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

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.

Super-rich hit a sobering wall

Business Times, 24 Aug 2009


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."

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.

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


(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.

An elite investment gets its day in the sun

Business Times - 13 Aug 2009

Sales of Good Class Bungalows gather steam, with some predicting healthy price rise


(SINGAPORE) The Good Class Bungalow (GCB) market has sprung to life with high-net-worth individuals stepping up their purchases.

July was an especially action-filled month which saw about 20 GCB transactions worth a total of more than $300 million. To put this in perspective, the entire first quarter of this year saw GCB deals worth only $27.5 million.

The action picked up in April, when $56 million worth of GCBs were transacted. It gathered pace in May and June, each month seeing deals amounting to around $188 million. In July, the market went ballistic.

So far this year, around 50 GCB deals have been transacted, according to caveats data compiled by property consultants and information on the latest transactions obtained by BT.

The year-to-date tally of over $800 million is healthy, considering that the whole of last year saw just 51 deals worth $830 million.

GCB agents expect the sales flow to continue in coming months. CB Richard Ellis's director, luxury homes, Douglas Wong said: 'It's likely that a total of 60-65 GCBs will be sold in the whole of 2009 - more than the 51 GCBs sold in 2008. The total quantum is likely to be around $1.1 billion to $1.2 billion, about 35-45 per cent higher than the quantum of $830 million in 2008.'

Savills Singapore director of investment sales & prestige homes Steven Ming says that 'although we do not expect the spike in GCB sales that was seen in May to July to be sustained, we do expect to still see healthy buying activity continue for the rest of the year'. He expects 60-70 transactions for the whole of 2009.

Apart from the general feeling that the worst of the financial crisis is over, he cites the low mortgage and deposit rates as reasons for the GCB market revival.

Agreeing, Newsman Realty managing director KH Tan notes that high-net- worth individuals prefer GCB investments to letting their cash idle in banks. They are also wary of investing in financial products following the Lehman debacle, he said.

'Another group of GCB buyers are foreigners who have become Singapore PRs and PRs who have become citizens,' adds Mr Tan, who recently brokered the $38 million sale of a Cluny Park bungalow.

BT understands the property was sold by former Kim Eng Securities managing director Douglas Ooi to a buyer who also picked up No 3 Cluny Hill earlier this year.

'When the IRs (integrated resorts) are ready, even more rich people from overseas will come to Singapore and become citizens. Some would be interested to invest in the GCB market,' said Mr Tan.

Typically, one has to be a Singapore citizen before one can own a GCB. However, PRs are known to have been given permission by the government on a case-by-case basis to buy small GCBs with land areas of about 15,000 sq ft, depending on their contribution to Singapore, according to Mr Tan.

Major GCB deals in recent months include a site at Dalvey Road said to have been sold by a certain Thomas Chan Ho Lam, for $27.01 million. Interestingly, a person with the same name is also understood to have bought a bungalow at Belmont Road for $30.5 million last month from Ong Kok Thai, managing director of Vanguard Interiors and the Peranakan Place Group.

Meanwhile, GuocoLand chairman Sat Pal Khattar is believed to be the seller of a bungalow at Rochalie Drive, which fetched $18.32 million. BreadTalk founder and chairman George Quek is reported to have sold his 2 Swettenham Road bungalow for $29.2 million to developer Simon Cheong.

The GCB market peaked in 2006 with $1.23 billion of transactions involving 119 deals. The following year saw 87 deals for a total $1.15 billion, according to CBRE figures. In the first seven months of this year, 47 deals totalling $710 million took place, CBRE said.

However, BT has learnt there are about six other transactions not yet captured in caveats, located in places like Belmont and Leedon roads, Maryland Drive and Astrid Hill. If these were to be included, the year-to-date tally would cross $800 million.

GCBs are the creme de la creme of Singapore's housing market, with stringent planning requirements.

There are only about 2,400 such bungalows in Singapore's 39 gazetted GCB Areas.

Mr Tan estimates GCB prices could increase about 20 per cent on average over the next 12 months.

Says Savills' Mr Ming: 'GCBs, being limited in availability, are a highly sought-after investment among the well heeled. As more rich are created, demand for these exclusive bungalows will gradually outstrip available supply for sale.'

