Debt Rattle, June 1 2008: Walking through a hall of mirrors

Dorothea Lange Spud Cellar October 1939
Tavern on main street of potato town during harvest season. Merrill, Oregon.

Ilargi: "It is like walking through a hall of mirrors in a fairground" is a very appropriate metaphor for the practice of banks financing the (fire-)sale of their assets with loans they themselves provide. In essence, it comes down to this: ".. recycling a bank's own funds back into its own assets". And it's not just recycling, it allows them to increase their leverage even more.

This happens all over the financial world these days, and it should be obvious why it can’t possibly lead to anything but deep darkness.


Banks' credit crisis "solutions" have echoes of 1929 Depression

'We are in the midst of the worst financial crisis since the 1930s," warns the eminent financier George Soros in his latest book, The New Paradigm for Financial Markets. It's a rather extreme view, but the man who broke the Bank of England is not alone in his dark funk.

At a recent event, one banker laced Soros's sentiment with a little gallows humour, ruefully predicting "10 years of depression followed by a world war". Comparisons with the great crash of 1929 are inevitable and the parallels manifold. Then it was an over-inflated stock market that burst before wider economic malaise ushered in the Great Depression.

This time, in the words of Intermediate Capital managing director Tom Attwood, sub-prime was merely "a catalyst" for the inevitable pricking of the credit market bubble as "disciplines were bypassed in favour of loan book growth at almost any cost".

Again the talk is of recession, certainly in the US and possibly in the UK. Perhaps the most intriguing parallel, though, is the crude attempt at self-preservation made by the investment trusts in 1929 and the banks now.

In the great crash, investment trusts with vast cross-holdings in each other tried to stem their collapse by buying up their own stock in what the economist JK Galbraith in his book, The Great Crash 1929, described as an act of "fiscal self-immolation".

At the time, "support of the stock of one's own company seemed a bold, imaginative and effective course," Galbraith wrote, but ultimately the trusts were just "swindling themselves".

Modern economists have compared the trusts' actions with what the banks are now doing. "They seem to be just papering over the cracks," says Brendan Brown, chief economist at Mitsubishi UFJ Securities.

To free their books of the estimated $1,000bn (£505bn) of sub-prime assets and $340bn of leveraged loans banks have been left carrying since the credit markets shut down last year, lenders are offering to sell these damaged assets cut-price and - crucially - are willing to lend investors the money to buy them.

In other words, the banks are providing new debt for the old debt they no longer want. At first glance, as with the investment trusts, the arrangement seems little more than trickery - recycling a bank's own funds back into its own assets.

As one senior industry expert described it: "It is like walking through a hall of mirrors in a fairground. There are far fewer people who really understand it than profess to understand it. Even the central bankers don't know where all the risk is ending up."

Sandy Chen, banks analyst at Panmure Gordon, is not convinced the arrangements are anything more than "clever accounting". He said: "In the case of leveraged loans, if the underlying company gets into difficulties and can't service the cash flow, then it's back to square one for the banks."

It's an opinion that the credit markets seem to reflect. Despite clear indications that this is how the banks intend to deal with their problems, credit default swaps - the clearest measure of perceived risk - have not narrowed.

But today's banks are far more sophisticated than the investment trusts of early last century. They claim their actions are an attempt to tackle capital shortfalls and liquidity risk. If they can reduce their credit risk in the process, that's an added bonus.

There have been two big public deals where the banks have provided funding for the purchase of the debt or sub-prime assets they own. UBS sold a $22bn portfolio of sub-prime assets to US fund manager BlackRock and a consortium of banks that financed last year's £9bn Alliance Boots merger offloaded £2bn of the debt to private equity.

Less publicly, bankers say "everyone is looking at this". Citigroup and Deutsche Bank are each believed to have off-loaded $10bn-$12bn of US leveraged loans in recent months, part-funding the purchase themselves. The same banks, as well as Merrill Lynch, have found buyers for tens of billions of dollars of their sub-prime debt, with similar funding arrangements.

