weeks ahead. Even activist investors are often just looking for a quick turn.
Ideally, equity investors might somehow be prodded to take a more active and long-term interest in management. But it is hard to see how that can happen without draconian changes in capital markets: Ending the cult of relative performance and imposing multi-year minimum holding periods.
But something less radical could work even better. Why not admit that absentee equity investors of large publicly traded companies shouldn't generally be treated as owners in the first place? That seems to be the thinking underpinning Mr Myners' idea that many shareholders could choose to disenfranchise themselves by investing in B-shares.
The attribution of ownership to common shares is something of a historical accident. It can still work well for small companies run by their controlling shareholders. But for big companies, common shares are best seen as one of many types of capital. Bondholders and lending banks provide other types of financial capital. Workers bring human capital. Governments and communities offer social capital. There is no good reason to give equity holders absolute priority over all the other capital providers, in the broad sense of the term.
The responsibilities of ownership are best handed to management. Top managers often say that 'shareholder value' is their only or their ultimate concern. That may be true in some theoretical sense - especially if they are talking about shareholder value a generation or two from now. But in practice, the managers spend most of their time trying to serve and balance the needs and desires of many constituencies.
Shareholders are certainly one of them, and should be more important than, say, former workers. But equity investors typically focus on strong quarterly earnings and pleasing patter. Those are usually less important than such other management - or rather ownership - responsibilities as big investment decisions, keeping key workers on board, meeting environmental regulations and ensuring that there is enough cash to keep up with debt payments.
Managers overall do a good job in working for all capital providers. They are certainly better placed to run companies day-to-day and quarter-to-quarter than any outsiders, including the so-called owners. Even when it comes to company-shaping decisions - major investments, acquisitions or being acquired - managers are better placed than anyone else.
As long as markets are liquid, most shareholders will prefer to sell than to try to change companies. That's probably a sensible use of their time, since it's hard to believe these outsiders could add much value to corporate decision-making, even if they tried.
If you want someone to oversee the managers, it should not be the shareholders but the board of directors. Board members aren't generally as short-term in their thinking as the shareholders who usually rubber-stamp their election. A well-chosen board can offer managers outside perspective, relevant experience and even ethical guidance. True, few boards are good at standing up to domineering chief executives. But that's the nature of collaborative enterprises. No system of corporate governance will ever be perfect.
Mr Myners' notion of creating voting and non-voting shares could help address one of the main weaknesses of the current system: That it is too hard to change incompetent boards. If only half the shares carried votes and the prices of voting and non-voting shares were not much different, it would take roughly half as much money to influence corporate direction. That lower threshold could reduce complacency.
In any case, corporate reformers should leave indifferent shareholders alone. For anyone who is serious about improving the oversight of companies - and protecting the long-term interests of shareholders - the board of directors should be the first port of call.
BREAKINGVIEWS.COM
By EDWARD HADAS
SHAREHOLDERS own companies. That is what the law says, but when it comes to big listed corporations, most of these owners don't take much care over their property. Lord Myners, the UK City minister, is the latest to complain about this cavalier approach.
Mr Myners' previous suggestions for reform - selling votes, and offering extra votes to long-term holders - don't address the main problem: Most shareholders these days can't or won't think like owners. But his latest proposal - to have more non-voting shares for apathetic investors - is a sensible acknowledgement of the reality that most equity investors make bad owners.
Small private investors generally don't know enough about business and finance. The professional portfolio investor looks only a year or two ahead, and the constant struggle to outperform peers leaves almost no time to worry about individual holdings. Pure traders rarely look more than a few weeks ahead. Even activist investors are often just looking for a quick turn.
Ideally, equity investors might somehow be prodded to take a more active and long-term interest in management. But it is hard to see how that can happen without draconian changes in capital markets: Ending the cult of relative performance and imposing multi-year minimum holding periods.
But something less radical could work even better. Why not admit that absentee equity investors of large publicly traded companies shouldn't generally be treated as owners in the first place? That seems to be the thinking underpinning Mr Myners' idea that many shareholders could choose to disenfranchise themselves by investing in B-shares.
The attribution of ownership to common shares is something of a historical accident. It can still work well for small companies run by their controlling shareholders. But for big companies, common shares are best seen as one of many types of capital. Bondholders and lending banks provide other types of financial capital. Workers bring human capital. Governments and communities offer social capital. There is no good reason to give equity holders absolute priority over all the other capital providers, in the broad sense of the term.
The responsibilities of ownership are best handed to management. Top managers often say that 'shareholder value' is their only or their ultimate concern. That may be true in some theoretical sense - especially if they are talking about shareholder value a generation or two from now. But in practice, the managers spend most of their time trying to serve and balance the needs and desires of many constituencies.
Shareholders are certainly one of them, and should be more important than, say, former workers. But equity investors typically focus on strong quarterly earnings and pleasing patter. Those are usually less important than such other management - or rather ownership - responsibilities as big investment decisions, keeping key workers on board, meeting environmental regulations and ensuring that there is enough cash to keep up with debt payments.
Managers overall do a good job in working for all capital providers. They are certainly better placed to run companies day-to-day and quarter-to-quarter than any outsiders, including the so-called owners. Even when it comes to company-shaping decisions - major investments, acquisitions or being acquired - managers are better placed than anyone else.
As long as markets are liquid, most shareholders will prefer to sell than to try to change companies. That's probably a sensible use of their time, since it's hard to believe these outsiders could add much value to corporate decision-making, even if they tried.
If you want someone to oversee the managers, it should not be the shareholders but the board of directors. Board members aren't generally as short-term in their thinking as the shareholders who usually rubber-stamp their election. A well-chosen board can offer managers outside perspective, relevant experience and even ethical guidance. True, few boards are good at standing up to domineering chief executives. But that's the nature of collaborative enterprises. No system of corporate governance will ever be perfect.
Mr Myners' notion of creating voting and non-voting shares could help address one of the main weaknesses of the current system: That it is too hard to change incompetent boards. If only half the shares carried votes and the prices of voting and non-voting shares were not much different, it would take roughly half as much money to influence corporate direction. That lower threshold could reduce complacency.
In any case, corporate reformers should leave indifferent shareholders alone. For anyone who is serious about improving the oversight of companies - and protecting the long-term interests of shareholders - the board of directors should be the first port of call.
A comfortable, not lavish, retirement
Business Times - 02 Sep 2009
Surviving retirement without a big pension that never runs out isn't easy, but it's possible with sensible tweaking along the way
By RON LIEBER
WHEN you retire, you'll probably want to visit your grandchildren more than once each year. Perhaps you'll aim to give money each month to charity or your religious congregation.
The amount you have saved will clearly matter a great deal in whether you can do these things. But so will your portfolio withdrawal rate - the percentage of your assets that you take out each year to pay your expenses. You want it to be high enough to afford fun and generosity but low enough that you have little risk of running out of money.
Until a few years ago, the standard advice was that 4 or 4.5 per cent was about the best you could do. So if you had US$500,000 in savings, 4 per cent would give you about US$20,000 in your first year of retirement to augment Social Security and any other income. Then, you could give yourself a raise each year based on inflation. At 3 per cent inflation, you'd end up with US$20,600 in the second year of retirement and so on from there.
More recently, however, several studies have suggested that withdrawing 5 or even 6 per cent was possible - and still prudent. Retirees rejoiced.
And then the stock market fell to pieces. In the wake of the carnage, people who hope to retire anytime soon will probably be starting with a kitty smaller than they had expected just a few years ago. So an extra percentage point on the withdrawal rate matters even more than it might have in 2007. It could be the difference between travelling to see family or not, or it could determine when you get to retire in the first place.
But could it also lead you on a path towards ruin? This week, I went back to two of the researchers who had come up with the more generous formulas to see whether they're sticking by them. Not only are they staying the course, but one is telling his clients that they can take out as much as 6 per cent of their money during the next year. How can they justify something like this after the year we've just had?
Setting a rate
Here's one big reason to be suspicious about applying that same 4.5 per cent withdrawal rate to all people, no matter when they retire: Should a person who had the bad luck to retire in March 2009, at the stock market's recent bottom, spend 4.5 per cent of, say, US$350,000, or could they spend a bit more? After all, people who retired a year or two earlier with the same portfolio, before the bulk of the stock market's decline, might have started with 4.5 per cent of US$550,000 (and taken inflation-adjusted raises each year from that initial amount until they died).
It didn't seem right to Michael E Kitces, a financial planner and director of research at Pinnacle Advisory Group in Columbia, Maryland. He said he was uncomfortable with all the decisions made based on 'the day you happen to come into my office and the balance on that day'. In fact, he started looking into this before the market collapsed, and his research ended up suiting the conditions of the last year perfectly. He tried to figure out whether one could estimate how much better or worse stockmarket returns might be in the years after big declines - and whether the answer might allow for a more generous initial withdrawal rate.
What he concluded was that the overall market's price-earnings ratio - taking the current price for the Standard & Poor's 500-stock index divided by the average inflation-adjusted earnings for the past 10 years before the date of withdrawal - was predictive enough to produce guidelines. Then he came up with the following suggestions for a portfolio of 60 per cent stocks and 40 per cent bonds meant to last through 30 years of retirement.
If the ratio was above 20, indicating that stocks were overvalued, then a 4.5 per cent withdrawal rate was prudent given that the stock market was likely to fall. But if it was between 12 and 20 (the historical median is roughly 15.5), a 5 per cent rate was safe, tested against every historical period for which data was available. And if it was under 12 - a level it almost got to earlier this year - a rate of 5.5 per cent would work.
The most recent figure was 17.67, which suggests a 5 per cent withdrawal rate for current retirees. It had been above 20 until last October.
Mr Kitces gets his ratios from a set of data that Yale professor Robert Shiller creates and stores on Yale's website, at http:bit.ly/3gexz.
Making adjustments
Jonathan Guyton, a financial planner with Cornerstone Wealth Advisors in Edina, Minnesota, looked at the 4.5 per cent baseline and asked a different question: Couldn't it be a whole lot higher if a client was willing to forgo the annual inflation raise when conditions called for a bit of thrift? And if so, under what conditions would that happen - and would people be willing to, in effect, cut their own retirement paycheck?
It didn't take Mr Guyton long to find out. Two studies he worked on in 2004 and 2006 led him to the following conclusions about a portfolio meant to last 40 years: Using Mr Kitces' research to establish a baseline initial withdrawal rate of up to 5.5 per cent (or 5 per cent given valuations at the moment), the initial withdrawal rate could rise another whole percentage point, to 6.5 per cent, if at least 65 per cent of the money was in a variety of stocks, as long as the owner followed a few rules.
First, if the portfolio lost money in any given year, there would be no raise at all for inflation. And if the size of the withdrawal, in dollars, in any year amounted to an actual percentage rate of the remaining portfolio that was at least 20 per cent more than the initial withdrawal rate, retirees would have to take a 10 per cent cut in their annual allowance that year. Then, the increase for inflation would build on that new base the following year.
While Mr Guyton also put a 'prosperity' rule into place that allowed for a 10 per cent increase in particularly good years, 2008 tested his 'capital preservation' rule first. So he cut his clients' withdrawals by 10 per cent.
How did they take it? 'Many of them said, 'really, that's all?' ' he recalled. 'Keep in mind how dire things seemed.' Others blanched, noting that they had played by the rules and didn't cause the financial crisis. But they came around when Mr Guyton gave them a good talking to. 'For us to maintain the same degree of long-term financial security for you that you said you wanted, this is what you need to do,' he told them. 'It's a system. And the great thing about a policy is that it leaves no doubt about what you are supposed to do.' Another cut of 10 per cent might severely hurt their purchasing power, but the stock market's performance since March suggests that it won't be necessary in the coming months.
The real world
The actual execution of these strategies requires a bit more work.
You need to figure out what stocks and bonds should make up your investments in the first place, for instance, and how best to minimise taxes when you sell each year.
All this together seems complicated enough to suggest to a cynic that it's just a ruse to keep a client coming back each year for costly check-ups. That said, surviving retirement without a big pension that never runs out isn't easy, and paying a bit of money each year in exchange for help in prudently raising your withdrawal rate by 20 per cent does not strike me as completely insane.
Retirees also have to wonder whether the market will behave in the future as it has in the past. Or whether retirees can realistically stick to a strict budget.
'Even if you tell me that spending fluctuates a bit here and there, we still have to start somewhere,' said Mr Kitces. 'What on earth is your alternative? Are you not going to give any spending recommendations whatsoever?'
Mr Guyton solves this issue for clients who can afford it by carving out a separate discretionary fund. Retirees can spend that money on anything, but once it's gone, it's gone - unless they manage to replenish it out of their regular annual withdrawal.
There are still plenty of retirees and advisers who will balk at what appears to be outsize aggressiveness, whatever the studies indicate. To them, Mr Guyton suggests an entirely different consideration.
'The only problem is you run out of money? I don't buy that,' he said. 'For a lot of people who lock in on a 4 per cent figure, it's a formula for regret. They get 15 years in and look back at all of the things they didn't do. And now their health is gone.' - NYT
Surviving retirement without a big pension that never runs out isn't easy, but it's possible with sensible tweaking along the way
By RON LIEBER
WHEN you retire, you'll probably want to visit your grandchildren more than once each year. Perhaps you'll aim to give money each month to charity or your religious congregation.
The amount you have saved will clearly matter a great deal in whether you can do these things. But so will your portfolio withdrawal rate - the percentage of your assets that you take out each year to pay your expenses. You want it to be high enough to afford fun and generosity but low enough that you have little risk of running out of money.
Until a few years ago, the standard advice was that 4 or 4.5 per cent was about the best you could do. So if you had US$500,000 in savings, 4 per cent would give you about US$20,000 in your first year of retirement to augment Social Security and any other income. Then, you could give yourself a raise each year based on inflation. At 3 per cent inflation, you'd end up with US$20,600 in the second year of retirement and so on from there.
More recently, however, several studies have suggested that withdrawing 5 or even 6 per cent was possible - and still prudent. Retirees rejoiced.
And then the stock market fell to pieces. In the wake of the carnage, people who hope to retire anytime soon will probably be starting with a kitty smaller than they had expected just a few years ago. So an extra percentage point on the withdrawal rate matters even more than it might have in 2007. It could be the difference between travelling to see family or not, or it could determine when you get to retire in the first place.