Wednesday, August 12, 2009

Oil be not proud

(An abridged version of this essay appeared in the Business Times of 4 October 2008)

Looking beyond the current financial crisis, the future is bright and breezy as solar and wind energy will spell the end of oil's importance.


CEO, New Independent

In the Sunday Times of 6 July 2008 (oil was trading at about US$140 a barrel then), I predicted that the price will fall to US$50 in ten years. Since then we have moved half way there. The price of crude oil rose by 50% in 7 months and fell by 35% in 6 weeks. Until today, many policy makers insist that it is because of supply and demand and speculation played only a minor role. Did demand rise or supply fall by 50% in 7 months? Clearly not.

Published data shows that, physical demand and supply are approximately in balance at around 86 million barrels per day. Indeed, demand worldwide has been decelerating since the beginning of the year. For example, US demand has fallen by about 4% yoy in June to about 20.4 million barrels a day. On the other hand, available spare capacity in the oil producing nations have been thin – perhaps 1.5 million barrels per day. To aggravate matters, demand and supply for crude oil is inelastic in the near term. Most cars can only run on petrol and it takes 5 to 10 years to bring new field discoveries into production. Thus, no matter what the price, consumers and businesses have to pay up until they cannot.

Why then should prices continue to rise when crude oil demand is falling? I believe this is because of the demand from financial investors such as hedge and pension funds and, more mundanely, ETF holders. If spare capacity is plentiful, the impact of financial investors would not be significant. However, if spare capacity is small, financial demand of just the equivalent of 1 million barrels/day could drive prices skyward. This would be equivalent to an investment inflow of about US$50 billion per annum or about 3 months of China’s trade surplus or about 1.5% of the US$3 trillion in Sovereign Wealth Funds i.e. US$50 billion is thus a fairly small sum. It is even smaller if one remembers that oil futures are bought on margin.

I also suspect that both buyers and sellers of oil have been hoarding. As a producer of crude oil, I would delay bringing my product onto the market if prices are rising at the rate of 10% per month if my finances are in good shape.

There was also a huge divergence between the price of oil and the performance of oil stocks such as BP, ExxonMobil etc., which underperformed the price of crude oil by some 55% in the first six months of 2008. Exxon Mobil, based on a present value analysis, was being valued as if crude oil will trade at an average of US$80/barrel over the long term. The reason for this is clear. Buy US$50 billion of the public oil companies and the needle hardly moves. Throw US$50 billion into oil futures creates a quake because it is a relatively small market. The financial speculators know this.

Another anomaly is the huge premium over the marginal cost of production. The most expensive marginal barrel of oil is estimated to be around US$60 -70 a barrel. Being a commodity, that should be the sustainable price. Indeed, coal, which is many times more plentiful than crude oil, could apparently be converted into crude oil at around US$40 a barrel. Being replaced by another fossil fuel, however, is not the crude oil killer. It is renewable energy.

Renewable energy sources, together with the re-tooling of our energy supply infrastructure, will spell the end of oil’s importance. It will come sooner than many think. A view shared by the perpetually pessimistic “Economist “in its June 21st edition. It is not a pipe-dream such as aiming to go the moon in 1960. Most of the technologies are already commercially viable – it is a question of how fast mankind can re-tool.

The most promising alternatives are wind and (thin-film) solar energy – our nuclear fusion reactor in the sky. The earth absorbs 400 times more energy from the sun than all of mankind’s energy needs. Investments in solar energy are growing at 200% per annum. Indeed thin-film solar using nano-tailored ink as the energy absorbing medium is analogous to one of nature’s more potent processes – photosynthesis. Yes, plants get most of their energy needs from sunlight - not crude oil. Apparently, the leaders in this new technology are able to generate electricity as cheaply as coal if the cost of pollution is factored in.

Even as we get excited about solar energy today, the developments in the laboratory are even more exciting. Scientists have now developed material that could absorb infra-red radiation (heat) and convert it to electricity. The potential here is mine boggling e.g. air conditioners as we know them may be obsolete in future.

Although renewables are relatively small suppliers of energy currently, their rapid growth and huge potential will erode demand for oil at the margin as their share of total supply grows. For example the US could generate the equivalent of 6 million barrels per day of oil in its “wind belt” running north-south from Texas to the Canadian border. If the oil market were oversupplied by 6 million barrels today, the price of crude oil would plunge fairly quickly to US$50.