The incentive for private equity is clear. The debt in the Alliance Boots case, for example, is being sold at 91 per cent of face value and the interest rate is being lowered. The UBS sub-prime sale is even more extreme. Having written the assets down to $15bn, BlackRock is enjoying a 32 per cent discount. If the debt or assets perform, there is a large potential upside.

The banks hope to benefit in four ways. The first is through capital relief. UBS may be providing $11.25bn of the $15bn BlackRock is paying for the sub-prime assets, but it does mean the Swiss bank is insured against the first $3.75bn of deterioration in the portfolio. With Alliance Boots, the banks are lending the private equity buyers just 80 per cent of the purchase price of the debt.

Because the banks can argue that this is a genuine transfer of risk, they can reduce the amount of capital the rules require them to set against the assets. UBS says that the move will provide 0.2-0.25 percentage points of capital relief - lifting its tier one ratio, a key measure of financial strength, above the current 10.5 per cent.

The second benefit for banks is asset diversification. In the case of Alliance Boots, debt in a retailer is transferred for debt in private equity - the buyers of the £2bn of loans being Apollo, Blackstone and TPG. As private equity is invested in a variety of sectors, its bonds are viewed as safer under the Basle II rules on capital adequacy. The result, again, is a reduction in capital required to be set aside.

The third benefit is the chance to rewrite loan covenants. Covenant-lite arrangements at the peak of the credit boom left banks carrying much more risk than would normally be accepted at very low prices. By reselling the debt, albeit at a discount, the banks have a chance to renegotiate covenants.

The fourth opportunity this provides banks is the chance to crystallise losses and draw a line under their sub-prime or leverage loan positions. By selling the assets, they set a firm market price to use when marking down the rest of their portfolios, providing some stability.

The point of it all is to "tidy up the balance sheet", as one banker explained. Banks desperately need to improve their capital positions, which can be achieved either through fundraisings or shrinking the balance sheet. Funding the purchasers of their debt may make banks look like fiscal contortionists, but doing so also makes them appear stronger.

As such, counterparties in the money markets will be more willing to accept their bonds as collateral for loans, improving the banks' liquidity profiles. Liquidity, or the lack of it, is what did for Bear Stearns and Northern Rock. But questions remain as to whether these clever solutions are anything other than a short-term fix.

As Brendan Brown points out: "Creditors are far more attuned to how the rules work now, and will want to look at what the risks actually are in a bank. These actions are not going to do much to reduce the real problem: their credit exposure."

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Ilargi: Confidence in traditional instruments to gauge risk, especially the AAA-soup from the 3 main ratings agencies, as well as LIBOR rates, is now in the basement and digging a deeper hole. Behind their office doors, the less gullible among investors have already silently turned to bond markets and CDS spreads to get a more accurate, reality-based, assessment of what they’re up against.

Now it looks to me like the traditional players are waking up to the need to cut their losses. Moody’s, Fitch and S&P run the risk of their ratings becoming obsolete, and they try new models, even while defending the old ones. At the same time, the British Bankers Association is revising the way LIBOR is calculated.

I wouldn’t be surprised if in both cases, it’s too late already, not least of all because those less gullible investors have figured out they can make money by being the first to use better gauges. Why should they get back in the fold?

Moody's Implied Ratings Show MBIA, Ambac Turn to Junk

Moody's Investors Service has created a new unit that surprises even its own director. The team from Moody's Analytics, which operates separately from Moody's ratings division, uses credit-default swap prices as an alternative system of grading debt.

These so-called implied ratings often differ significantly from Moody's official grades. The implied ratings frequently show that swap traders think debt is in more danger of defaulting than Moody's credit ratings signify. And here's the kicker: The swaps traders are usually right.

"When I first saw this product, my reaction was, `Goodness gracious, Moody's has got a product that is basically publicizing where the market disagrees with Moody's,"' says David Munves, managing director for credit strategy research at Moody's Analytics.

The implied-ratings unit works in a corner of Moody's new world headquarters in lower Manhattan, across the street from Ground Zero. "But these differences are out there," Munves says. "We might as well capture and learn from it what we can."