But could it also lead you on a path towards ruin? This week, I went back to two of the researchers who had come up with the more generous formulas to see whether they're sticking by them. Not only are they staying the course, but one is telling his clients that they can take out as much as 6 per cent of their money during the next year. How can they justify something like this after the year we've just had?
Setting a rate
Here's one big reason to be suspicious about applying that same 4.5 per cent withdrawal rate to all people, no matter when they retire: Should a person who had the bad luck to retire in March 2009, at the stock market's recent bottom, spend 4.5 per cent of, say, US$350,000, or could they spend a bit more? After all, people who retired a year or two earlier with the same portfolio, before the bulk of the stock market's decline, might have started with 4.5 per cent of US$550,000 (and taken inflation-adjusted raises each year from that initial amount until they died).
It didn't seem right to Michael E Kitces, a financial planner and director of research at Pinnacle Advisory Group in Columbia, Maryland. He said he was uncomfortable with all the decisions made based on 'the day you happen to come into my office and the balance on that day'. In fact, he started looking into this before the market collapsed, and his research ended up suiting the conditions of the last year perfectly. He tried to figure out whether one could estimate how much better or worse stockmarket returns might be in the years after big declines - and whether the answer might allow for a more generous initial withdrawal rate.
What he concluded was that the overall market's price-earnings ratio - taking the current price for the Standard & Poor's 500-stock index divided by the average inflation-adjusted earnings for the past 10 years before the date of withdrawal - was predictive enough to produce guidelines. Then he came up with the following suggestions for a portfolio of 60 per cent stocks and 40 per cent bonds meant to last through 30 years of retirement.
If the ratio was above 20, indicating that stocks were overvalued, then a 4.5 per cent withdrawal rate was prudent given that the stock market was likely to fall. But if it was between 12 and 20 (the historical median is roughly 15.5), a 5 per cent rate was safe, tested against every historical period for which data was available. And if it was under 12 - a level it almost got to earlier this year - a rate of 5.5 per cent would work.
The most recent figure was 17.67, which suggests a 5 per cent withdrawal rate for current retirees. It had been above 20 until last October.
Mr Kitces gets his ratios from a set of data that Yale professor Robert Shiller creates and stores on Yale's website, at http:bit.ly/3gexz.
Making adjustments
Jonathan Guyton, a financial planner with Cornerstone Wealth Advisors in Edina, Minnesota, looked at the 4.5 per cent baseline and asked a different question: Couldn't it be a whole lot higher if a client was willing to forgo the annual inflation raise when conditions called for a bit of thrift? And if so, under what conditions would that happen - and would people be willing to, in effect, cut their own retirement paycheck?
It didn't take Mr Guyton long to find out. Two studies he worked on in 2004 and 2006 led him to the following conclusions about a portfolio meant to last 40 years: Using Mr Kitces' research to establish a baseline initial withdrawal rate of up to 5.5 per cent (or 5 per cent given valuations at the moment), the initial withdrawal rate could rise another whole percentage point, to 6.5 per cent, if at least 65 per cent of the money was in a variety of stocks, as long as the owner followed a few rules.
First, if the portfolio lost money in any given year, there would be no raise at all for inflation. And if the size of the withdrawal, in dollars, in any year amounted to an actual percentage rate of the remaining portfolio that was at least 20 per cent more than the initial withdrawal rate, retirees would have to take a 10 per cent cut in their annual allowance that year. Then, the increase for inflation would build on that new base the following year.
While Mr Guyton also put a 'prosperity' rule into place that allowed for a 10 per cent increase in particularly good years, 2008 tested his 'capital preservation' rule first. So he cut his clients' withdrawals by 10 per cent.
How did they take it? 'Many of them said, 'really, that's all?' ' he recalled. 'Keep in mind how dire things seemed.' Others blanched, noting that they had played by the rules and didn't cause the financial crisis. But they came around when Mr Guyton gave them a good talking to. 'For us to maintain the same degree of long-term financial security for you that you said you wanted, this is what you need to do,' he told them. 'It's a system. And the great thing about a policy is that it leaves no doubt about what you are supposed to do.' Another cut of 10 per cent might severely hurt their purchasing power, but the stock market's performance since March suggests that it won't be necessary in the coming months.
The real world
The actual execution of these strategies requires a bit more work.
You need to figure out what stocks and bonds should make up your investments in the first place, for instance, and how best to minimise taxes when you sell each year.
All this together seems complicated enough to suggest to a cynic that it's just a ruse to keep a client coming back each year for costly check-ups. That said, surviving retirement without a big pension that never runs out isn't easy, and paying a bit of money each year in exchange for help in prudently raising your withdrawal rate by 20 per cent does not strike me as completely insane.
Retirees also have to wonder whether the market will behave in the future as it has in the past. Or whether retirees can realistically stick to a strict budget.
'Even if you tell me that spending fluctuates a bit here and there, we still have to start somewhere,' said Mr Kitces. 'What on earth is your alternative? Are you not going to give any spending recommendations whatsoever?'
Mr Guyton solves this issue for clients who can afford it by carving out a separate discretionary fund. Retirees can spend that money on anything, but once it's gone, it's gone - unless they manage to replenish it out of their regular annual withdrawal.
There are still plenty of retirees and advisers who will balk at what appears to be outsize aggressiveness, whatever the studies indicate. To them, Mr Guyton suggests an entirely different consideration.
'The only problem is you run out of money? I don't buy that,' he said. 'For a lot of people who lock in on a 4 per cent figure, it's a formula for regret. They get 15 years in and look back at all of the things they didn't do. And now their health is gone.' - NYT
Navigating the global credit crisis
Business Times - 02 Sep 2009
MONEY MATTERS
Coming months are likely to show not only recovery but, in the case of US, accelerating recovery investors have been hoping for
By NORMAN VILLAMIN
INVESTORS can learn a lot from history. Looking back at the first quarter of 2009, many investors, fretting about the woeful state of the global economy, failed to focus on the things that matter - valuation and the rapid acceleration of global policy momentum. As it turned out, the combination of these factors created the backdrop for the sharp rally in global equities over the past six months.
Looking forward now from the heights that global equity prices have achieved, it is understandable that investors are getting increasingly wary. Admittedly, the valuation case has weakened with the rallies to date. But global policy effectiveness has not waned. Rather, it has begun to shift from the Chinese-led successes of the first half of 2009 to a broader, global story, with US policy achievements, in particular, emerging recently. This leaves the prospect, we believe, for another leg in the global rally in equities that began in March 2009.
Continued momentum in US economic and earnings data in coming weeks, underpinned by US policy momentum of the second quarter, is expected to drive this leg of the rally. Year-to-date, economic recovery momentum has been key to identifying relative outperformers globally. With emerging markets recovering from the 'Great Recession' more quickly than developed markets, economic momentum reflected in data releases has been a focus of market attention in the current rally. Recall, early in the year, news of the US and Chinese economic policy changes that helped set the stage for a bottoming in global markets. With Chinese stimulus coming sooner and more aggressively, unsurprisingly, the MSCI China rose 35 per cent in the first half of 2009, compared with a meagre 5 per cent for MSCI World.
With Chinese policy now stabilising, as Beijing tries to contain rapid year-to-date loan growth, US growth momentum is beginning to benefit from Washington's stimulus efforts of the late-first quarter of 2009. Their effectiveness was most recently seen in the July 2009 expansion of the Institute of Supply Management's New Orders Index, which historically has provided a three to six-month lead to turns in the US economy. Indeed, the most recent reading suggests that investors' concerns about job growth in the United States may begin to be addressed in coming months (see chart), providing further economic support to the earnings drivers that may emerge come October this year.
Looking a bit further ahead, the US third-quarter earnings season likewise looks set to provide support to the market in coming weeks. Indeed, during the rally since March, the US earnings season - the first six weeks of each quarter - was a key driver for market performance. Recall, as the first-quarter earnings season got under way in April, world equities, represented by MSCI World, rallied 18 per cent before stalling in mid-May as the earnings season came to a close. Similarly, as the second-quarter earnings season got under way in July 2009, world equities rallied another 12 per cent up to mid-August, as the season came to a close again. In total, on a compounded basis, the earnings-season rallies accounted for almost two-thirds of the 52 per cent rise in global equities up to Aug 21. With another earnings season quickly coming upon us in October, Tobias Levkovich, Citi's US equity strategist, notes that upward revisions to earnings expectations could continue into the northern autumn, potentially providing a catalyst for the next leg of the rally we have seen since March.
The resumption of US economic growth momentum and positive prospects for US earnings surprises in the third quarter suggest he global economic recovery is starting to transition from one with China as the sole driver to a more balanced US-China model. Indeed, since mid-year, this transition in policy and data has resulted in US equities outperforming their Chinese counterparts, with MSCI US rising 11.5 per cent up to Aug 21, exceeding the 5.7 per cent increase in MSCI China over the same period.
Therefore, although we can appreciate the caution investors are expressing, given that valuations are no longer cheap, expected news flow leads us to believe that caution will not be rewarded by the markets in the coming months. Rather, we encourage investors to manage their risk by managing their exposure within global equities. We expect that Asian equities, even after a near-50 per cent rally year-to-date, as indicated by MSCI Asia ex-Japan, may participate in this next leg. However, unlike the first half of 2009, where they trumped the flattish 5 per cent performance of global equities, we don't believe that they will necessarily lead regional performances as they did in the first semester.
Rather, investors who ignored US equities early in the year may wish to reconsider opportunities provided by this market. However, they should keep in mind that while recovery looks entrenched, the US recovery is expected to come in sub-trend, with GDP growth in the recovery phase falling short of previous cycle peaks. With this in mind, investors may seek to focus on opportunities that continue to under-price even the modest economic recovery we expect.
In this regard, we see opportunities in US and global energy services companies. While global crude prices have rallied from near-production cost at the beginning of the year to above US$70 a barrel recently, Citi analysts are still able to identify stocks where down-cycle price-to-book value multiples remain in place. As a result, even though global book valuations are expected to recover at only a moderate pace, the prospect for price-to-book value multiple expansion leaves an attractive risk-reward outlook for investors looking ahead.
Despite our optimism through to year-end, we must admit that the global recovery story must be strengthened further to sustain the rally into the new year. China, already grappling with rapid loan growth, must moderate its aggressive easing policy of early-2009 and structurally, continue to build its domestic consumer base. As for the US, it needs to transition its economy from a stimulus-led recovery back to a private sector-driven demand story.
On balance, though, while there are certainly concerns on the horizon, news flow over the coming months is expected to show not only recovery but, in the case of the US, accelerating recovery that investors have been hoping for, leaving the balance of risk and reward through year-end still pointed in favour of the reward camp, and creating an opportunity for investors to broaden out their focus from first-half leader emerging markets to include opportunities presented by US markets as well.
The writer is head of investment analysis & advice, wealth management, Asia-Pacific, Citi
MONEY MATTERS
Coming months are likely to show not only recovery but, in the case of US, accelerating recovery investors have been hoping for
By NORMAN VILLAMIN
INVESTORS can learn a lot from history. Looking back at the first quarter of 2009, many investors, fretting about the woeful state of the global economy, failed to focus on the things that matter - valuation and the rapid acceleration of global policy momentum. As it turned out, the combination of these factors created the backdrop for the sharp rally in global equities over the past six months.
Looking forward now from the heights that global equity prices have achieved, it is understandable that investors are getting increasingly wary. Admittedly, the valuation case has weakened with the rallies to date. But global policy effectiveness has not waned. Rather, it has begun to shift from the Chinese-led successes of the first half of 2009 to a broader, global story, with US policy achievements, in particular, emerging recently. This leaves the prospect, we believe, for another leg in the global rally in equities that began in March 2009.
Continued momentum in US economic and earnings data in coming weeks, underpinned by US policy momentum of the second quarter, is expected to drive this leg of the rally. Year-to-date, economic recovery momentum has been key to identifying relative outperformers globally. With emerging markets recovering from the 'Great Recession' more quickly than developed markets, economic momentum reflected in data releases has been a focus of market attention in the current rally. Recall, early in the year, news of the US and Chinese economic policy changes that helped set the stage for a bottoming in global markets. With Chinese stimulus coming sooner and more aggressively, unsurprisingly, the MSCI China rose 35 per cent in the first half of 2009, compared with a meagre 5 per cent for MSCI World.
With Chinese policy now stabilising, as Beijing tries to contain rapid year-to-date loan growth, US growth momentum is beginning to benefit from Washington's stimulus efforts of the late-first quarter of 2009. Their effectiveness was most recently seen in the July 2009 expansion of the Institute of Supply Management's New Orders Index, which historically has provided a three to six-month lead to turns in the US economy. Indeed, the most recent reading suggests that investors' concerns about job growth in the United States may begin to be addressed in coming months (see chart), providing further economic support to the earnings drivers that may emerge come October this year.
Looking a bit further ahead, the US third-quarter earnings season likewise looks set to provide support to the market in coming weeks. Indeed, during the rally since March, the US earnings season - the first six weeks of each quarter - was a key driver for market performance. Recall, as the first-quarter earnings season got under way in April, world equities, represented by MSCI World, rallied 18 per cent before stalling in mid-May as the earnings season came to a close. Similarly, as the second-quarter earnings season got under way in July 2009, world equities rallied another 12 per cent up to mid-August, as the season came to a close again. In total, on a compounded basis, the earnings-season rallies accounted for almost two-thirds of the 52 per cent rise in global equities up to Aug 21. With another earnings season quickly coming upon us in October, Tobias Levkovich, Citi's US equity strategist, notes that upward revisions to earnings expectations could continue into the northern autumn, potentially providing a catalyst for the next leg of the rally we have seen since March.
The resumption of US economic growth momentum and positive prospects for US earnings surprises in the third quarter suggest he global economic recovery is starting to transition from one with China as the sole driver to a more balanced US-China model. Indeed, since mid-year, this transition in policy and data has resulted in US equities outperforming their Chinese counterparts, with MSCI US rising 11.5 per cent up to Aug 21, exceeding the 5.7 per cent increase in MSCI China over the same period.
Therefore, although we can appreciate the caution investors are expressing, given that valuations are no longer cheap, expected news flow leads us to believe that caution will not be rewarded by the markets in the coming months. Rather, we encourage investors to manage their risk by managing their exposure within global equities. We expect that Asian equities, even after a near-50 per cent rally year-to-date, as indicated by MSCI Asia ex-Japan, may participate in this next leg. However, unlike the first half of 2009, where they trumped the flattish 5 per cent performance of global equities, we don't believe that they will necessarily lead regional performances as they did in the first semester.