This rapid growth in alternative energy is happening not only in the developed world. China is now the world’s second largest wind turbine market after the US and the central government has set clear goals for the exploitation of wind and solar energy. Renewable energy makes even more sense for China given that China requires about 80% more energy than the US for every GDP dollar generated.

Unlike a coal plant that takes 5 years to build or a nuclear one which takes 10 years, and would be useless if only half completed, a solar or wind generator takes less than a year to build and could generate electricity even if half finished.

However, can land scarce Singapore be energy independent? Just like our water supply, there is good possibility that careful planning and technology will make this a possibility to a certain extent. Every HDB block is a potential solar generator not only for the residents but could sell surplus electricity to the grid. Another possibility for Singapore is to float the solar generators over our numerous reservoirs or along our sheltered coastlines. This is what small Denmark, which gets 20% of its electricity from wind energy, has done. It has installed some of its wind turbines offshore. Indeed, the world’s largest wind turbine maker is a Danish company, Vestas Wind Systems.

On a more global scale, the commercialization of alternative renewable energy has tremendous implications for mankind. Especially, the rural third world where the main hurdle to development has always been affordable electricity. Cheap solar has the potential to make irrigation, mechanization, sanitation and communication assessable for these people. It has the potential to reverse the trend towards urban overpopulation and squalor.

Indeed, we see this happening to rural communities in the US. Sweetwater in Texas has seen a major rejuvenation in jobs and population after the installation of a major wind farm. Ironically, farmers in Texas earn more leasing their land for wind turbine use than from farming. Texan farmers get $3000 per acre from wind compared to $150 per acre from corn. Wind farming is the most profitable cash crop.

In many ways, this renewable energy revolution will dwarf the internet in its potential to improve the lot of mankind. Looking beyond the current financial crisis, the future is indeed bright and breezy.

Harnessing the ETF revolution

Business Times - 24 Jun 2009


Exchange-traded funds now straddle virtually all asset classes and have become a global phenomenon


GLOBAL equity markets are roughly unchanged year to date. But this statistical calm masks a roller-coaster ride. Stocks fell 30 per cent until the second week of March - before rebounding 40 per cent. It was fear on a grand scale.

During this mayhem, we predicted in our column 'The paradox of thrift, and other thoughts' (BT, Feb 7, 2009) that things would soon sort themselves out.

Looking at big-picture data, we predicted that equities and hard assets such as precious metals and property would do well. So far, so good with our predictions.

Looking at forward indicators, most developed economies will be out of recession in the second half of 2009. This includes even Europe.

However, this recovery will be different from previous ones. The global economic landscape has changed markedly. Investors now need to scrutinise Chinese retail spending and PMI data as closely as they watch figures out of the United States. Ten years ago, few cared what the Chinese consumer spent.

Amid on-going fundamental shifts in the global economy, the money management industry is undergoing significant changes. And one factor behind the changing complexion of the wealth management business is the exchange-traded fund (ETF). Essentially, ETFs are open-end index funds that are listed and traded on exchanges - like stocks.

From the first humble listing in the US in 1993, ETFs now straddle virtually all asset classes - long and short - and have become a global phenomenon. There are currently more than 1,600 ETFs worldwide, with almost US$660 billion in assets. Twenty-five per cent of all trades on the New York Stock Exchange are driven by ETFs.

ETFs are also the choice instrument for macro bets by hedge fund managers. For example, when hedge fund manager John Paulson, the billionaire who made a fortune shorting the US sub-prime market, wanted to bet on gold recently, he did it through an ETF.

During the savage bear market of 2008, ETFs experienced net inflows, while unit trusts experienced net outflows. Indeed, most traditional unit trust managers see ETFs as one of the biggest threats to their business. Just as mutual funds did to bank deposits, ETFs are disintermediating traditional mutual funds as more investors chose to do away with the cost of active stock-picking work. Indeed, the ETF business is one of the main reasons Blackrock coughed up US$13 billion to buy Barclays Global Investors.

And on an infinitely more humble scale, that is why we soft-launched a new portfolio management service on June 1 to harness the global ETF revolution.