The credit quality of bond insurers, which have been at the center of the subprime storm, differs dramatically. The official ratings of these companies say the insurers are in great shape; the alternative ratings say they're in dire danger of defaulting on their debts.

MBIA Inc. and Ambac Assurance Insurance Inc., the two largest bond insurers, got themselves into trouble by veering away from the plain-vanilla business of insuring debt issued by municipalities and corporations.

The insurers began selling credit-default swaps, which are a type of insurance, to banks eager to hedge their own risks from collateralized debt obligations. Because many of those CDOs were bundles of debt laced with securitized subprime home loans and other asset-backed securities, the insurers might now shoulder tens of billions of dollars in losses.

Ambac and MBIA have raised billions of dollars of new capital so that Moody's and Standard & Poor's would keep top ratings for the bond insurers -- and the rating firms have done just that. Moody's implied-ratings group paints a completely different picture. Using CDS market prices, Munves's unit assigns implied ratings of Caa1 to both MBIA and Ambac. That's seven notches below junk and 15 below the official Moody's rating.

Swap traders see there's a huge risk that Ambac and MBIA will default, hedge fund adviser Tim Backshall says. He says swap traders don't trust S&P's and Moody's investment-grade ratings for the companies.

"The only thing holding them at AAA is simply the model that the rating agencies claim they use to judge that capital and the fact they know that if they downgrade the companies, it'll push them into default," says Backshall, of Walnut Creek, California- based Credit Derivatives Research LLC.

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Ilargi: Option ARM mortgages are not the only kinds of loans that are about to be reset to -much- higher levels. The British press is waking up to a world of many grueling dangers.

When covenants kick in, we'll see a squeeze

I was amazed this week by the reaction of one executive to news that the price of debt had spiked again. "It's just a bit of volatility. Hedge funds are starting to buy some big tranches of debt; the credit markets are coming back."

His optimism is shared by executives, politicians and even central bankers. A few weeks ago Rob Templeman, chief executive of Debenhams, said: "This is not a recession problem but a financing problem. It came very fast and could disappear very fast."

They are wrong. If the credit crunch means company finances being squeezed, then forget "a new bite" or the "second phase". We will shortly experience something more painful still: the covenant crunch. Last week, it emerged that spreads across debt markets are back to near record levels. But the reality is that these prices have neither properly hit companies nor benefited the banks - yet.

Look through the other end of the telescope. With revenues, profits and cash-flows falling, most companies are financially significantly weaker now than they were this time last year. Marry this with the fact most executives loaded up with cheap debt between 2005 and 2007 and you have a corporate Britain that is financially lop-sided.

Traditionally, the imbalance would have been addressed by lending banks donning their size 15 shoes and going in to reclaim their money. Instead the cov-lite lending agreements have meant that some firms are able to under-perform by as much as 25 per cent before breaching their loan agreements.

Better still, even if a covenant is breached, most agreements allow for a company or private equity sponsor to pay a small fee to waive it, or simply inject a bit more equity, and carry on. Borrowers are not yet having to pay the increased price of debt.

Banks are desperate to renegotiate these terms to reflect the far higher cost and risk of the debt. For obvious reasons, executives are equally keen not to renegotiate. It's a bit like those with fixed-rate mortgages. Who would renegotiate now knowing the terms would be far more onerous?

Until recently, most lending banks were refinancing about a third of their loan portfolios, mostly to keep up with competition that drove prices down. Now the banks are only managing to do a tenth of their portfolio. But these cov-lite agreements do not last forever. Most have proper tests that kick in after 12 or 24 months, and when they do, borrowers will face a rise in the price of debt by as much as three times.

Even when the credit markets do re-open properly, they will do so on very different terms as well as prices. One banker said: "We used to base lending decisions on the basics: looking at the client's risk, character, cash flow and quality of collateral. But over the past decade these have been corrupted by competition and we've waived almost all concerns. Now we've got to return to old-fashioned ways."