Rather, investors who ignored US equities early in the year may wish to reconsider opportunities provided by this market. However, they should keep in mind that while recovery looks entrenched, the US recovery is expected to come in sub-trend, with GDP growth in the recovery phase falling short of previous cycle peaks. With this in mind, investors may seek to focus on opportunities that continue to under-price even the modest economic recovery we expect.
In this regard, we see opportunities in US and global energy services companies. While global crude prices have rallied from near-production cost at the beginning of the year to above US$70 a barrel recently, Citi analysts are still able to identify stocks where down-cycle price-to-book value multiples remain in place. As a result, even though global book valuations are expected to recover at only a moderate pace, the prospect for price-to-book value multiple expansion leaves an attractive risk-reward outlook for investors looking ahead.
Despite our optimism through to year-end, we must admit that the global recovery story must be strengthened further to sustain the rally into the new year. China, already grappling with rapid loan growth, must moderate its aggressive easing policy of early-2009 and structurally, continue to build its domestic consumer base. As for the US, it needs to transition its economy from a stimulus-led recovery back to a private sector-driven demand story.
On balance, though, while there are certainly concerns on the horizon, news flow over the coming months is expected to show not only recovery but, in the case of the US, accelerating recovery that investors have been hoping for, leaving the balance of risk and reward through year-end still pointed in favour of the reward camp, and creating an opportunity for investors to broaden out their focus from first-half leader emerging markets to include opportunities presented by US markets as well.
The writer is head of investment analysis & advice, wealth management, Asia-Pacific, Citi
Wednesday, August 26, 2009
Interpreting the Crisis
Business Times, 26 Aug 2009
The events of last September and October exhibited some features of a classic panic
This is the second and final part of an excerpt of the speech by US Federal Reserve chairman Ben Bernanke at the Federal Reserve Bank of Kansas City's Annual Economic Symposium at Jackson Hole, Wyoming on Aug 21.
HOW should we interpret the extraordinary events of the past year, particularly the sharp intensification of the financial crisis in September and October? Certainly, fundamentals played a critical role in triggering those events. As I noted earlier, the economy was already in recession, and it had weakened further over the summer. The continuing dramatic decline in house prices and rising rates of foreclosure raised serious concerns about the values of mortgage-related assets, and thus about large potential losses at financial institutions. More broadly, investors remained distrustful of virtually all forms of private credit, especially structured credit products and other complex or opaque instruments.
At the same time, however, the events of September and October also exhibited some features of a classic panic, of the type described by (British economist and journalist Walter) Bagehot and many others.
A panic is a generalised run by providers of short-term funding to a set of financial institutions, possibly resulting in the failure of one or more of those institutions. The historically most familiar type of panic, which involves runs on banks by retail depositors, has been made largely obsolete by deposit insurance or guarantees and the associated government supervision of banks.
But a panic is possible in any situation in which longer-term, illiquid assets are financed by short-term, liquid liabilities, and in which suppliers of short-term funding either lose confidence in the borrower or become worried that other short-term lenders may lose confidence.
Although, in a certain sense, a panic may be collectively irrational, it may be entirely rational at the individual level, as each market participant has a strong incentive to be among the first to the exit.
Panics arose in multiple contexts last year. For example, many financial institutions, notably including the independent investment banks, financed a portion of their assets through short-term repo agreements. In repo agreements, the asset being financed serves as collateral for the loan, and the maximum amount of the loan is the current assessed value of the collateral less a haircut.
In a crisis, haircuts typically rise as short-term lenders attempt to protect themselves from possible declines in asset prices. But this individually rational behaviour can set off a run-like dynamic: As high haircuts make financing portfolios more difficult, some borrowers may have no option but to sell assets into illiquid markets. These forced sales drive down asset prices, increase volatility, and weaken the financial positions of all holders of similar assets, which in turn increases the risks borne by repo lenders and thus the haircuts they demand.
This unstable dynamic was apparent around the time of the near- failure of Bear Stearns in March 2008, and haircuts rose particularly sharply during the worsening of the crisis in mid-September.
As we saw last fall, when a vicious funding spiral of this sort is at work, falling asset prices and the collapse of lender confidence may create financial contagion, even between firms without significant counterparty relationships. In such an environment, the line between insolvency and illiquidity may be quite blurry.
Panic-like phenomena
Panic-like phenomena occurred in other contexts as well. Structured investment vehicles and other asset-backed programmes that relied heavily on the commercial paper market began to have difficulty rolling over their short-term funding very early in the crisis, forcing them to look to bank sponsors for liquidity or to sell assets.
Following the Lehman collapse, panic gripped the money market mutual funds and the commercial paper market, as I have discussed. More generally, during the crisis, runs of uninsured creditors have created severe funding problems for a number of financial firms. In some cases, runs by creditors were augmented by other types of 'runs' - for example, by prime brokerage customers of investment banks concerned about the funds they held in margin accounts. Overall, the role played by panic helps to explain the remarkably sharp and sudden intensification of the financial crisis last fall, its rapid global spread, and the fact that the abrupt deterioration in financial conditions was largely unforecasted by standard market indicators.
The view that the financial crisis had elements of a classic panic, particularly during its most intense phases, has helped to motivate a number of the Federal Reserve's policy actions.
Mr Bagehot instructed central banks - the only institutions that have the power to increase the aggregate liquidity in the system - to respond to panics by lending freely against sound collateral.
Following that advice, from the beginning of the crisis, the Fed (like other central banks) has provided large amounts of short-term liquidity to financial institutions. As I have discussed, it also provided backstop liquidity support for money market mutual funds and the commercial paper market, and added significant liquidity to the system through purchases of longer-term securities.
To be sure, the provision of liquidity alone can by no means solve the problems of credit risk and credit losses; but it can reduce liquidity premiums, help restore the confidence of investors, and thus promote stability. It is noteworthy that the use of Fed liquidity facilities has declined sharply since the beginning of the year - a clear market signal that liquidity pressures are easing and market conditions are normalising.
What does this perspective on the crisis imply for future policies and regulatory reforms? We have seen during the past two years that the complex interrelationships among credit, market, and funding risks of key players in financial markets can have far-reaching implications, particularly during a general crisis of confidence.
In particular, the experience has underscored that liquidity risk management is as essential as capital adequacy and credit and market risk management, particularly during times of intense financial stress. Both the Basel Committee on Banking Supervision and the US bank regulatory agencies have recently issued guidelines for strengthening liquidity risk management at financial institutions. Among other objectives, liquidity guidelines must take into account the risks that inadequate liquidity planning by major financial firms pose for the broader financial system, and they must ensure that these firms do not become excessively reliant on liquidity support from the central bank.
But liquidity risk management at the level of the firm, no matter how carefully done, can never fully protect against systemic events. In a sufficiently severe panic, funding problems will almost certainly arise and are likely to spread in unexpected ways. Only central banks are well positioned to offset the ensuing sharp decline in liquidity and credit provision by the private sector. They must be prepared to do so.
Systemwide approach
The role of liquidity in systemic events provides yet another reason why, in the future, a more systemwide or macroprudential approach to regulation is needed. The hallmark of a macroprudential approach is its emphasis on the interdependencies among firms and markets that have the potential to undermine the stability of the financial system, including the linkages that arise through short-term funding markets and other counterparty relationships, such as over-the-counter derivatives contracts. A comprehensive regulatory approach must examine those interdependencies as well as the financial conditions of individual firms in isolation.
Since we last met here, the world has been through the most severe financial crisis since the Great Depression. The crisis in turn sparked a deep global recession, from which we are only now beginning to emerge.
As severe as the economic impact has been, however, the outcome could have been decidedly worse. Unlike in the 1930s, when policy was largely passive and political divisions made international economic and financial cooperation difficult, during the past year, monetary, fiscal and financial policies around the world have been aggressive and complementary.
Without these speedy and forceful actions, last October's panic would likely have continued to intensify, more major financial firms would have failed, and the entire global financial system would have been at serious risk. We cannot know for sure what the economic effects of these events would have been, but what we know about the effects of financial crises suggests that the resulting global downturn could have been extraordinarily deep and protracted.
Although we have avoided the worst, difficult challenges still lie ahead. We must work together to build on the gains already made to secure a sustained economic recovery, as well as to build a new financial regulatory framework that will reflect the lessons of this crisis and prevent a recurrence of the events of the past two years.
I hope and expect that, when we meet here a year from now, we will be able to claim substantial progress towards both those objectives.
When the pursuit of prosperity crosses borders
Business Times - 26 Aug 2009
THERE will be no end to people pursuing two main things: wealth and prosperity. These are pursued by Singapore too. One of Singapore main achievements is economic.
The socio-economic status of the city state with a population of almost four million is on par with that of the world's richest countries. Following its separation from Malaysia that saddened Lee Kuan Yew, the country nursed the ambition of becoming a manufacturing hub, and subsequently became a centre for the service sector.
Processing of permits, service and prowess in attracting investors and tourists largely guide them in their every policy and action. Education is promoted - in fact, subsidies are granted to churn out intelligent and skilled citizens. Nationalism and self-defence are other aspects that get enhanced too, including national service and campaigns aimed at inculcating national pride. It has among the most sophisticated weapons in the region. Singapore is one of the respected countries that could not be ignored in terms of military might.
Like it or not, Singapore is in fact one of the countries that Indonesia depends on while Indonesians enjoy visiting it. Indonesians make up the largest number of international visitors to Singapore. When they make trips to various parts of the world, most Indonesians fly Singapore Airlines.
Singapore is also the transit point for imports, exports and other socioeconomic activities. It is also the business capital and hub for the region which includes Indonesia.
The problem that crops up is that Singapore's comprehensive and clear policy attaches importance to its own interest. This is only logical, and all countries do likewise. No matter how harsh the criticism and strong the hatred towards Singapore, it enjoys sovereignty.
However, if its policy overlaps with another country's, problems at times break out. Apart from Malaysia, Indonesia becomes the 'victim' here.
Singapore's arguments are also strong with its anticipatory, visionary and tactical policy, if not to say rather 'cunning'. Which country is not tactical or, say, 'cunning' when it concerns international relations?
In this context of being cunning, Indonesia needs to understand, and do the same. However, Indonesia is clearly way behind and loses out here.
This may be noticed, for instance, when Indonesia wishes to get its corrupt citizens 'hiding' in Singapore extradited. To conclude an extradition treaty, Singapore wants it to be complemented with a Defence Cooperation Agreement (DCA) which essentially allows it to conduct military training in Indonesian territory with a relatively free hand.
It is here that problems arise, because it involves sovereignty. In other words, the extradition treaty must be complemented with the DCA. The oddity lies with the Indonesian side. And, after a process that was not made known to the public, the extradition treaty and DCA were inked in Bali.
Subsequently, there were protests in parliament that declined to ratify the agreements. What did Singapore have to say? 'After the agreements were signed, came the objections. In fact, after the signing, we partied and even had karaoke,' said Singapore Foreign Minister George Yeo.
Blame game
The agreements stalled, with Singapore putting the 'blame' more on Indonesia. However, Singapore Prime Minister Lee Hsien Loong said: 'Singapore made a new proposal for the agreements to be restored.' However, Singapore insists on treating the extradition treaty and DCA as a package. 'However, Indonesia chose to stand firm to this issue,' said Mr Lee.
Apparently, the ball is now in Indonesia's court. And the question is how could Indonesia be unaware of what was happening? How could Indonesia, or at least a handful of people, go through a process that ended with the extradition treaty and DCA? Does the old position still surface, ie whatever the government does is bound to have been approved by the People's Representative Council (DPR)? In drawing up the extradition treaty, which was most probably based on international law, must a certain degree of Indonesia's territorial 'sovereignty' be sacrificed?
The conclusion is: We are not ready and do not understand Singapore's tactical and comprehensive strategy.
The above editorial was published in Indonesia's Kompas on Aug 14
THERE will be no end to people pursuing two main things: wealth and prosperity. These are pursued by Singapore too. One of Singapore main achievements is economic.
The socio-economic status of the city state with a population of almost four million is on par with that of the world's richest countries. Following its separation from Malaysia that saddened Lee Kuan Yew, the country nursed the ambition of becoming a manufacturing hub, and subsequently became a centre for the service sector.
Processing of permits, service and prowess in attracting investors and tourists largely guide them in their every policy and action. Education is promoted - in fact, subsidies are granted to churn out intelligent and skilled citizens. Nationalism and self-defence are other aspects that get enhanced too, including national service and campaigns aimed at inculcating national pride. It has among the most sophisticated weapons in the region. Singapore is one of the respected countries that could not be ignored in terms of military might.
Like it or not, Singapore is in fact one of the countries that Indonesia depends on while Indonesians enjoy visiting it. Indonesians make up the largest number of international visitors to Singapore. When they make trips to various parts of the world, most Indonesians fly Singapore Airlines.
Singapore is also the transit point for imports, exports and other socioeconomic activities. It is also the business capital and hub for the region which includes Indonesia.
The problem that crops up is that Singapore's comprehensive and clear policy attaches importance to its own interest. This is only logical, and all countries do likewise. No matter how harsh the criticism and strong the hatred towards Singapore, it enjoys sovereignty.
However, if its policy overlaps with another country's, problems at times break out. Apart from Malaysia, Indonesia becomes the 'victim' here.
Singapore's arguments are also strong with its anticipatory, visionary and tactical policy, if not to say rather 'cunning'. Which country is not tactical or, say, 'cunning' when it concerns international relations?
In this context of being cunning, Indonesia needs to understand, and do the same. However, Indonesia is clearly way behind and loses out here.
This may be noticed, for instance, when Indonesia wishes to get its corrupt citizens 'hiding' in Singapore extradited. To conclude an extradition treaty, Singapore wants it to be complemented with a Defence Cooperation Agreement (DCA) which essentially allows it to conduct military training in Indonesian territory with a relatively free hand.
It is here that problems arise, because it involves sovereignty. In other words, the extradition treaty must be complemented with the DCA. The oddity lies with the Indonesian side. And, after a process that was not made known to the public, the extradition treaty and DCA were inked in Bali.
Subsequently, there were protests in parliament that declined to ratify the agreements. What did Singapore have to say? 'After the agreements were signed, came the objections. In fact, after the signing, we partied and even had karaoke,' said Singapore Foreign Minister George Yeo.