Utilising more than 1,000 ETFs traded on 22 exchanges around the world through one consolidated Internet account, we are providing clients with the flexibility to invest long and short in equities, fixed income, commodities and currencies globally. The goal is to achieve absolute returns regardless of market direction.

ETFs allow us to go long and short efficiently, while automatically achieving diversification and avoiding single-stock risks. But while avoiding single-stock risks, the investor can pursue targeted sectors as opportune.

Investment theory and practice show we can eliminate specific risk of individual securities by diversifying broadly, thus only having exposure to market risk - that is, the ups and downs of the market in general. Market risk cannot be diversified away in a long-only portfolio, unlike one that can go short.

Given the expected uneven nature of the recovery and eventual policy tightening by central banks around the world, the flexibility to go short is expected to be very useful.

The following is an example of a long-short strategy from the recent past. At the beginning of 2008, the outlook was poor for the US but benign for the rest of the world. Reflecting this, the US dollar was weak but US exports were growing because the rest of the world was still prosperous. Overall equity valuations in the rest of the world were not expensive.

One would, therefore, expect equities ex-US to outperform US equities, but US government bonds to do well. A typical strategy congruent with this outlook would be to invest in a global equity ETF but short (or eliminate) the US exposure by investing in an inverse US equity ETF.

Exposure to US government bonds would be through a US Treasury ETF with a maturity of around five years, which would be relatively stable. Therefore, the strategy would have been translated into three ETFs:

· iShares S&P Global 100 Index (IOO) - 45 per cent of portfolio.

· Short S&P500 ProShares (SH) - 25 per cent of portfolio.

· iShares Barclays 3-7 Year Treasury Bond (IEI) - 30 per cent of portfolio.

Such a construction would position the portfolio for upside but provide protection on the downside. Despite the most horrendous year for global equities since the 1930s, this simple three-ETF portfolio would have lost only 1.8 per cent at the end of 2008.

Our new portfolio management service built around ETFs gives individuals the flexibility to invest like a hedge fund but at low cost and with real-time transparency.

It gives investors the scope of large institutions - without the need for massive portfolios and outlays. The advent of the Internet technology and the richness of ETF choices have made this possible. Investors and advisers tend to look at events through the lens of their mandate and available instrument choices. Hence, long-only mandates result in a bias to interpret events on the upside, unlike a strategy that can go both long and short - one that is indifferent to market direction.

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It's just a business cycle as usual

Business Times - 12 Aug 2009


Pushing break-even points down will ensure profits, which will lead to re-investment and re-hiring - and thus growth


I AM gratefully astonished by the very positive response to our last BT contribution of June 24, 2009 - 'Harnessing the ETF revolution'. Searching on Google with the key phrase 'ETF revolution' two days after publication, I was surprised that of 85,000-plus articles listed, 'Harnessing the ETF revolution' was number one, besting similar pieces from far larger media houses such as FOX Business. It remained that way, until the piece was archived a week later. Readers, who wish to access the article can still do so at Perhaps the marketing experts at SPH may have some thoughts about monetising such articles, instead of archiving them?

Apropos revolutions, the good recent second-quarter announcements from global bellwether companies such as Intel, Apple, ABB and Honda were treated like revolutions in the business media. It is not a revolution - it is the business cycle at work.

We had a financial crisis that precipitated a deep recession. Companies globally reacted swiftly, throttling production and shedding excess inventory, production capacity and excess labour and benefits, thus pushing revenue break-even points down. At micro-level, we saw this in our general insurance business, as companies cut back coverage and benefits. Labour, which is in excess now, has little bargaining power.

Pushing break-even points down is the needed pain for the economy. This will ensure profits, even in a weak revenue environment. Profitability will eventually lead to re-investment and re-hiring - and thus growth. No revolution here, just the business cycle.

Profit announcements have shown other key traits besides cost cuts - better revenue estimates in the second half and margin expansion. This bottom-up perspective is congruent with the macro view that we have had for some time. We knew that revenue would be better going forward from the PMI sub-indices for new orders from the major economies, led by China.

From the macro perspective, we expected margins to improve because of the divergence in CPI and PPI around the world. The PPI, producer price index or a measure of input costs for businesses, has been falling far faster than the CPI, consumer price index or a measure of what businesses charge consumers, in most major economies. When PPI lags CPI, it is normally good news for businesses and the equity markets as it generally signals improving margins.