Analysts are cottoning on. In an effort to re-assess company credit worthiness, KBC Peel Hunt has just dusted down the "Z-Score", developed in the 1960s by Edward Altman, professor of finance at New York University's Stern School of Business, to predict the vulnerability of companies to financial stress.

The results show that companies with high levels of gearing have the lowest Z-Scores, suggesting that investors should proceed with care. KBC's Robin Savage said: "Debenhams has a low Z-Score. It has lending agreements with few bank covenants. But this can't go on forever and when it comes to refinancing, it will be far more expensive."

According to KBC's Z-Score, highly leveraged companies whose revenues are also suffering, such as retailers and pub companies, will be hardest hit. Those, too, that geared up and returned cash to shareholders, particularly those in cyclical sectors, are likely to have to ask investors for the money back again.

Of course all these companies insist there is no need for action now. They are right. But once the covenants kick in, they will have to act to find more cash, and fast. Then we'll see a proper squeeze.

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Ilargi: “At its peak, in March 2006, [Bradford & Bingley]’s stock-market value hit £3.2 billion. It is now a shadow of its former self and at Friday’s close was worth only £545m.”

Hmm, looks like they lost 83% of value. Still, analysts say B&B is well-capitalized. You have to wonder how much official statements to date in England have been removed from reality. To understand the huge downward potential, you need to look no further than that UK home prices inflated twice as much the past decade as those in the US. And no, it will not be alright, or a soft landing, or anything like that. It will be brutal.

Bradford & Bingley to issue profit warning

Britain’s biggest lender of buy-to-let mortgages, Bradford & Bingley, which is in the middle of a rights-issue roadshow, will stun the City this week with a profit warning and the departure of its embattled chief executive, Steven Crawshaw.

The announcement will trigger widespread concern that British banks are sitting on a time-bomb of rising mortgage arrears and mounting bad debt. It will also reignite fears about the viability of some of our top financial institutions.

Rod Kent, the bank’s chairman, will take over executive control of the bank, which has a network of 200 branches, while it looks for a replacement chief executive. It is understood that Crawshaw, 47, has been unwell for some time and has been looking to step down. The profit warning is expected to be contained within the bank’s rights-issue document that will be sent to investors in the next five days.

Profits for this financial year will be significantly lower than analysts’ forecasts. The bank has been hit hard by mounting arrears from borrowers and squeezed margins. Last year B&B made pretax profits before exceptionals of £336m. This year analysts had predicted a range between £160m and £200m. However, this is thought to be far too optimistic and profits will be lower.

The B&B profit warning comes at a bad time for the banking sector. HBOS, Britain’s biggest mortgage lender, is about to launch its £4 billion rights issue, while Royal Bank of Scotland is in the closing stages of raising £12 billion. For B&B, the admission of lower profits comes at a time when it is trying to raise £300m from shareholders.

On Friday, its share price closed just 61/2p above the 82p-per-share price of the rights issue. In the past four weeks the price has fallen as concerns grow about the state of the bank’s finances. However, while its profits will be lower, this is not a repeat of the nationalisation of Northern Rock. Analysts say even if the share price falls beneath the rights-issue price it has been underwritten by investment banks.

They also say that the bank is well capitalised and its shares are trading at half its net asset value. Kent, a City veteran who built his reputation as chief executive of Close Brothers, the boutique investment bank, must work hard to rebuild the confidence of shareholders.

One of the bank’s top five investors said this weekend: “It’s a bit like they are driving along in a little cartoon car, just waiting to fall off the cliff.” Another said: “The share price has been saying for weeks that something is wrong, but no guidance has been given to the City”.

At its peak, in March 2006, B&B’s stock-market value hit £3.2 billion. It is now a shadow of its former self and at Friday’s close was worth only £545m. Most analysts believe that the bank will struggle to remain independent and that a takeover is now inevitable. Crawshaw joined the company nine years ago before becoming chief executive in 2004. He is seen as an able operator but the scale of the problems have proved too much.