Blame game
The agreements stalled, with Singapore putting the 'blame' more on Indonesia. However, Singapore Prime Minister Lee Hsien Loong said: 'Singapore made a new proposal for the agreements to be restored.' However, Singapore insists on treating the extradition treaty and DCA as a package. 'However, Indonesia chose to stand firm to this issue,' said Mr Lee.
Apparently, the ball is now in Indonesia's court. And the question is how could Indonesia be unaware of what was happening? How could Indonesia, or at least a handful of people, go through a process that ended with the extradition treaty and DCA? Does the old position still surface, ie whatever the government does is bound to have been approved by the People's Representative Council (DPR)? In drawing up the extradition treaty, which was most probably based on international law, must a certain degree of Indonesia's territorial 'sovereignty' be sacrificed?
The conclusion is: We are not ready and do not understand Singapore's tactical and comprehensive strategy.
The above editorial was published in Indonesia's Kompas on Aug 14
Tuesday, August 25, 2009
Looking back at the Crisis
Business Times, 25 Aug 2009
Bernanke reflects on the events of the past year, the challenges they posed, the measures taken, and the lessons learnt
This is the first part of an excerpt of the speech by US Federal Reserve chairman Ben Bernanke at the Federal Reserve Bank of Kansas City's Annual Economic Symposium at Jackson Hole, Wyoming on Aug 21. The second and final part will appear tomorrow.
BY THE standards of recent decades, the economic environment at the time of this symposium one year ago was quite challenging. A year after the onset of the current crisis in August 2007, financial markets remained stressed, the economy was slowing, and inflation - driven by a global commodity boom - had risen significantly. What we could not fully appreciate when we last gathered here was that the economic and policy environment was about to become vastly more difficult.
One very clear lesson of the past year - no surprise, of course, to any student of economic history, but worth noting nonetheless - is that a full-blown financial crisis can exact an enormous toll in both human and economic terms. A second lesson - once again, familiar to economic historians - is that financial disruptions do not respect borders. The crisis has been global, with no major country having been immune.
History is full of examples in which the policy responses to financial crises have been slow and inadequate, often resulting ultimately in greater economic damage and increased fiscal costs. In this episode, by contrast, policymakers in the United States and around the globe responded with speed and force to arrest a rapidly deteriorating and dangerous situation. Looking forward, we must urgently address structural weaknesses in the financial system, in particular in the regulatory framework, to ensure that the enormous costs of the past two years will not be borne again.
September-October 2008: The crisis intensifies
When we met last year, financial markets and the economy were continuing to suffer the effects of the ongoing crisis. We know now that the National Bureau of Economic Research has determined December 2007 as the beginning of the recession. The US unemployment rate had risen to 53/4 per cent by July, about one percentage point above its level at the beginning of the crisis, and household spending was weakening.
Ongoing declines in residential construction and house prices and rising mortgage defaults and foreclosures continued to weigh on the US economy, and forecasts of prospective credit losses at financial institutions both here and abroad continued to increase. Indeed, one of the nation's largest thrift institutions, IndyMac, had recently collapsed under the weight of distressed mortgages, and investors continued to harbour doubts about the condition of the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, despite the approval by the Congress of open-ended support for the two firms.
Notwithstanding these significant concerns, however, there was little to suggest that market participants saw the financial situation as about to take a sharp turn for the worse. For example, although indicators of default risk such as interest rate spreads and quotes on credit default swaps remained well above historical norms, most such measures had declined from earlier peaks, in some cases by substantial amounts.
And in early September, when the target for the federal funds rate was 2 per cent, investors appeared to see little chance that the federal funds rate would be below 13/4 per cent six months later. That is, this time last year, market participants evidently believed it improbable that significant additional monetary policy stimulus would be needed in the United States.
Nevertheless, shortly after our last convocation, the financial crisis intensified dramatically. Despite the steps that had been taken to support Fannie Mae and Freddie Mac, their condition continued to worsen. In early September, the companies' regulator placed both into conservatorship, and the Treasury used its recently enacted authority to provide the firms with massive financial support.
Shortly thereafter, several additional large US financial firms also came under heavy pressure from creditors, counterparties, and customers. The Federal Reserve has consistently maintained the view that the disorderly failure of one or more systemically important institutions in the context of a broader financial crisis could have extremely adverse consequences for both the financial system and the economy. We have therefore spared no effort, within our legal authorities and in appropriate cooperation with other agencies, to avert such a failure.
The case of the investment bank Lehman Brothers proved exceptionally difficult, however. Concerted government attempts to find a buyer for the company or to develop an industry solution proved unavailing, and the company's available collateral fell well short of the amount needed to secure a Federal Reserve loan of sufficient size to meet its funding needs. As the Federal Reserve cannot make an unsecured loan, and as the government as a whole lacked appropriate resolution authority or the ability to inject capital, the firm's failure was, unfortunately, unavoidable. The Federal Reserve and the Treasury were compelled to focus instead on mitigating the fallout from the failure, for example, by taking measures to stabilise the triparty repurchase (repo) market.
In contrast, in the case of the insurance company American International Group (AIG), the Federal Reserve judged that the company's financial and business assets were adequate to secure an US$85 billion line of credit, enough to avert its imminent failure. Because AIG was counterparty to many of the world's largest financial firms, a significant borrower in the commercial paper market and other public debt markets, and a provider of insurance products to tens of millions of customers, its abrupt collapse likely would have intensified the crisis substantially further, at a time when the US authorities had not yet obtained the necessary fiscal resources to deal with a massive systemic event.
The failure of Lehman Brothers and the near-failure of AIG were dramatic but hardly isolated events. Many prominent firms struggled to survive as confidence plummeted. The investment bank Merrill Lynch, under pressure in the wake of Lehman's failure, agreed to be acquired by Bank of America; the major thrift institution Washington Mutual was resolved by the Federal Deposit Insurance Corporation (FDIC) in an assisted transaction; and the large commercial bank Wachovia, after experiencing severe liquidity outflows, agreed to be sold. The two largest remaining free-standing investment banks, Morgan Stanley and Goldman Sachs, were stabilised when the Federal Reserve approved, on an emergency basis, their applications to become bank holding companies.
Nor were the extraordinary pressures on financial firms during September and early October confined to the United States: For example, on Sept 18, the UK mortgage lender HBOS, with assets of more than US$1 trillion, was forced to merge with Lloyds TSB. On Sept 29, the governments of Belgium, Luxembourg, and the Netherlands effectively nationalised Fortis, a banking and insurance firm that had assets of around US$1 trillion.
The same day, German authorities provided assistance to Hypo Real Estate, a large commercial real estate lender, and the British government nationalised another mortgage lender, Bradford and Bingley. On the next day, Sept 30, the governments of Belgium, France, and Luxembourg injected capital into Dexia, a bank with assets of more than US$700 billion, and the Irish government guaranteed the deposits and most other liabilities of six large Irish financial institutions.
Soon thereafter, the Icelandic government, lacking the resources to rescue the three largest banks in that country, put them into receivership and requested assistance from the International Monetary Fund (IMF) and from other Nordic governments. In mid-October, the Swiss government announced a rescue package of capital and asset guarantees for UBS, one of the world's largest banks. The growing pressures were not limited to banks with significant exposure to US or UK real estate or to securitised assets. For example, unsubstantiated rumours circulated in late September that some large Swedish banks were having trouble rolling over wholesale deposits, and on Oct 13, the Swedish government announced measures to guarantee bank debt and to inject capital into banks.
The rapidly worsening crisis soon spread beyond financial institutions into the money and capital markets more generally. As a result of losses on Lehman's commercial paper, a prominent money market mutual fund announced on Sept 16 that it had 'broken the buck' - that is, its net asset value had fallen below US$1 per share. Over the subsequent several weeks, investors withdrew more than US$400 billion from so-called prime money funds.
Conditions in short-term funding markets, including the interbank market and the commercial paper market, deteriorated sharply. Equity prices fell precipitously, and credit risk spreads jumped. The crisis also began to affect countries that had thus far escaped its worst effects. Notably, financial markets in emerging market economies were whipsawed as a flight from risk-led capital inflows to those countries to swing abruptly to outflows.
The policy response
Authorities in the United States and around the globe moved quickly to respond to this new phase of the crisis. The financial system of the United States gives a much greater role to financial markets and to non-bank financial institutions than is the case in most other nations, which rely primarily on banks. Thus, in the United States, a wider variety of policy measures was needed than in some other nations. In the United States, the Federal Reserve established new liquidity facilities with the goal of restoring basic functioning in various critical markets. Together, these steps helped stem the massive outflows from the money market mutual funds and stabilise the commercial paper market.
During this period, foreign commercial banks were a source of heavy demand for US dollar funding, thereby putting additional strain on global bank funding markets, including US markets, and further squeezing credit availability in the United States.
To address this problem, the Federal Reserve expanded the temporary swap lines that had been established earlier with the European Central Bank (ECB) and the Swiss National Bank, and established new temporary swap lines with seven other central banks in September and five more in late October, including four in emerging market economies. In further coordinated action, on Oct 8, the Federal Reserve and five other major central banks simultaneously cut their policy rates by 50 basis points.
The failure of Lehman Brothers demonstrated that liquidity provision by the Federal Reserve would not be sufficient to stop the crisis; substantial fiscal resources were necessary. On Oct 3, on the recommendation of the administration and with the strong support of the Federal Reserve, Congress approved the creation of the Troubled Asset Relief Program, or TARP, with a maximum authorisation of US$700 billion to support the stabilisation of the US financial system.
Markets remained highly volatile and pressure on financial institutions intense through the first weeks of October. On Oct 10, in what would prove to be a watershed in the global policy response, the Group of Seven (G-7) finance ministers and central bank governors, meeting in Washington, committed in a joint statement to work together to stabilise the global financial system. In particular, they agreed to prevent the failure of systemically important financial institutions; to ensure that financial institutions had adequate access to funding and capital, including public capital if necessary; and to put in place deposit insurance and other guarantees to restore the confidence of depositors.
In the following days, many countries around the world announced comprehensive rescue plans for their banking systems that built on the G-7 principles. To stabilise funding, during October, more than 20 countries expanded their deposit insurance programmes, and many also guaranteed non-deposit liabilities of banks. In addition, amid mounting concerns about the solvency of the global banking system, by the end of October, more than a dozen countries had announced plans to inject public capital into banks, and several announced plans to purchase or guarantee bank assets.
This strong and unprecedented international policy response proved broadly effective. Critically, it averted the imminent collapse of the global financial system, an outcome that seemed all too possible to the finance ministers and central bankers that gathered in Washington on Oct 10. However, although the intensity of the crisis moderated and the risk of systemic collapse declined in the wake of the policy response, financial conditions remained highly stressed.
For example, although short-term funding spreads in global markets began to turn down in October, they remained elevated into this year. And, although generalised pressures on financial institutions subsided somewhat, government actions to prevent the disorderly failures of individual, systemically significant institutions continued to be necessary. In the United States, support packages were announced for Citigroup in November and Bank of America in January. Broadly similar support packages were also announced for some large European institutions, including firms in the United Kingdom and the Netherlands.
Although concerted policy actions avoided much worse outcomes, the financial shocks of September and October nevertheless severely damaged the global economy - starkly illustrating the potential effects of financial stress on real economic activity. In the fourth quarter of 2008 and the first quarter of this year, global economic activity recorded its weakest performance in decades.
In the United States, real GDP plummeted at nearly a 6 per cent average annual pace over those two quarters - an even sharper decline than had occurred in the 1981-82 recession. Economic activity contracted even more precipitously in many foreign economies, with real GDP dropping at double-digit annual rates in some cases. The crisis affected economic activity not only by pushing down asset prices and tightening credit conditions, but also by shattering household and business confidence around the world.
In response to these developments, the Federal Reserve expended the remaining ammunition in the traditional arsenal of monetary policy, bringing the federal funds rate down, in steps, to a target range of zero to 25 basis points by mid-December of last year. It also took several measures to further supplement its traditional arsenal. In particular, on Nov 25, the Fed announced that it would purchase up to US$100 billion of debt issued by the housing-related GSEs and up to US$500 billion of agency-guaranteed mortgage-backed securities, programmes that were expanded substantially and augmented by a programme of purchases of Treasury securities in March.
The goal of these purchases was to provide additional support to private credit markets, particularly the mortgage market. Also, on Nov 25, the Fed announced the creation of the Term Asset-Backed Securities Loan Facility (TALF). This facility aims to improve the availability and affordability of credit for households and small businesses, and to help facilitate the financing and refinancing of commercial real estate properties.
The TALF has shown early success in reducing risk spreads and stimulating new securitisation activity for assets included in the programme. Foreign central banks also cut policy rates to very low levels and implemented unconventional monetary measures.
On Feb 10, Treasury Secretary Geithner and the heads of the federal banking agencies unveiled the outlines of a new strategy for ensuring that banking institutions could continue to provide credit to households and businesses during the financial crisis. A central component of that strategy was the exercise that came to be known as the bank stress test.
Under this initiative, the banking regulatory agencies undertook a forward-looking, simultaneous evaluation of the capital positions of 19 of the largest bank holding companies in the United States, with the Treasury committing to provide public capital as needed. The goal of this supervisory assessment was to ensure that the equity capital held by these firms was sufficient - in both quantity and quality - to allow those institutions to withstand a worse-than-expected macroeconomic environment over the subsequent two years and yet remain healthy and capable of lending to creditworthy borrowers.
This exercise, unprecedented in scale and scope, was led by the Federal Reserve in cooperation with the Office of the Comptroller of the Currency and the FDIC. Importantly, the agencies' report made public considerable information on the projected losses and revenues of the 19 firms, allowing private analysts to judge for themselves the credibility of the exercise. Financial market participants responded favourably to the announcement of the results, and many of the tested banks were subsequently able to tap public capital markets.
Overall, the policy actions implemented in recent months have helped stabilise a number of key financial markets, both in the United States and abroad. Short-term funding markets are functioning more normally, corporate bond issuance has been strong, and activity in some previously moribund securitisation markets has picked up. Stock prices have partially recovered, and US mortgage rates have declined markedly since last fall.
Critically, fears of financial collapse have receded substantially. After contracting sharply over the past year, economic activity appears to be levelling out, both in the United States and abroad, and the prospects for a return to growth in the near term appear good.
Notwithstanding this noteworthy progress, critical challenges remain: Strains persist in many financial markets across the globe, financial institutions face significant additional losses, and many businesses and households continue to experience considerable difficulty gaining access to credit. Because of these and other factors, the economic recovery is likely to be relatively slow at first, with unemployment declining only gradually from high levels.