The accompanying chart shows the trend of CPI less PPI over the past 20 years for the US. Readers will notice that periods when CPI less PPI was positive have correlated with improving corporate margins and healthy equity markets.

We are now entering a sweet spot in the business cycle for equity markets - expanding margins and revenues. Corporate profit growth is back. Throw excess liquidity (M3 minus nominal GDP growth) into the cocktail and that's a recipe for very strong equity markets, as we had predicted in our contrarian call in BT of April 8, 2009 ('No, the recovery isn't a mirage any more'). Readers who want to access the article can still do so on Indeed, the Shanghai stock market's 90 per cent climb from the bottom could be a precursor for developed markets.

The improving demand picture and corporate profits are also correlated to the performance of the Singapore residential property market. When we stuck our neck out with our bullish contrarian call in BT on Dec 10, 2008 ('A city of two tales') amid widespread fear, we had an internal forecast of 25 per cent upside in 12 months. It looks as if we may have been too conservative.

Even without the expected additional demand generated by the integrated resorts in 2010, annual average take-up has been around 8,100 units since 1995. With the recovering global economy, we should at least see this number in 2010. Unfortunately - or fortunately, if you are an investor - there will be only 5,500 completions in 2010. This shortfall will push the rental vacancy rate down.

I estimate that this will fall from the current 5.9 per cent to below 4.9 per cent. The last time this happened, in early 2007, rents and capital values surged. Unlike in 2006, the cushion of surplus HDB flats is probably no longer there. I say probably because HDB, unlike URA, has yet to publish data on the inventory of unsold flats.

It looks like quite a party for the residential property market in the next 12 months, barring an external shock or government action. It is strange that when the Straits Times Index jumps 80 per cent in five months, no one screams speculation. However, when the residential property market prices begin to turn around (according to most recent URA data), many are calling for a change to the rules and the guillotine for 'speculators' while demanding 'affordable' prices.

What signal are we sending to those brave investors who take risk and prop the market (and banking system) in the despair of the first quarter of this year, when even the government was issuing statements full of gloom? In future, we may find no buyers at any price when things turn down because we acquire a reputation as rule changers. Curb 'speculation' with care. Otherwise, we may regret what we wish for.

The writer is CEO of financial adviser New Independent. He welcomes feedback at This article is for information only. Readers should seek independent advice before making any investment decisions

Beijing fails to capitalise on success at Olympics

Business Times - 12 Aug 2009


A YEAR after the Beijing Olympics, China is showing greater confidence and its international standing is rising, largely as a result of the global financial crisis, which has showcased its economic success at a time when the United States is seen as being in decline.

After the International Olympics Committee voted in July 2001 to give China the right to stage the 2008 Summer Games, many people overseas hoped that its human rights situation would improve, while within the country it was commonly believed that China's prestige would grow.

Hope for human rights progress was based on pledges made by Chinese officials. For example, Liu Jingmin, vice- president of the Beijing 2008 bid committee, had said that 'by allowing Beijing to host the Games you will help the development of human rights'. In the end, very little, if any, progress was made.

Beijing also promised that the international media would be completely free to report. This was one area where there was movement. Liberalised rules were put in place from the beginning of 2007 to Oct 17, 2008, whereby foreign journalists were no longer required to get government approval to conduct interviews across the country. After the Olympics ended, China announced that these rules would continue to apply. To date, that is the one tangible improvement in human rights. Even so, the Foreign Correspondents' Club of China, while acknowledging that the relaxed rules have made travel within the country easier for correspondents, also reported that 'intimidating of sources and domestic staff mar this progress towards internationally accepted reporting conditions'. Journalists said such intimidation is 'a trend that threatens progress towards greater openness'.

Actually, the 12 months since the Olympics have been marked by heightened repression, with human rights lawyers being especially targeted for harsh treatment. They have been kidnapped, beaten up and even disbarred. There are now signs that the government is turning its attention to non-governmental organisations.

Last month, the Open Constitution Initiative, or Gongmeng, a group that offered legal assistance, was shut down, ostensibly for tax evasion. The group had released a report on Tibet in May that challenged the official position on the 2008 protests in Lhasa.