Pressure will also come on some of the nonexecutives, including Kent, for failing to ensure that the City was kept informed. Analysts say to raise money with so much uncertainty about the group’s future profitability is going to be tough.

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B&B Chief Crawshaw Quits; Capital Statement Planned

Bradford & Bingley Plc, the U.K.'s biggest mortgage lender to landlords, said Chief Executive Officer Stephen Crawshaw quit for health reasons and that it would provide more details on a capital increase tomorrow. "We will be updating the market tomorrow regarding our capital raising," spokeswoman Nickie Aiken said in a telephone interview today.

The Sunday Times reported earlier that Chairman Rod Kent would replace Crawshaw until a replacement is found. The Bingley, England-based lender will say earnings this year are likely to be "significantly" below analyst expectations, the newspaper said.

The lender in May said it planned to raise 300 million pounds ($593 million) through the sale of new stock to replenish depleted capital, a month after denying it needed more funding. The company has curtailed lending amid higher financing costs as house prices deteriorate.

Bradford & Bingley has declined 67 percent this year in London trading, the worst performance among the eight companies making up the FTSE 350 Banks Index. The rights offer, underwritten by UBS AG and Citigroup Inc., will give investors the right to buy 16 shares for every 25 they own at 82 pence apiece, the company said May 14. Since then, the stock has slumped 39 percent and closed on May 30 at 88.25 pence.

The share offer comes as Royal Bank of Scotland Group Plc and HBOS Plc ask investors for a total of 16 billion pounds as lenders shore up their balance sheets. Financial services companies have announced writedowns and credit losses of $386.7 billion globally related to the collapse of the subprime mortgage market in the U.S., according to Bloomberg data.

Bradford & Bingley, with roots in building societies going back to 1851, in April reduced the number of home loans it offers, raised prices on mortgage products and lifted borrowers' minimum deposits. Losses on its structured-finance portfolio rose by 38 million pounds in the first quarter, the company said at the time.

Bradford & Bingley's 2007 profit dropped 48 percent to 93.2 million pounds as it wrote down investments and sold assets.

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UK 'water poverty' is just a meter away

So far. this year, the energy and oil companies have taken the flak. Price increases for petrol, gas and electricity that are well above the rate of inflation have hit consumers already reeling from increased food costs.
 
In such circumstances, it is no surprise that news of multi-million-pound profits from the oil giants and energy groups have caused blood pressures to soar and sent ministers scurrying to intervene.

In the current environment, then, water companies are braced for a similar backlash this week when the main listed groups report annual profit figures expected to top £1bn, with a sizeable proportion of that figure gushing to shareholders in the form of dividends.

Ofwat, the water industry regulator, said average water and sewerage bills will rise by 5.8 per cent this year, with some companies able to increase prices by 8 per cent or more under the regulatory framework set down in 2004. And with companies now preparing their business plans for the next regulatory review period, which comes into effect late next year, the pressure is mounting.

Ofwat came under fire for being too generous to the water companies during the most recent pricing review. Aided by historically low interest rates, the companies subsequently became attractive takeover targets and several have recently changed hands.

In more recent months, however, this takeover activity has dried up and few expect future interest at similar levels if, as many predict, Ofwat is not so lenient this time and reduces the level of returns water companies are allowed to make.

The phrase "fuel poverty" has already entered the lexicon as the Government's definition of those paying more than 10 per cent of their incomes on electricity and gas bills. Now "water poverty" - water bills taking up more than 3 per cent of net income after housing costs - seems set to follow.

The Consumer Council for Water estimates that soon more than 20 per cent of households may fall into that position, particularly if, as expected, bills have to rise to pay for an extension of water metering, improvement to water treatment works and the capital expenditure needed to ensure that the taps don't run dry when more houses are built in drought-prone areas such as the South East.

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Ilargi: Are we tuned in to how useless these sorts of "alternative energy" propositions are? We can’t produce these numbers of solar panels etc. fast enough. There’s no production capacity, no mining capacity, a lack of skilled people etc etc. The UK would be only one in a long pool of countries that will try this, and all these factors put together would raise prices ten-fold. Receding horizons.