Bernanke reflects on the events of the past year, the challenges they posed, the measures taken, and the lessons learnt
This is the first part of an excerpt of the speech by US Federal Reserve chairman Ben Bernanke at the Federal Reserve Bank of Kansas City's Annual Economic Symposium at Jackson Hole, Wyoming on Aug 21. The second and final part will appear tomorrow.
BY THE standards of recent decades, the economic environment at the time of this symposium one year ago was quite challenging. A year after the onset of the current crisis in August 2007, financial markets remained stressed, the economy was slowing, and inflation - driven by a global commodity boom - had risen significantly. What we could not fully appreciate when we last gathered here was that the economic and policy environment was about to become vastly more difficult.
One very clear lesson of the past year - no surprise, of course, to any student of economic history, but worth noting nonetheless - is that a full-blown financial crisis can exact an enormous toll in both human and economic terms. A second lesson - once again, familiar to economic historians - is that financial disruptions do not respect borders. The crisis has been global, with no major country having been immune.
History is full of examples in which the policy responses to financial crises have been slow and inadequate, often resulting ultimately in greater economic damage and increased fiscal costs. In this episode, by contrast, policymakers in the United States and around the globe responded with speed and force to arrest a rapidly deteriorating and dangerous situation. Looking forward, we must urgently address structural weaknesses in the financial system, in particular in the regulatory framework, to ensure that the enormous costs of the past two years will not be borne again.
September-October 2008: The crisis intensifies
When we met last year, financial markets and the economy were continuing to suffer the effects of the ongoing crisis. We know now that the National Bureau of Economic Research has determined December 2007 as the beginning of the recession. The US unemployment rate had risen to 53/4 per cent by July, about one percentage point above its level at the beginning of the crisis, and household spending was weakening.
Ongoing declines in residential construction and house prices and rising mortgage defaults and foreclosures continued to weigh on the US economy, and forecasts of prospective credit losses at financial institutions both here and abroad continued to increase. Indeed, one of the nation's largest thrift institutions, IndyMac, had recently collapsed under the weight of distressed mortgages, and investors continued to harbour doubts about the condition of the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, despite the approval by the Congress of open-ended support for the two firms.
Notwithstanding these significant concerns, however, there was little to suggest that market participants saw the financial situation as about to take a sharp turn for the worse. For example, although indicators of default risk such as interest rate spreads and quotes on credit default swaps remained well above historical norms, most such measures had declined from earlier peaks, in some cases by substantial amounts.
And in early September, when the target for the federal funds rate was 2 per cent, investors appeared to see little chance that the federal funds rate would be below 13/4 per cent six months later. That is, this time last year, market participants evidently believed it improbable that significant additional monetary policy stimulus would be needed in the United States.
Nevertheless, shortly after our last convocation, the financial crisis intensified dramatically. Despite the steps that had been taken to support Fannie Mae and Freddie Mac, their condition continued to worsen. In early September, the companies' regulator placed both into conservatorship, and the Treasury used its recently enacted authority to provide the firms with massive financial support.
Shortly thereafter, several additional large US financial firms also came under heavy pressure from creditors, counterparties, and customers. The Federal Reserve has consistently maintained the view that the disorderly failure of one or more systemically important institutions in the context of a broader financial crisis could have extremely adverse consequences for both the financial system and the economy. We have therefore spared no effort, within our legal authorities and in appropriate cooperation with other agencies, to avert such a failure.
The case of the investment bank Lehman Brothers proved exceptionally difficult, however. Concerted government attempts to find a buyer for the company or to develop an industry solution proved unavailing, and the company's available collateral fell well short of the amount needed to secure a Federal Reserve loan of sufficient size to meet its funding needs. As the Federal Reserve cannot make an unsecured loan, and as the government as a whole lacked appropriate resolution authority or the ability to inject capital, the firm's failure was, unfortunately, unavoidable. The Federal Reserve and the Treasury were compelled to focus instead on mitigating the fallout from the failure, for example, by taking measures to stabilise the triparty repurchase (repo) market.
In contrast, in the case of the insurance company American International Group (AIG), the Federal Reserve judged that the company's financial and business assets were adequate to secure an US$85 billion line of credit, enough to avert its imminent failure. Because AIG was counterparty to many of the world's largest financial firms, a significant borrower in the commercial paper market and other public debt markets, and a provider of insurance products to tens of millions of customers, its abrupt collapse likely would have intensified the crisis substantially further, at a time when the US authorities had not yet obtained the necessary fiscal resources to deal with a massive systemic event.
The failure of Lehman Brothers and the near-failure of AIG were dramatic but hardly isolated events. Many prominent firms struggled to survive as confidence plummeted. The investment bank Merrill Lynch, under pressure in the wake of Lehman's failure, agreed to be acquired by Bank of America; the major thrift institution Washington Mutual was resolved by the Federal Deposit Insurance Corporation (FDIC) in an assisted transaction; and the large commercial bank Wachovia, after experiencing severe liquidity outflows, agreed to be sold. The two largest remaining free-standing investment banks, Morgan Stanley and Goldman Sachs, were stabilised when the Federal Reserve approved, on an emergency basis, their applications to become bank holding companies.
Nor were the extraordinary pressures on financial firms during September and early October confined to the United States: For example, on Sept 18, the UK mortgage lender HBOS, with assets of more than US$1 trillion, was forced to merge with Lloyds TSB. On Sept 29, the governments of Belgium, Luxembourg, and the Netherlands effectively nationalised Fortis, a banking and insurance firm that had assets of around US$1 trillion.
The same day, German authorities provided assistance to Hypo Real Estate, a large commercial real estate lender, and the British government nationalised another mortgage lender, Bradford and Bingley. On the next day, Sept 30, the governments of Belgium, France, and Luxembourg injected capital into Dexia, a bank with assets of more than US$700 billion, and the Irish government guaranteed the deposits and most other liabilities of six large Irish financial institutions.
Soon thereafter, the Icelandic government, lacking the resources to rescue the three largest banks in that country, put them into receivership and requested assistance from the International Monetary Fund (IMF) and from other Nordic governments. In mid-October, the Swiss government announced a rescue package of capital and asset guarantees for UBS, one of the world's largest banks. The growing pressures were not limited to banks with significant exposure to US or UK real estate or to securitised assets. For example, unsubstantiated rumours circulated in late September that some large Swedish banks were having trouble rolling over wholesale deposits, and on Oct 13, the Swedish government announced measures to guarantee bank debt and to inject capital into banks.
The rapidly worsening crisis soon spread beyond financial institutions into the money and capital markets more generally. As a result of losses on Lehman's commercial paper, a prominent money market mutual fund announced on Sept 16 that it had 'broken the buck' - that is, its net asset value had fallen below US$1 per share. Over the subsequent several weeks, investors withdrew more than US$400 billion from so-called prime money funds.
Conditions in short-term funding markets, including the interbank market and the commercial paper market, deteriorated sharply. Equity prices fell precipitously, and credit risk spreads jumped. The crisis also began to affect countries that had thus far escaped its worst effects. Notably, financial markets in emerging market economies were whipsawed as a flight from risk-led capital inflows to those countries to swing abruptly to outflows.
The policy response
Authorities in the United States and around the globe moved quickly to respond to this new phase of the crisis. The financial system of the United States gives a much greater role to financial markets and to non-bank financial institutions than is the case in most other nations, which rely primarily on banks. Thus, in the United States, a wider variety of policy measures was needed than in some other nations. In the United States, the Federal Reserve established new liquidity facilities with the goal of restoring basic functioning in various critical markets. Together, these steps helped stem the massive outflows from the money market mutual funds and stabilise the commercial paper market.
During this period, foreign commercial banks were a source of heavy demand for US dollar funding, thereby putting additional strain on global bank funding markets, including US markets, and further squeezing credit availability in the United States.
To address this problem, the Federal Reserve expanded the temporary swap lines that had been established earlier with the European Central Bank (ECB) and the Swiss National Bank, and established new temporary swap lines with seven other central banks in September and five more in late October, including four in emerging market economies. In further coordinated action, on Oct 8, the Federal Reserve and five other major central banks simultaneously cut their policy rates by 50 basis points.
The failure of Lehman Brothers demonstrated that liquidity provision by the Federal Reserve would not be sufficient to stop the crisis; substantial fiscal resources were necessary. On Oct 3, on the recommendation of the administration and with the strong support of the Federal Reserve, Congress approved the creation of the Troubled Asset Relief Program, or TARP, with a maximum authorisation of US$700 billion to support the stabilisation of the US financial system.
Markets remained highly volatile and pressure on financial institutions intense through the first weeks of October. On Oct 10, in what would prove to be a watershed in the global policy response, the Group of Seven (G-7) finance ministers and central bank governors, meeting in Washington, committed in a joint statement to work together to stabilise the global financial system. In particular, they agreed to prevent the failure of systemically important financial institutions; to ensure that financial institutions had adequate access to funding and capital, including public capital if necessary; and to put in place deposit insurance and other guarantees to restore the confidence of depositors.
In the following days, many countries around the world announced comprehensive rescue plans for their banking systems that built on the G-7 principles. To stabilise funding, during October, more than 20 countries expanded their deposit insurance programmes, and many also guaranteed non-deposit liabilities of banks. In addition, amid mounting concerns about the solvency of the global banking system, by the end of October, more than a dozen countries had announced plans to inject public capital into banks, and several announced plans to purchase or guarantee bank assets.
This strong and unprecedented international policy response proved broadly effective. Critically, it averted the imminent collapse of the global financial system, an outcome that seemed all too possible to the finance ministers and central bankers that gathered in Washington on Oct 10. However, although the intensity of the crisis moderated and the risk of systemic collapse declined in the wake of the policy response, financial conditions remained highly stressed.
For example, although short-term funding spreads in global markets began to turn down in October, they remained elevated into this year. And, although generalised pressures on financial institutions subsided somewhat, government actions to prevent the disorderly failures of individual, systemically significant institutions continued to be necessary. In the United States, support packages were announced for Citigroup in November and Bank of America in January. Broadly similar support packages were also announced for some large European institutions, including firms in the United Kingdom and the Netherlands.
Although concerted policy actions avoided much worse outcomes, the financial shocks of September and October nevertheless severely damaged the global economy - starkly illustrating the potential effects of financial stress on real economic activity. In the fourth quarter of 2008 and the first quarter of this year, global economic activity recorded its weakest performance in decades.
In the United States, real GDP plummeted at nearly a 6 per cent average annual pace over those two quarters - an even sharper decline than had occurred in the 1981-82 recession. Economic activity contracted even more precipitously in many foreign economies, with real GDP dropping at double-digit annual rates in some cases. The crisis affected economic activity not only by pushing down asset prices and tightening credit conditions, but also by shattering household and business confidence around the world.
In response to these developments, the Federal Reserve expended the remaining ammunition in the traditional arsenal of monetary policy, bringing the federal funds rate down, in steps, to a target range of zero to 25 basis points by mid-December of last year. It also took several measures to further supplement its traditional arsenal. In particular, on Nov 25, the Fed announced that it would purchase up to US$100 billion of debt issued by the housing-related GSEs and up to US$500 billion of agency-guaranteed mortgage-backed securities, programmes that were expanded substantially and augmented by a programme of purchases of Treasury securities in March.
The goal of these purchases was to provide additional support to private credit markets, particularly the mortgage market. Also, on Nov 25, the Fed announced the creation of the Term Asset-Backed Securities Loan Facility (TALF). This facility aims to improve the availability and affordability of credit for households and small businesses, and to help facilitate the financing and refinancing of commercial real estate properties.
The TALF has shown early success in reducing risk spreads and stimulating new securitisation activity for assets included in the programme. Foreign central banks also cut policy rates to very low levels and implemented unconventional monetary measures.
On Feb 10, Treasury Secretary Geithner and the heads of the federal banking agencies unveiled the outlines of a new strategy for ensuring that banking institutions could continue to provide credit to households and businesses during the financial crisis. A central component of that strategy was the exercise that came to be known as the bank stress test.
Under this initiative, the banking regulatory agencies undertook a forward-looking, simultaneous evaluation of the capital positions of 19 of the largest bank holding companies in the United States, with the Treasury committing to provide public capital as needed. The goal of this supervisory assessment was to ensure that the equity capital held by these firms was sufficient - in both quantity and quality - to allow those institutions to withstand a worse-than-expected macroeconomic environment over the subsequent two years and yet remain healthy and capable of lending to creditworthy borrowers.
This exercise, unprecedented in scale and scope, was led by the Federal Reserve in cooperation with the Office of the Comptroller of the Currency and the FDIC. Importantly, the agencies' report made public considerable information on the projected losses and revenues of the 19 firms, allowing private analysts to judge for themselves the credibility of the exercise. Financial market participants responded favourably to the announcement of the results, and many of the tested banks were subsequently able to tap public capital markets.
Overall, the policy actions implemented in recent months have helped stabilise a number of key financial markets, both in the United States and abroad. Short-term funding markets are functioning more normally, corporate bond issuance has been strong, and activity in some previously moribund securitisation markets has picked up. Stock prices have partially recovered, and US mortgage rates have declined markedly since last fall.
Critically, fears of financial collapse have receded substantially. After contracting sharply over the past year, economic activity appears to be levelling out, both in the United States and abroad, and the prospects for a return to growth in the near term appear good.
Notwithstanding this noteworthy progress, critical challenges remain: Strains persist in many financial markets across the globe, financial institutions face significant additional losses, and many businesses and households continue to experience considerable difficulty gaining access to credit. Because of these and other factors, the economic recovery is likely to be relatively slow at first, with unemployment declining only gradually from high levels.
Super-rich hit a sobering wall
Business Times, 24 Aug 2009
FOCUS: WEALTH GAP
A 30-year period in which affluent Americans became both wealthier and more numerous may be ending, analysts say
THE rich have been getting richer for so long that the trend has come to seem almost permanent. They began to pull away from everyone else in the 1970s. By 2006, income was more concentrated at the top than it had been since the late 1920s.
The recent news about resurgent Wall Street pay has seemed to suggest that not even the Great Recession could reverse the rise in income inequality.
But economists say - and data is beginning to show - that a significant change may in fact be under way. The rich, as a group, are no longer getting richer. Over the last two years, they have become poorer. And many may not return to their old levels of wealth and income anytime soon.