At about the same time, the office of the Beijing Yirenping Centre, which is dedicated to promoting the interests of health-disadvantaged groups, such as carriers of the Hepatitis B virus, was raided. Copies of its newsletter opposing discrimination were confiscated. There is now fear of a crackdown on NGOs not only in Beijing but across the country.

Many people think that this crackdown is due to the current politically sensitive period, with the approach of the 60th anniversary of the founding of the People's Republic on Oct 1. However, it is not at all clear that there will be any easing after that date.

As for China's international prestige, there is little evidence of an Olympics-related rise. A BBC World Service poll released in February, six months after the Olympics, showed that public views of China had slipped considerably. Whereas in 2008 those polled leaned towards saying China had a positive influence in the world, the 2009 survey showed positive ratings had fallen from 44 per cent to 39 per cent, while 40 per cent felt that China's influence was negative.

The Pew Global Attitudes survey this year, released last month, did indicate that China's image has improved, but only slightly. This is likely to reflect the impact of the financial crisis more than that of the Olympics.

American public opinion of China has grown more positive, with 50 per cent of Americans rating China favourably, compared with 39 per cent in 2008 and 42 per cent in 2007.

But in Western Europe, the improvement was much less. True, in Britain, favourable views rose from 47 per cent in 2008 to 52 per cent this year. However, views remained mostly negative elsewhere. There were slight improvements in France and Spain, with positive views rising from about 30 per cent to 40 per cent. In Germany, however, opinions remained negative, with only 29 per cent holding a positive view. It is only in Africa that the attitude towards China is overwhelmingly positive.

The two issues - human rights and China's international standing - are clearly related. If China had made use of the Olympics to improve its human rights record, as it had promised, there is no doubt that its prestige today would be much higher, even without a financial crisis. Beijing dazzled the world at the Olympics, especially with its spectacular opening ceremonies. What a pity China did not capitalise more on such a wonderful opportunity.

The writer is a Hong Kong-based journalist and commentator

Causeway expansion rejected

Business Times - 12 Aug 2009

(JOHOR BARU) The Johor Baru Umno Youth division has opposed a Singapore proposal to expand the Johor Causeway as it will not solve the pollution problem in the Johor Straits.

Its chief, Khalid Mohamad, said that the proposal to expand the 85-year-old Johor Causeway by Singapore Prime Minister Lee Hsien Loong should be rejected as it was not based on mutual benefit.

'The expansion of the Johor Causeway will only prolong the water pollution problem in the Johor Straits. It will not address the problem,' he said.

He said that the proposal to expand the Johor Causeway was made in the interest of one party and would not solve the many problems faced by Johor and Malaysia.

He added that Johor Baru city folk wanted to see free flow of water from the East and West of the Johor Straits\. \-- Bernama

Lawyers may stop holding conveyancing monies

Business Times - 12 Aug 2009

Govt suggests that such funds be held by Law Academy or banks


LAWYERS may soon be prohibited from holding conveyancing monies if a new proposal by the Ministry of Law goes through.

This follows the infamous case of lawyer David Rasif running off with some $10 million of his clients' money in 2006, as well as a string of recent cases in which lawyers absconded with clients' conveyancing money.

Aimed at preventing lawyers from holding large sums of cash for their clients, the new move is unlikely to dampen business in this area of legal work, market watchers said.

Conveyancing money refers to money used as part of transactions for housing purchases. This includes stamp duty payment and option deposits.

A seller receives an option deposit - typically amounting to 4 or 9 per cent of the purchase price which a buyer pays - once the option to purchase is exercised.

In a public consultation paper released yesterday, the ministry has suggested having the Singapore Academy of Law as the main entity appointed to hold conveyancing money.

The option deposit can also be held by entities approved and appointed by the Ministry of Law.

The three local banks have also been engaged to look into offering services in this area.

'We have been in discussions with the Ministry of Law on the possibility of providing the service to hold the option deposit,' said Chow Theng Kai, head of cash management, group transaction banking, at OCBC Bank.

Lawyer Gan Hiang Chye from Rajah & Tann LLP told BT that this move would not take away any business.

'The law firm will still be doing the administrative work for the client,' he said, noting that the clients can use a cashier's order to be paid to the respective parties, but this can be deposited by the law firm.

'The legwork is still being done by the law firm for the client. The client just has to make one small visit to the bank to buy the cashier's order.'