This sort of discussion is utterly void of any meaning, and invariably has only one goal: to deflect attention away from real issues. Talk to the hand.

Greener power to the people: the real energy alternative?

Ministers could avoid building nuclear reactors by encouraging families to fit solar panels and other renewable energy equipment to their homes, a startling official report concludes.

The government-backed report, to be published tomorrow, says that, with changed policies, the number of British homes producing their own clean energy could multiply to one million – about one in every three – within 12 years.

These would produce enough power to replace five large nuclear power stations, tellingly at about the same time as the first of the much-touted new generation of reactors is likely to come on stream. And, it adds, by 2030, such "microgeneration" would save the same amount of emissions of carbon dioxide – the main cause of global warming – as taking all Britain's lorries and buses off the road.

The conclusions of the report – approved and partly financed by the Department of Business, Enterprise and Regulatory Reform (DBERR) – sharply contrast with initiatives hurriedly launched by Gordon Brown last week in reaction to the lorry drivers' fuel-price protests.

In his most pro-nuclear announcement to date, the Prime Minister indicated that he wanted greatly to increase the number of atomic power stations to be built in Britain. And he met oil executives in Scotland to urge them to pump more of the black gold from the North Sea's fast-declining fields – even though his own energy minister, Malcolm Wicks, admitted that this would do nothing to reduce the price of fuel.

Even more embarrassingly for the embattled Mr Brown, the report closely mirrors policies announced by the Conservative Party six months ago to start "a decentralised energy revolution" by "enabling every small business, every local school, every local hospital, and every household in the country to generate electricity".

Yesterday Peter Ainsworth, the shadow Environment Secretary, said: "We have found that there are huge economic, social and environmental gains to be made by doing this. It is good that, at last, part of the Government seems belatedly to be coming to the same conclusion, and we can only hope that the Prime Minister can rise above his panic-stricken clutching at old technologies and grasp the opportunities microgeneration offers for clean and more secure energy supplies."

The 130-page report, due to be launched by Mr Wicks, has been produced by a consultancy, Element Energy, after a wide-ranging survey of public attitudes on installing household renewable energy systems. It has been financed, and steered by, 14 official and other bodies including DBERR, the official Energy Savings Trust, five regional development agencies, British Gas, the Micropower Council and the Ashden Trust.

The department's approval marks something of a revolution in itself, since its predecessor, the Department of Trade and Industry, was for decades hostile to renewable energy and microgeneration. Its mandarins hated the thought of allowing millions of ordinary people to affect energy supplies by generating their own heat and power.

As a result, Britain is almost bottom of the European league for exploiting renewables – above only Luxembourg and Malta – despite having the best resources in the entire continent. Though ministers claim their efforts have been "highly successful" in boosting these clean sources of energy, they now account for only about 4 per cent of electricity – compared, for example, with 14 per cent in Germany.

Ministers also boast that 100,000 British homes now have microgeneration, mainly solar thermal panels that heat water – but in Germany they adorn more than a million roofs. Last year just 270 solar photovoltaic panels, which produce electricity, were put on Britain's homes, compared with 130,000 in Germany.

At this rate, David Orr, chief executive of the National Housing Federation told MPs last month, it would take the UK 1,500 years to equal the number Germany has. Britain's only manufacturer of the panels, Sharp, calculates that less than a week of its year-round production actually gets installed in this country, with the rest exported to the continent.

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CFTC Probes Possible Manipulation in Cotton Market

The U.S. Commodity Futures Trading Commission is investigating potential market manipulation of cotton futures after prices surged and then abruptly plunged in March, two people familiar with the probe said. Results of the investigation may be released as soon as June 3, said the people, who asked not to be identified because the probe hasn't been made public.

The Washington-based commission, which also is examining potentially improper trading in oil markets, began the cotton inquiry after seeing unusual gaps between futures and spot prices, the people said. Cotton traded on IntercontinentalExchange Inc.'s ICE Futures U.S. unit rose to a 12-year high of 92.86 cents a pound on March 5, then fell as much as 26 percent by March 20 to 69.02 cents.