For every investment banker whose pay has recovered to its pre-recession levels, there are several who have lost their jobs - as well as many wealthy investors who have lost millions. As a result, economists and other analysts say, a 30-year period in which the super-rich became both wealthier and more numerous may be ending.
The relative struggles of the rich may elicit little sympathy from less-well-off families who are dealing with the effects of the worst recession in a generation. But the change does raise several broader economic questions. Among them is whether harder times for the rich will ultimately benefit the middle class and the poor, given that the huge recent increase in top incomes coincided with slow income growth for almost every other group. In blunter terms, the question is whether the better metaphor for the economy is a rising tide that can lift all boats - or a zero-sum game.
Just how much poorer the rich will become remains unclear. It will be determined by, among other things, whether the stock market continues its recent rally and what new laws Congress passes in the wake of the financial crisis. At the very least, though, the rich seem unlikely to return to the trajectory they were on.
Last year, the number of Americans with a net worth of at least US$30 million dropped 24 per cent, according to CapGemini and Merrill Lynch Wealth Management. Monthly income from stock dividends, which is concentrated among the affluent, has fallen more than 20 per cent since last summer - the biggest such decline since the government began keeping records in 1959.
Bill Gates, Warren Buffett, the heirs to the Wal-Mart Stores fortune and the founders of Google each lost billions last year, according to Forbes magazine. In one stark example, John McAfee, an entrepreneur who founded the antivirus software company that bears his name, is now worth about US$4 million, from a peak of more than US$100 million. Mr McAfee will soon auction off his last big property because he needs cash to pay his bills after having been caught off guard by the simultaneous crash in real estate and stocks. 'I had no clue,' he said, 'that there would be this tandem collapse.'
Some of the clearest signs of the reversal of fortunes can be found in data on spending by the wealthy. An index that tracks the price of art, the Mei Moses index, has dropped 32 per cent in the last six months. The New York Yankees failed to sell many of the most expensive tickets in their new stadium and had to drop the price. In one ZIP code in Vail, Colorado, only five houses sold for more than US$2 million in the first half of this year, down from 34 in the first half of 2007, according to MDA Dataquick. In Bronxville, an affluent New York suburb, the decline was to two, from 17, according to Coldwell Banker Residential Brokerage.
'We had a period of roughly 50 years, from 1929 to 1979, when the income distribution tended to flatten,' said Neal Soss, the chief economist at Credit Suisse. 'Since the early 1980s, incomes have tended to get less equal. And I think we've entered a phase now where society will move to a more equal distribution.'
Few economists expect the country to return to the relatively flat income distribution of the 1950s and 1960s; indeed, they say that inequality is likely to remain significantly greater than it was for most of the 20th century. The Obama administration has not proposed completely rewriting the rules for Wall Street or raising the top income-tax rate to anywhere near 70 per cent, its level as recently as 1980. Market forces that have increased inequality, like globalisation, are also not going away.
No swift recovery
But economists say that the rich will probably not recover their losses immediately, as they did in the wake of the dotcom crash earlier this decade. That quick recovery came courtesy of a new bubble in stocks, which in 2007 were more expensive by some measures than they had been at any other point save the bull markets of the 1920s or 1990s. This time, analysts say, Wall Street seems unlikely to return soon to the extreme levels of borrowing that made such a bubble possible.
Any major shift in the financial status of the rich could have big implications. A drop in their income and wealth would complicate life for elite universities, museums and other institutions that received lavish donations in recent decades. Governments - federal and state - could struggle too because they rely heavily on the taxes paid by the affluent.
Perhaps the broadest question is what a hit to the wealthy would mean for the middle class and the poor. The best-known data on the rich comes from an analysis of Internal Revenue Service (IRS) returns by Thomas Piketty and Emmanuel Saez, two economists. Their work shows that in the late 1970s, the cutoff to qualify for the highest-earning 1/10,000th of households was roughly US$2 million, in inflation-adjusted, pretax terms; by 2007, it had jumped to US$11.5 million.
The gains for the merely affluent were also big, if not quite huge. The cutoff to be in the top one per cent doubled since the late 1970s, to roughly US$400,000.
By contrast, pay at the median - which was about US$50,000 in 2007 - rose less than 20 per cent, Census data shows. Near the bottom of the income distribution, the increase was about 12 per cent.
Some economists believe that the contrasting trends are unrelated. If anything, these economists say, any problems the wealthy have will trickle down, in the form of less charitable giving and less consumer spending. Over the last century, the worst years for the rich were the early 1930s, the heart of the Great Depression.
Other economists say the recent explosion of incomes at the top did hurt everyone else, by concentrating economic and political power among a relatively small group.
'I think incredibly high incomes can have a pernicious effect on the polity and the economy,' said Lawrence Katz, a Harvard economist.
Much of the growth of high-end incomes stemmed from market forces, like technological innovation, Mr Katz said. But a significant amount also stemmed from the wealthy's newfound ability to win favourable government contracts, low tax rates and weak financial regulation, he added.
The IRS has not yet released its data for 2008 or 2009. But Mr Saez, a professor at the University of California, Berkeley, said he believed that the rich had become poorer. Asked to speculate where the cutoff for the top 1/10,000th of households was now, he said from US$6 million to US$8 million. For the number to return to US$11 million quickly, he said, would probably require a large financial bubble.
The US economy experienced two such bubbles in recent years - one in stocks, the other in real estate - and both helped the rich become richer.
Mr McAfee, whose tattoos and tinted hair suggest an independent streak, is an extreme but telling example. For two decades, at almost every step of his career, he figured out a way to make more money.
In the late 1980s, he founded McAfee Associates, the antivirus software company. It gave away its software, unlike its rivals, but charged fees to those who wanted any kind of technical support. That decision helped make it a huge success.
The company went public in 1992, in the early years of one of biggest stockmarket booms in history.
But Mr McAfee is, by his own description, an atypical businessman - easily bored and given to serial obsessions. As a young man, he travelled through Mexico, India and Nepal and, more recently, he wrote a book called Into the Heart of Truth: The Spirit of Relational Yoga. Two years after McAfee Associates went public, he was bored again.
So he sold his remaining stake, bringing his gains to about US$100 million. In the coming years, he started new projects and made more investments. Almost inevitably, they paid off.
Closely tied to stock market
'History told me that you just keep working, and it is easy to make more money,' he said, sitting in the kitchen of his adobe house in the southwest corner of New Mexico. With low tax rates, he added, the rich could keep much of what they made.
One of the starkest patterns in the data on inequality is the extent to which the incomes of the very rich are tied to the stock market. They have risen most rapidly during the biggest bull markets: in the 1920s and the 20 years starting in 1987.
'We are coming from an abnormal period where a tremendous amount of wealth was created largely by selling assets back and forth,' said Mohamed A El-Erian, chief executive of Pimco, one of the country's largest bond traders, and the former manager of Harvard's endowment.
Some of this wealth was based on real economic gains, like those from the computer revolution. But much of it was not, Mr El-Erian said. 'You had wealth creation that could not be tied to the underlying economy,' he added, 'and the benefits were very skewed: they went to the assets of the rich. It was financial engineering.'
But if the rich have done well in bubbles, they have taken enormous hits to their wealth during busts. A recent study by two Northwestern University economists found that the incomes of the affluent tend to fall more, in percentage terms, in recessions than the incomes of the middle class.
The incomes of the very affluent - the top 1/10,000th - fall the most.
Over the last several years, Mr McAfee began to put a large chunk of his fortune into real estate, often in remote locations. He bought the house in New Mexico as a playground for himself and fellow aerotrekkers, people who fly unlicensed, open-cockpit planes. On a 63.5 hectare spread, he built a general store, a 35-seat movie theatre and a cafe, and he bought vintage cars for his visitors to use.
He continued to invest in financial markets, sometimes borrowing money to increase the potential returns. He typically chose his investments based on suggestions from his financial advisers. One of their recommendations was to put millions of dollars into bonds tied to Lehman Brothers.
For a while, Mr McAfee's good run, like that of many of the American wealthy, seemed to continue. In the wake of the dotcom crash, stocks started rising again, while house prices just continued to rise.
Outside's Go magazine and National Geographic Adventure ran articles on his New Mexico property, leading him to believe that 'this was the hottest property on the planet', he said.
But then things began to change. In 2007, Mr McAfee sold a 10,000 square foot home in Colorado with a view of Pike's Peak. He had spent US$25 million to buy the property and build the house; he received US$5.7 million for it. When Lehman collapsed last fall, its bonds became virtually worthless. Mr McAfee's stock investments cost him millions more.
One day, he realised, as he said, 'whoa, my cash is gone', His remaining net worth of about US$4 million makes him vastly wealthier than most Americans, of course. But he has nonetheless found himself needing cash and desperately trying to reduce his monthly expenses.
He has sold a 10-passenger Cessna jet and flies coach. This week, his oceanfront estate on 216 ha in Hawaii sold for US$1.5 million, with only a handful of bidders at the auction. He plans to spend much of his time in Belize, in part because of more favourable taxes there.
Next week, his New Mexico property will be the subject of a no-floor auction, meaning that Mr McAfee has promised to accept the top bid, no matter how low it is.
'I am trying to face up to the reality here that the auction may bring next to nothing,' he said.
In the past, when his stock investments did poorly, he sold real estate and replenished his cash; this time, that has not been an option.
The possibility that the stock market will quickly recover from its collapse, as it did earlier this decade, is perhaps the biggest uncertainty about the financial condition of the wealthy. Since March, the Standard & Poor's 500-stock index has risen 49 per cent.
Yet Wall Street still has a long way to go before reaching its previous peaks. The S&P 500 remains 35 per cent below its 2007 high.
Aggregate compensation for the financial sector fell 14 per cent from 2007 to 2008, according to the Securities Industry and Financial Markets Association - far less than profits or revenue fell, but a decline nonetheless.
'The difference this time,' predicted Byron R Wein, a former chief investment strategist at Morgan Stanley, who started working on Wall Street in 1965, 'is that the high water mark that people reached in 2007 is not going to be exceeded for a very long time.'
Without a financial bubble, there will simply be less money available for Wall Street to pay itself or for corporate chief executives to pay themselves. Some companies - like Goldman Sachs and JPMorgan Chase, which face less competition now and have been helped by the government's attempts to prop up credit markets - will still hand out enormous paychecks. Overall, though, there will be fewer such checks, analysts say. Roger Freeman, an analyst at Barclays Capital, said he thought that overall Wall Street compensation would, at most, increase moderately over the next couple of years.
Beyond the stock market, government policy may have the biggest effect on top incomes. Mr Katz, the Harvard economist, argues that without policy changes, top incomes may indeed approach their old highs in the coming years. Historically, government policy, like the New Deal, has had more lasting effects on the rich than financial busts, he said.
One looming policy issue today is what steps Congress and the administration will take to re-regulate financial markets.
A second issue is taxes. In the three decades after World War II, when the incomes of the rich grew more slowly than those of the middle class, the top marginal rate ranged from 70 to 91 per cent. Mr Piketty, one of the economists who analysed the IRS data, argues that these high rates did not affect merely post-tax income. They also helped hold down the pretax incomes of the wealthy, he says, by giving them less incentive to make many millions of dollars.
Raising tax rates
Since 1980, tax rates on the affluent have fallen more than rates on any other group; this year, the top marginal rate is 35 per cent.
President Barack Obama has proposed raising it to 39 per cent and has said he would consider a surtax on families making more than US$1 million a year, which could push the top rate above 40 per cent.
What any policy changes will mean for the non-wealthy remains unclear. There have certainly been periods when the rich, the middle class and the poor all have done well (like the late 1990s), as well as periods when all have done poorly (like last year). For much of the 1950s, '60s and '70s, both the middle class and the wealthy received raises that outpaced inflation.
Yet there is also a reason to think that the incomes of the wealthy could potentially have a bigger impact on others than in the past: as a share of the economy, they are vastly larger than they once were.
In 2007, the top 1/10,000th of households took home 6 per cent of the nation's income, up from 0.9 per cent in 1977. It was the highest such level since at least 1913, the first year for which the IRS has data.
The top one percent of earners took home 23.5 per cent of income, up from 9 per cent three decades earlier. -- NYT
FOCUS: WEALTH GAP
A 30-year period in which affluent Americans became both wealthier and more numerous may be ending, analysts say
THE rich have been getting richer for so long that the trend has come to seem almost permanent. They began to pull away from everyone else in the 1970s. By 2006, income was more concentrated at the top than it had been since the late 1920s.
The recent news about resurgent Wall Street pay has seemed to suggest that not even the Great Recession could reverse the rise in income inequality.
But economists say - and data is beginning to show - that a significant change may in fact be under way. The rich, as a group, are no longer getting richer. Over the last two years, they have become poorer. And many may not return to their old levels of wealth and income anytime soon.
For every investment banker whose pay has recovered to its pre-recession levels, there are several who have lost their jobs - as well as many wealthy investors who have lost millions. As a result, economists and other analysts say, a 30-year period in which the super-rich became both wealthier and more numerous may be ending.
The relative struggles of the rich may elicit little sympathy from less-well-off families who are dealing with the effects of the worst recession in a generation. But the change does raise several broader economic questions. Among them is whether harder times for the rich will ultimately benefit the middle class and the poor, given that the huge recent increase in top incomes coincided with slow income growth for almost every other group. In blunter terms, the question is whether the better metaphor for the economy is a rising tide that can lift all boats - or a zero-sum game.
Just how much poorer the rich will become remains unclear. It will be determined by, among other things, whether the stock market continues its recent rally and what new laws Congress passes in the wake of the financial crisis. At the very least, though, the rich seem unlikely to return to the trajectory they were on.
Last year, the number of Americans with a net worth of at least US$30 million dropped 24 per cent, according to CapGemini and Merrill Lynch Wealth Management. Monthly income from stock dividends, which is concentrated among the affluent, has fallen more than 20 per cent since last summer - the biggest such decline since the government began keeping records in 1959.
Bill Gates, Warren Buffett, the heirs to the Wal-Mart Stores fortune and the founders of Google each lost billions last year, according to Forbes magazine. In one stark example, John McAfee, an entrepreneur who founded the antivirus software company that bears his name, is now worth about US$4 million, from a peak of more than US$100 million. Mr McAfee will soon auction off his last big property because he needs cash to pay his bills after having been caught off guard by the simultaneous crash in real estate and stocks. 'I had no clue,' he said, 'that there would be this tandem collapse.'