He added that the recent cases of lawyers absconding with clients' money has 'diminished' the profession.

The proposed changes come after Chief Justice Chan Sek Keong expressed concern last year that such criminal conduct of lawyers harms not only the reputation of the legal profession, but also the victims who could not get full compensation.

This is despite tightening the Solicitors' Accounts rules in July 2007, such that no sum exceeding $5,000 can be drawn unless two lawyers okay it.

With the amendment, a lawyer also could not receive or hold conveyancing monies unless he had at least two signatories to his client account.

A review committee chaired by Justice VK Rajah was then set up to look into making changes to the conveyancing system.

The central recommendation to prohibit lawyers from receiving such monies was made in the committee's report.

The Chief Justice agreed with the recommendation and forwarded this to the Ministry of Law.

The proposed changes are likely to be implemented at the end of the year.

Clearing the air on 'algo' trading

Business Times - 12 Aug 2009

Hock Lock Siew


THE first thing to note about high-speed computerised trading, whether it applies to trading in stocks or derivatives, is that it's been around for more than 20 years, so it's not a new phenomenon. The second is that its development probably parallels the evolution of financial markets and so its pervasiveness in today's markets is inevitable and unavoidable.

The biggest thing however, is that high-speed trading, program trading or 'algo' (short for algorithmic) trading as it's sometimes known, has been getting a bit of a bad rap lately, though this is probably due more to misinformation than anything else. This doesn't mean the activity is entirely kosher or doesn't warrant attention from regulators or policymakers; however, there is evidence to suggest that present fears may be a tad overblown.

When the US stock market crashed 20 per cent on Oct 19, 1987, a lot of fingers were pointed at program trading as one possible culprit. However, extensive studies at the time failed to establish a convincing connection between algo trading and the crash, especially when it was found that the largest falls occurred when programs were not operating.

In addition, several other markets that did not have program trading actually crashed by more than the US. As a result, other than introducing 'circuit breakers' to slow or halt large moves in the major indices, regulators did not act to rein in high-speed trading.

Fast forward 22 years and the debate over whether algo trading should be regulated was revived a couple of weeks ago when a US senator raised the need for legislation to prohibit 'flash' trading. It's important to note that the call was made specifically for one type of algo trading, but somehow or other subsequent media reporting roped in the entire gamut of high-speed techniques as also possibly requiring regulatory scrutiny.

Flash trading (which incidentally, is a technique not found in the local market and is expressly prohibited here) is simply high-speed front-running. It involves delaying order routing to the best quoted prices by a few milliseconds to let some parties view those orders first. These parties can then buy (or sell) ahead of the actual order execution. Since this is blatantly wrong, few would object to the need for some form of official control to stop this practice.

However, as noted earlier, all other types of algo trading have now been flagged as 'bad' or in need of some form of official intervention. For example, algos usually slice up large orders into smaller blocks, mainly to preserve anonymity and prevent detection by other algos. In the US, for example, although high-speed computerised trading has sparked exponential volume growth in the past few years - as it probably has in the Singapore market - average trade size has dropped sharply, and according to a recent paper, the average trade size at the end of 2008 was only 300 shares.

This in turn has led institutions who need to move large blocks quickly to search out alternative venues, known popularly as 'dark pools' where prices may be better and transactions quicker. Since retail players don't have access to these venues, it is sometimes argued that the playing field is thus not level, especially since dark pools are off-exchange and so present an opaque face to the outside world.

The dark pool story is complicated and the issues numerous. However, if we were to keep the discussion as simple as possible, it's worth noting that if algo trading leads to the proliferation of dark pools and this in turn robs some liquidity from established exchanges while offering benefits to large players, it is then incumbent on the affected exchanges to compete by improving efficiency and offering customers better service.

Over time, this should lead to everyone benefiting - spreads should narrow, transaction costs should fall and price discovery must logically become more efficient.

Of course this presupposes that regulators and exchanges can find a way to live in harmony or complement the dark pool movement.

In Singapore, it is clear that the exchange is very aware of this and is closely watching developments in the high-speed trading and dark pool arenas. The starting point, however, appears correct - except for flash trading, most other forms of algo/program trading are probably okay since they enhance liquidity, market sophistication and market efficiency. As such, only a light regulatory touch would probably suffice.