Supplies in the U.S. didn't justify the increase, cotton merchants told the commission during an April hearing on the role speculators are playing in rising commodities prices. "The market is broken, it's out of whack, and someone has to step in and bring relief," William Dunavant Jr., chairman of cotton merchant Dunavant Enterprises Inc., said at the April hearing.

CFTC spokesman Dennis Holden said today in an interview the commission doesn't comment on whether it's conducting investigations. Intercontinental Exchange spokeswoman Kelly Loeffler said her organization also doesn't comment on possible probes. The investigation was reported earlier in the Wall Street Journal and the New York Times.

The CFTC, which regulates markets including silver and soybeans and derivatives linked to stock indexes and bonds, is under pressure from Congress to ensure commodity markets aren't being manipulated as the prices of gold, copper, corn and wheat rose to records, said one of the people familiar with the probe.

The Reuters-Jefferies CRB Commodity Index has jumped 37 percent in the past year, touching a record 435.53 on May 22. Oil has doubled, making it the biggest gainer. Cotton jumped 48 percent, the eighth-biggest increase of 19 commodities on the CRB. Cotton for December delivery fell 0.27 cent, or 0.4 percent, to 74.37 cents a pound yesterday on ICE Futures U.S., formerly the New York Board of Trade.

Joseph Lieberman, chairman of the Senate Homeland Security and Government Affairs Committee, said May 20 he is considering legislation limiting large institutional investors in commodities markets. The legislation would be aimed at speculators and other investors who use commodities to hedge against swings in other investment instruments such as stocks and the U.S. dollar, Lieberman, a Connecticut independent, said during a hearing.

The CFTC said in a statement May 29 it is investigating U.S. oil trading to determine whether the doubling of prices in the past year is the result of manipulation or fraud. The CFTC has been investigating the transportation, storage and trading of crude oil in the U.S. since December, the regulator said in the statement posted on its Web site.

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Treasury's Paulson says sovereign wealth fund investments into US not political

US Treasury Secretary Henry Paulson, on a tour of Persian Gulf countries, again endorsed investments by their government-owned sovereign wealth funds (SWFs) into the US, saying they are motivated by profit and not by politics.

'The question is, are sovereign wealth funds what I believe them to be, pools of investable capital that are driven for commercial reasons to get risk adjusted rates of return, or as some people have a concern, that in some instances they may be politically driven,' Paulson told reporters today after meeting with Qatari government officials.

Paulson called for more transparency by the often-secretive funds to make clear their lack of politically motivated investment decisions.
'Lets have some best practices,' he said, 'that are voluntary that will help make the case for those who want to push back against protectionist sentiment.'

The US has already agreed on a set of SWF practice principles with the Abu Dhabi and Singapore governments. Their intent is to serve as a model for the International Monetary Fund's current effort to work out a set of best practices for SWFs worldwide.

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A recession without contraction?

The economy will perform a neat trick this year, experts predict: fall into recession without contracting. That hasn't happened since the government began tracking quarterly growth of gross domestic product (GDP) in 1947.

"Remarkably, the economy has been able, barely, to keep its head above water despite all the negative shocks," says Josh Feinman, DB Advisors' chief economist. While many believe a recession indicates a contraction in GDP, the National Bureau of Economic Research, known as the arbiter of recessions, merely looks for "a significant decline in economic activity" lasting more than a few months. It may appear in GDP, income or other measures.

GDP limped along at a 0.9 percent rate in the first quarter. But the Federal Reserve has slashed interest rates and eased credit-market tightness. Tax-rebate checks also will likely boost consumer spending this summer. Plus, the weak dollar is fueling exports.
Two recent surveys — from the National Association for Business Economics and the Fed of Philadelphia — see growth, albeit mild, through 2008.

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Ilargi: Canada’s media lionize the man who put the Caisse into a $20 billion ABCP black hole. From which there is no escaping for the pension fund itself, or its clients, but the addicted gambler himself is allowed to leave the sinking ship. Instead of being revered, he should be indicted on a whole slew of charges.