Some of the clearest signs of the reversal of fortunes can be found in data on spending by the wealthy. An index that tracks the price of art, the Mei Moses index, has dropped 32 per cent in the last six months. The New York Yankees failed to sell many of the most expensive tickets in their new stadium and had to drop the price. In one ZIP code in Vail, Colorado, only five houses sold for more than US$2 million in the first half of this year, down from 34 in the first half of 2007, according to MDA Dataquick. In Bronxville, an affluent New York suburb, the decline was to two, from 17, according to Coldwell Banker Residential Brokerage.
'We had a period of roughly 50 years, from 1929 to 1979, when the income distribution tended to flatten,' said Neal Soss, the chief economist at Credit Suisse. 'Since the early 1980s, incomes have tended to get less equal. And I think we've entered a phase now where society will move to a more equal distribution.'
Few economists expect the country to return to the relatively flat income distribution of the 1950s and 1960s; indeed, they say that inequality is likely to remain significantly greater than it was for most of the 20th century. The Obama administration has not proposed completely rewriting the rules for Wall Street or raising the top income-tax rate to anywhere near 70 per cent, its level as recently as 1980. Market forces that have increased inequality, like globalisation, are also not going away.
No swift recovery
But economists say that the rich will probably not recover their losses immediately, as they did in the wake of the dotcom crash earlier this decade. That quick recovery came courtesy of a new bubble in stocks, which in 2007 were more expensive by some measures than they had been at any other point save the bull markets of the 1920s or 1990s. This time, analysts say, Wall Street seems unlikely to return soon to the extreme levels of borrowing that made such a bubble possible.
Any major shift in the financial status of the rich could have big implications. A drop in their income and wealth would complicate life for elite universities, museums and other institutions that received lavish donations in recent decades. Governments - federal and state - could struggle too because they rely heavily on the taxes paid by the affluent.
Perhaps the broadest question is what a hit to the wealthy would mean for the middle class and the poor. The best-known data on the rich comes from an analysis of Internal Revenue Service (IRS) returns by Thomas Piketty and Emmanuel Saez, two economists. Their work shows that in the late 1970s, the cutoff to qualify for the highest-earning 1/10,000th of households was roughly US$2 million, in inflation-adjusted, pretax terms; by 2007, it had jumped to US$11.5 million.
The gains for the merely affluent were also big, if not quite huge. The cutoff to be in the top one per cent doubled since the late 1970s, to roughly US$400,000.
By contrast, pay at the median - which was about US$50,000 in 2007 - rose less than 20 per cent, Census data shows. Near the bottom of the income distribution, the increase was about 12 per cent.
Some economists believe that the contrasting trends are unrelated. If anything, these economists say, any problems the wealthy have will trickle down, in the form of less charitable giving and less consumer spending. Over the last century, the worst years for the rich were the early 1930s, the heart of the Great Depression.
Other economists say the recent explosion of incomes at the top did hurt everyone else, by concentrating economic and political power among a relatively small group.
'I think incredibly high incomes can have a pernicious effect on the polity and the economy,' said Lawrence Katz, a Harvard economist.
Much of the growth of high-end incomes stemmed from market forces, like technological innovation, Mr Katz said. But a significant amount also stemmed from the wealthy's newfound ability to win favourable government contracts, low tax rates and weak financial regulation, he added.
The IRS has not yet released its data for 2008 or 2009. But Mr Saez, a professor at the University of California, Berkeley, said he believed that the rich had become poorer. Asked to speculate where the cutoff for the top 1/10,000th of households was now, he said from US$6 million to US$8 million. For the number to return to US$11 million quickly, he said, would probably require a large financial bubble.
The US economy experienced two such bubbles in recent years - one in stocks, the other in real estate - and both helped the rich become richer.
Mr McAfee, whose tattoos and tinted hair suggest an independent streak, is an extreme but telling example. For two decades, at almost every step of his career, he figured out a way to make more money.
In the late 1980s, he founded McAfee Associates, the antivirus software company. It gave away its software, unlike its rivals, but charged fees to those who wanted any kind of technical support. That decision helped make it a huge success.
The company went public in 1992, in the early years of one of biggest stockmarket booms in history.
But Mr McAfee is, by his own description, an atypical businessman - easily bored and given to serial obsessions. As a young man, he travelled through Mexico, India and Nepal and, more recently, he wrote a book called Into the Heart of Truth: The Spirit of Relational Yoga. Two years after McAfee Associates went public, he was bored again.
So he sold his remaining stake, bringing his gains to about US$100 million. In the coming years, he started new projects and made more investments. Almost inevitably, they paid off.
Closely tied to stock market
'History told me that you just keep working, and it is easy to make more money,' he said, sitting in the kitchen of his adobe house in the southwest corner of New Mexico. With low tax rates, he added, the rich could keep much of what they made.
One of the starkest patterns in the data on inequality is the extent to which the incomes of the very rich are tied to the stock market. They have risen most rapidly during the biggest bull markets: in the 1920s and the 20 years starting in 1987.
'We are coming from an abnormal period where a tremendous amount of wealth was created largely by selling assets back and forth,' said Mohamed A El-Erian, chief executive of Pimco, one of the country's largest bond traders, and the former manager of Harvard's endowment.
Some of this wealth was based on real economic gains, like those from the computer revolution. But much of it was not, Mr El-Erian said. 'You had wealth creation that could not be tied to the underlying economy,' he added, 'and the benefits were very skewed: they went to the assets of the rich. It was financial engineering.'
But if the rich have done well in bubbles, they have taken enormous hits to their wealth during busts. A recent study by two Northwestern University economists found that the incomes of the affluent tend to fall more, in percentage terms, in recessions than the incomes of the middle class.
The incomes of the very affluent - the top 1/10,000th - fall the most.
Over the last several years, Mr McAfee began to put a large chunk of his fortune into real estate, often in remote locations. He bought the house in New Mexico as a playground for himself and fellow aerotrekkers, people who fly unlicensed, open-cockpit planes. On a 63.5 hectare spread, he built a general store, a 35-seat movie theatre and a cafe, and he bought vintage cars for his visitors to use.
He continued to invest in financial markets, sometimes borrowing money to increase the potential returns. He typically chose his investments based on suggestions from his financial advisers. One of their recommendations was to put millions of dollars into bonds tied to Lehman Brothers.
For a while, Mr McAfee's good run, like that of many of the American wealthy, seemed to continue. In the wake of the dotcom crash, stocks started rising again, while house prices just continued to rise.
Outside's Go magazine and National Geographic Adventure ran articles on his New Mexico property, leading him to believe that 'this was the hottest property on the planet', he said.
But then things began to change. In 2007, Mr McAfee sold a 10,000 square foot home in Colorado with a view of Pike's Peak. He had spent US$25 million to buy the property and build the house; he received US$5.7 million for it. When Lehman collapsed last fall, its bonds became virtually worthless. Mr McAfee's stock investments cost him millions more.
One day, he realised, as he said, 'whoa, my cash is gone', His remaining net worth of about US$4 million makes him vastly wealthier than most Americans, of course. But he has nonetheless found himself needing cash and desperately trying to reduce his monthly expenses.
He has sold a 10-passenger Cessna jet and flies coach. This week, his oceanfront estate on 216 ha in Hawaii sold for US$1.5 million, with only a handful of bidders at the auction. He plans to spend much of his time in Belize, in part because of more favourable taxes there.
Next week, his New Mexico property will be the subject of a no-floor auction, meaning that Mr McAfee has promised to accept the top bid, no matter how low it is.
'I am trying to face up to the reality here that the auction may bring next to nothing,' he said.
In the past, when his stock investments did poorly, he sold real estate and replenished his cash; this time, that has not been an option.
The possibility that the stock market will quickly recover from its collapse, as it did earlier this decade, is perhaps the biggest uncertainty about the financial condition of the wealthy. Since March, the Standard & Poor's 500-stock index has risen 49 per cent.
Yet Wall Street still has a long way to go before reaching its previous peaks. The S&P 500 remains 35 per cent below its 2007 high.
Aggregate compensation for the financial sector fell 14 per cent from 2007 to 2008, according to the Securities Industry and Financial Markets Association - far less than profits or revenue fell, but a decline nonetheless.
'The difference this time,' predicted Byron R Wein, a former chief investment strategist at Morgan Stanley, who started working on Wall Street in 1965, 'is that the high water mark that people reached in 2007 is not going to be exceeded for a very long time.'
Without a financial bubble, there will simply be less money available for Wall Street to pay itself or for corporate chief executives to pay themselves. Some companies - like Goldman Sachs and JPMorgan Chase, which face less competition now and have been helped by the government's attempts to prop up credit markets - will still hand out enormous paychecks. Overall, though, there will be fewer such checks, analysts say. Roger Freeman, an analyst at Barclays Capital, said he thought that overall Wall Street compensation would, at most, increase moderately over the next couple of years.
Beyond the stock market, government policy may have the biggest effect on top incomes. Mr Katz, the Harvard economist, argues that without policy changes, top incomes may indeed approach their old highs in the coming years. Historically, government policy, like the New Deal, has had more lasting effects on the rich than financial busts, he said.
One looming policy issue today is what steps Congress and the administration will take to re-regulate financial markets.
A second issue is taxes. In the three decades after World War II, when the incomes of the rich grew more slowly than those of the middle class, the top marginal rate ranged from 70 to 91 per cent. Mr Piketty, one of the economists who analysed the IRS data, argues that these high rates did not affect merely post-tax income. They also helped hold down the pretax incomes of the wealthy, he says, by giving them less incentive to make many millions of dollars.
Raising tax rates
Since 1980, tax rates on the affluent have fallen more than rates on any other group; this year, the top marginal rate is 35 per cent.
President Barack Obama has proposed raising it to 39 per cent and has said he would consider a surtax on families making more than US$1 million a year, which could push the top rate above 40 per cent.
What any policy changes will mean for the non-wealthy remains unclear. There have certainly been periods when the rich, the middle class and the poor all have done well (like the late 1990s), as well as periods when all have done poorly (like last year). For much of the 1950s, '60s and '70s, both the middle class and the wealthy received raises that outpaced inflation.
Yet there is also a reason to think that the incomes of the wealthy could potentially have a bigger impact on others than in the past: as a share of the economy, they are vastly larger than they once were.
In 2007, the top 1/10,000th of households took home 6 per cent of the nation's income, up from 0.9 per cent in 1977. It was the highest such level since at least 1913, the first year for which the IRS has data.
The top one percent of earners took home 23.5 per cent of income, up from 9 per cent three decades earlier. -- NYT
Thursday, August 13, 2009
Dark Pools Fire Back at Call for Ban
NEW YORK – Dark-pool operators are firing back at the chief executive of Nasdaq OMX Group Inc., arguing that banning their platforms would make buying and selling stocks more expensive for all investors.
This week Nasdaq CEO Bob Greifeld called for regulators to end all forms of "dark liquidity," ratcheting up the dialogue around the role of alternative- trading systems and off-exchange liquidity in U.S. cash markets.
Dark pools, a fast-growing form of alternative trading, are electronic-trading venues where money managers trade large blocks of shares anonymously.
Several dark-pool executives told Dow Jones Newswires that Mr. Greifeld's far-reaching proposal would have calamitous effects for retail and institutional traders.
"Undisplayed liquidity adds to execution quality," said Bob Gasser, chief executive of Investment Technology Group Inc., which is credited with creating the first of the modern-day dark pools roughly 20 years ago. "You can come up with all kinds of anecdotes, but the simple fact is, on behalf of all investors, dark liquidity adds to execution."
Other alternative-trading system executives called Mr. Greifeld's stance on the issue opportunistic given lawmakers' recent focus on related issues, and suggested that Nasdaq OMX is acting defensively after losing market share to non-displayed trading venues.
Several dark pool officials also noted that both Nasdaq OMX and NYSE Euronext, which has also been losing market share, maintain non-displayed liquidity pools.
As dark pools have grown -- accounting for more than 7% of all trades in June, according to Rosenblatt Securities -- the SEC has made it clear it is evaluating these alternative trading systems, indicating more regulation is likely.
In interviews with nearly a dozen dark-pool executives, none objected to the SEC's initiative. Dark-pool administrators are willing to provide more transparency and standardize volume reporting, with most even demanding it.
But Mr. Greifeld's letter this week went a step further, calling for the elimination of "market structure policies that do not contribute to public price formation and market transparency." The Nasdaq OMX chief tied dark pools to the issue of flash order types, a trading practice in which stock trades, after being checked against an exchange's order book, are sent to a select group of participants before being routed to other exchanges for filling.
Critics allege this gives such participants, sometimes including those that use dark pools, an unfair information advantage. Sen. Charles Schumer (D., N.Y.), last week told the SEC in a letter he will move to limit flash orders if the commission doesn't.
Nasdaq OMX adopted the practice with a nod toward competitive pressure from rivals BATS Exchange and Direct Edge, which have their own versions of flash orders. However, BATS and Nasdaq OMX have both voiced support for banning the practice in recent days.
The issue for dark pools is more complex. Unlike flash orders, retail investors use dark pools and benefit from them, proponents say.
Mutual funds, for example, receive cash from individuals, endowments, pensions and others, and then go to the market with one large pool of money. If they revealed a massive order to the displayed market, it would drive prices higher and make it more costly to invest.
Also, day traders with accounts through market providers such as E*Trade Financial Corp. or TD Ameritrade Holding Corp. go through brokers to find the national best bid and offer, or NBBO, which is often in dark pools. Operators of the platforms said Mr. Greifeld's comments overlook factors such as these.
"I understand when there's a duopoly, you want to maintain that, because it's a good business model," said Seth Merrin, founder and CEO of Liquidnet, among the largest independent dark pools. "But it's really detrimental to all the people who invest in pension funds or mutual funds, and people who manage institutional order flow."
This week Nasdaq CEO Bob Greifeld called for regulators to end all forms of "dark liquidity," ratcheting up the dialogue around the role of alternative- trading systems and off-exchange liquidity in U.S. cash markets.
Dark pools, a fast-growing form of alternative trading, are electronic-trading venues where money managers trade large blocks of shares anonymously.
Several dark-pool executives told Dow Jones Newswires that Mr. Greifeld's far-reaching proposal would have calamitous effects for retail and institutional traders.
"Undisplayed liquidity adds to execution quality," said Bob Gasser, chief executive of Investment Technology Group Inc., which is credited with creating the first of the modern-day dark pools roughly 20 years ago. "You can come up with all kinds of anecdotes, but the simple fact is, on behalf of all investors, dark liquidity adds to execution."
Other alternative-trading system executives called Mr. Greifeld's stance on the issue opportunistic given lawmakers' recent focus on related issues, and suggested that Nasdaq OMX is acting defensively after losing market share to non-displayed trading venues.
Several dark pool officials also noted that both Nasdaq OMX and NYSE Euronext, which has also been losing market share, maintain non-displayed liquidity pools.
As dark pools have grown -- accounting for more than 7% of all trades in June, according to Rosenblatt Securities -- the SEC has made it clear it is evaluating these alternative trading systems, indicating more regulation is likely.
In interviews with nearly a dozen dark-pool executives, none objected to the SEC's initiative. Dark-pool administrators are willing to provide more transparency and standardize volume reporting, with most even demanding it.
But Mr. Greifeld's letter this week went a step further, calling for the elimination of "market structure policies that do not contribute to public price formation and market transparency." The Nasdaq OMX chief tied dark pools to the issue of flash order types, a trading practice in which stock trades, after being checked against an exchange's order book, are sent to a select group of participants before being routed to other exchanges for filling.
Critics allege this gives such participants, sometimes including those that use dark pools, an unfair information advantage. Sen. Charles Schumer (D., N.Y.), last week told the SEC in a letter he will move to limit flash orders if the commission doesn't.
Nasdaq OMX adopted the practice with a nod toward competitive pressure from rivals BATS Exchange and Direct Edge, which have their own versions of flash orders. However, BATS and Nasdaq OMX have both voiced support for banning the practice in recent days.
The issue for dark pools is more complex. Unlike flash orders, retail investors use dark pools and benefit from them, proponents say.
Mutual funds, for example, receive cash from individuals, endowments, pensions and others, and then go to the market with one large pool of money. If they revealed a massive order to the displayed market, it would drive prices higher and make it more costly to invest.
Also, day traders with accounts through market providers such as E*Trade Financial Corp. or TD Ameritrade Holding Corp. go through brokers to find the national best bid and offer, or NBBO, which is often in dark pools. Operators of the platforms said Mr. Greifeld's comments overlook factors such as these.
"I understand when there's a duopoly, you want to maintain that, because it's a good business model," said Seth Merrin, founder and CEO of Liquidnet, among the largest independent dark pools. "But it's really detrimental to all the people who invest in pension funds or mutual funds, and people who manage institutional order flow."
The rise of dark pools
Attack of the clones
Jul 2nd 2009
From The Economist print edition
New trading venues offer a challenge to conventional exchanges
THERE is more than a hint of science fiction in the new jargon of finance. Systemic councils are being formed all over the place. America has appointed a “special master” to look at pay practices in bailed-out firms. And in the world of exchanges, “dark pools” are rising fast.
Dark pools are trading venues that match buyers and sellers anonymously. By concealing their identity, as well as the number of shares bought or sold, dark pools help institutional investors avoid price movements as the wider market reacts to their trades.
Most dark pools are operated by electronic exchanges and broker-dealers. As conventional exchanges increasingly handle small, frequently traded orders, dark pools have become the preferred venue for large “block” transactions. In America more than 40 dark pools are in operation, accounting for an estimated 9% of traded equities. The EU’s introduction of the Markets in Financial Instruments Directive (MiFID), a framework for financial services that provides for off-exchange trading, is sparking similar growth in Europe (see chart). On June 29th BATS Europe, an upstart electronic exchange with American roots, announced plans to offer dark-pool trading from next month.
The swell of dark pools raises questions for investors, regulators and exchanges. For investors, too many new trading venues may cause liquidity to fragment. Turquoise, a European dark-pool operator owned by a consortium of investment banks, will launch an aggregator on July 20th to scour the dark pools of nine broker-dealers including Citibank, Deutsche Bank and Merrill Lynch in an attempt to offer investors better pricing and a higher rate of matching trades. The market will also do its bit. Although dark pools have captured a significant chunk of equity-trading volumes, many are still struggling to turn a profit. “I have no doubt there will be downward pressure on the total number of dark pools,” says Marcus Hooper of Pipeline, another operator, who reckons consolidation will go furthest in Europe.
Regulators voice two contrasting concerns. One is that some dark pools give off signals, or indicators of interest, about positions that others can exploit. Backers say the pools are designed to reduce the ability of investors to front-run large orders. The other is that they hamper price discovery. Mary Schapiro, the chairman of the Securities and Exchange Commission, has expressed concern about their opacity. Immediate disclosure of orders, after they have been executed, is the obvious answer.
Conventional exchanges are already struggling with lower trading volumes and a meagre flow of public share offerings, both side-effects of the recession. They can ill afford to lose more business to dark pools. Some incumbents are taking the fight directly to the upstarts: the London Stock Exchange, one of the world’s oldest bourses, announced on June 29th that it had received regulatory approval for the launch of Baikal, its own pan-European dark pool. Yoda would approve.
Jul 2nd 2009
From The Economist print edition
New trading venues offer a challenge to conventional exchanges
THERE is more than a hint of science fiction in the new jargon of finance. Systemic councils are being formed all over the place. America has appointed a “special master” to look at pay practices in bailed-out firms. And in the world of exchanges, “dark pools” are rising fast.
Dark pools are trading venues that match buyers and sellers anonymously. By concealing their identity, as well as the number of shares bought or sold, dark pools help institutional investors avoid price movements as the wider market reacts to their trades.
Most dark pools are operated by electronic exchanges and broker-dealers. As conventional exchanges increasingly handle small, frequently traded orders, dark pools have become the preferred venue for large “block” transactions. In America more than 40 dark pools are in operation, accounting for an estimated 9% of traded equities. The EU’s introduction of the Markets in Financial Instruments Directive (MiFID), a framework for financial services that provides for off-exchange trading, is sparking similar growth in Europe (see chart). On June 29th BATS Europe, an upstart electronic exchange with American roots, announced plans to offer dark-pool trading from next month.
The swell of dark pools raises questions for investors, regulators and exchanges. For investors, too many new trading venues may cause liquidity to fragment. Turquoise, a European dark-pool operator owned by a consortium of investment banks, will launch an aggregator on July 20th to scour the dark pools of nine broker-dealers including Citibank, Deutsche Bank and Merrill Lynch in an attempt to offer investors better pricing and a higher rate of matching trades. The market will also do its bit. Although dark pools have captured a significant chunk of equity-trading volumes, many are still struggling to turn a profit. “I have no doubt there will be downward pressure on the total number of dark pools,” says Marcus Hooper of Pipeline, another operator, who reckons consolidation will go furthest in Europe.
Regulators voice two contrasting concerns. One is that some dark pools give off signals, or indicators of interest, about positions that others can exploit. Backers say the pools are designed to reduce the ability of investors to front-run large orders. The other is that they hamper price discovery. Mary Schapiro, the chairman of the Securities and Exchange Commission, has expressed concern about their opacity. Immediate disclosure of orders, after they have been executed, is the obvious answer.
Conventional exchanges are already struggling with lower trading volumes and a meagre flow of public share offerings, both side-effects of the recession. They can ill afford to lose more business to dark pools. Some incumbents are taking the fight directly to the upstarts: the London Stock Exchange, one of the world’s oldest bourses, announced on June 29th that it had received regulatory approval for the launch of Baikal, its own pan-European dark pool. Yoda would approve.
Exchange-backed dark pool in the offing by 2010
Business Times - 13 Aug 2009
SGX ties up with Chi-X to cross block trades in region for the big boys
By CHEW XIANG
(SINGAPORE) The Singapore Exchange (SGX) has joined hands with Chi-X to set up the region's first exchange-backed dark pool by mid-2010. The 50-50 joint venture will anonymously cross block trades of Singapore, Hong Kong, Japan and Australia-listed stocks for big funds and institutional investors.
Trades will be cleared through a pan-Asian central counterparty to be appointed, Chi-X and SGX said at a joint press conference yesterday. New York- headquartered Chi-X provides electronic trading platforms worldwide and a subsidiary will supply the technology for the planned dark pool.
'We expect and hope that it will improve overall trading liquidity here,' said Gan Seow Ann, senior executive vice-president and head of markets at SGX. The planned venture could be the fourth exchange-led dark pool set up, after NYSE Euronext's SmartPool, Nasdaq OMX's Neuro Dark and the London Stock Exchange's Baikal.
Incoming SGX CEO Magnus Bocker is now serving out his contract as president of Nasdaq OMX and is 'aware' of the Chi-X deal, said Mr Gan.
Dark pools, as the name suggests, provide a way to discreetly match large-volume orders without moving the market - making possible trades that previously would not have been crossed.
But they still rely on traditional exchanges for reference prices and there is concern, especially in Europe and the US, that markets will fragment as more trades take place in such anonymous venues, eroding the price discovery function of primary exchanges.
The joint venture between SGX and Chi-X is seen as a pre-emptive move. SGX's planned dark pool will act as an 'aggregator' linking broker-led dark pools as well as traditional brokerages, said Chi-X Global chairman Tony Mackay.
Two dark pools - Liquidnet, which focuses on buy-side clients, and CLSA-backed BlocSec - are already active in Singapore, and brokerages such as UBS are keen to introduce internal dark pools here as well. Dark pools already in Asia include those run by Goldman Sachs, Credit Suisse, UBS, Investment Technology Group and Instinet, which is Chi-X's parent company.
An exchange-backed dark pool would 'legitimise what we've been trying to do here to build up the market', said Greg Henry, head of Liquidnet in Singapore.
The pan-Asian dark pool will also complement Chi-X's efforts to introduce its alternative exchange systems throughout Asia, said Mr Mackay. These are essentially high-speed, low- cost electronic exchanges that in Europe have captured 15 per cent of trading in equities listed there, according to a June report from Aite Group. Chi-X is a market leader in such multilateral trading facilities there.
Chi-X was keen on setting up a similar alternative exchange in Singapore, according to a BT report last November. It has also applied, along with Liquidnet and AXE-ECN, a unit of the New Zealand Stock Exchange, to set up alternative exchanges in Australia. But the applications there have stalled as the Australian government has yet to grant market licences.
Such an exchange if approved in Singapore would have competed directly with SGX for trading fees but the two parties appear to have agreed to work together instead. Negotiations began at the start of the year, said John Lowrey, CEO of Chi-X Global.
Mr Lowrey said an exchange-backed dark pool would give it the size and the neutrality required to aggregate liquidity, and would also not hurt price discovery. 'I don't see dark pools dominating in terms of price formation,' he said yesterday.
Some fear that dark pools would also create an unequal playing field for investors but Chew Sutat, executive vice-president and head of market development at SGX, said the dark pool would not marginalise small investors. They could still access the primary market and should also benefit from increased liquidity in the system, he said.
The planned dark pool will apply for a recognised market operator licence here, Mr Lowrey said, and will get the necessary regulatory approvals in Australia, Hong Kong and Japan. 'Our experience has shown that users are looking for independent, genuinely neutral dark pools,' he said.
SGX ties up with Chi-X to cross block trades in region for the big boys
By CHEW XIANG
(SINGAPORE) The Singapore Exchange (SGX) has joined hands with Chi-X to set up the region's first exchange-backed dark pool by mid-2010. The 50-50 joint venture will anonymously cross block trades of Singapore, Hong Kong, Japan and Australia-listed stocks for big funds and institutional investors.
Trades will be cleared through a pan-Asian central counterparty to be appointed, Chi-X and SGX said at a joint press conference yesterday. New York- headquartered Chi-X provides electronic trading platforms worldwide and a subsidiary will supply the technology for the planned dark pool.
'We expect and hope that it will improve overall trading liquidity here,' said Gan Seow Ann, senior executive vice-president and head of markets at SGX. The planned venture could be the fourth exchange-led dark pool set up, after NYSE Euronext's SmartPool, Nasdaq OMX's Neuro Dark and the London Stock Exchange's Baikal.
Incoming SGX CEO Magnus Bocker is now serving out his contract as president of Nasdaq OMX and is 'aware' of the Chi-X deal, said Mr Gan.
Dark pools, as the name suggests, provide a way to discreetly match large-volume orders without moving the market - making possible trades that previously would not have been crossed.
But they still rely on traditional exchanges for reference prices and there is concern, especially in Europe and the US, that markets will fragment as more trades take place in such anonymous venues, eroding the price discovery function of primary exchanges.
The joint venture between SGX and Chi-X is seen as a pre-emptive move. SGX's planned dark pool will act as an 'aggregator' linking broker-led dark pools as well as traditional brokerages, said Chi-X Global chairman Tony Mackay.
Two dark pools - Liquidnet, which focuses on buy-side clients, and CLSA-backed BlocSec - are already active in Singapore, and brokerages such as UBS are keen to introduce internal dark pools here as well. Dark pools already in Asia include those run by Goldman Sachs, Credit Suisse, UBS, Investment Technology Group and Instinet, which is Chi-X's parent company.
An exchange-backed dark pool would 'legitimise what we've been trying to do here to build up the market', said Greg Henry, head of Liquidnet in Singapore.
The pan-Asian dark pool will also complement Chi-X's efforts to introduce its alternative exchange systems throughout Asia, said Mr Mackay. These are essentially high-speed, low- cost electronic exchanges that in Europe have captured 15 per cent of trading in equities listed there, according to a June report from Aite Group. Chi-X is a market leader in such multilateral trading facilities there.
Chi-X was keen on setting up a similar alternative exchange in Singapore, according to a BT report last November. It has also applied, along with Liquidnet and AXE-ECN, a unit of the New Zealand Stock Exchange, to set up alternative exchanges in Australia. But the applications there have stalled as the Australian government has yet to grant market licences.
Such an exchange if approved in Singapore would have competed directly with SGX for trading fees but the two parties appear to have agreed to work together instead. Negotiations began at the start of the year, said John Lowrey, CEO of Chi-X Global.
Mr Lowrey said an exchange-backed dark pool would give it the size and the neutrality required to aggregate liquidity, and would also not hurt price discovery. 'I don't see dark pools dominating in terms of price formation,' he said yesterday.
Some fear that dark pools would also create an unequal playing field for investors but Chew Sutat, executive vice-president and head of market development at SGX, said the dark pool would not marginalise small investors. They could still access the primary market and should also benefit from increased liquidity in the system, he said.
The planned dark pool will apply for a recognised market operator licence here, Mr Lowrey said, and will get the necessary regulatory approvals in Australia, Hong Kong and Japan. 'Our experience has shown that users are looking for independent, genuinely neutral dark pools,' he said.
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