Oh, there is a big loss here for sure, but not the one they claim. It’s the $20 billion hole he leaves behind.

ABCP: Caisse de Dépot CEO Leaves For Power Corp.

Wanted: One executive to run Canada's largest institutional investor. Must be a francophone Quebecer, financially literate, strategic and an accomplished operator. Political savvy is essential.

As news of the unexpected resignation of Henri-Paul Rousseau, chief executive of the Caisse de depot et placement du Quebec rippled across the province yesterday, talk in haute finance circles turned to who will replace the man who, in six years, righted Quebec's dominant financial institution -- which manages $155-billion in assets on behalf of more than 20 Quebec public pension and insurance funds -- following an era of poor management, political meddling from Quebec City and awful investment decisions.

An appointee of the Quebec government, Mr. Rousseau spearheaded the introduction of legislation that modernized the 43-year-old institution by introducing stronger governance, greater autonomy for the board and -- most important -- freed the Caisse of its twin mandate to seek returns and foster Quebec economic development.

The answer, all agreed, was that Mr. Rousseau, 60, who is leaving to join Power Corp. of Canada as vice-chairman next year, leaves such big shoes to fill that it was hard to fathom a replacement. "It's a big loss," said Monique Jerome-Forget, Quebec's Finance Minister. "It's a very sad story, for me, personally, and certainly for the government."

Names of feasible successors include Montreal Exchange chief executive Luc Bertrand, former National Bank of Canada chief financial officer Pierre Fitzgibbon and Michel Tremblay, executive vice-president of investments at insurer Industrial-Alliance, observers said.
"I don't see anybody internally that has the wealth and breadth of experience," said an observer close to the Caisse.

Pierre Brunet, chairman of the Caisse, said a seven-member board committee was struck to find a replacement. Mr. Rousseau joined six years ago as Quebec's ultimate establishment man. The economist for the Yes side in the 1980 referendum had transformed into an apolitical banker -- serving as CEO of Laurentian Bank of Canada prior to joining the Caisse -- and quickly slashed costs, shut foreign offices and scaled back the Caisse's bloated ambitions under predecessor Jean-Claude Scraire.

In his first year, Mr. Rousseau revealed the worst loss in the Caisse's history -- a 9.6% drop in 2002 -- blamed on the prior administration.
He introduced accountability and risk-management practices, recruited outside talent and increased the amount of assets invested in such "alternative" areas as hedge funds, infrastructure and private equity. "This man has managed to transform the Caisse into a very respected institution around the world," said Pierre Arbour, a former Caisse critic turned admirer.

The results: over the past five years, the Caisse posted an average return of 12.4%, among the top 5% of its peers in Canada. "I think that is an achievement," said Mr. Brunet. In the past year, much of Mr. Rousseau's time was spent fixing Canada's $35-billion non-bank asset-backed commercial paper market. He had recently appeared pale, gaunt and recessed, a shadow of his hefty, commanding presence.

The test of Mr. Rousseau's legacy will now be whether his replacement will be picked on his or her merits, rather than political connections, as had happened in the past. "That's the fear, as opposed to getting someone who has a focus on building the Caisse in the best interests of the citizens," said one close observer.

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Ilargi: A long article by Gillian Tett at FT, an in-depth look at derivatives. Here’s the first third:

Derivative thinking

Just over a decade ago, a British banker made a small piece of financial history. At the time, Robert Reoch was working as a trader in JPMorgan's London office. Like most of his peers, he spent his days on the phone, surrounded by computer screens, trying to cut deals with clients across Europe.

But one day an unusual trade crossed Reoch's desk: one of his clients wanted to buy a contract which would effectively protect him from the chance that any one of three government bonds might turn sour. “It was the first time we had done a transaction like that - I guess you could call it one of the first credit derivatives,” Reoch proudly recalls, noting that the trade was so “cutting edge” that the team only sorted out the legal documentation several weeks later.

Since then, Reoch has left the City dealing floors for the quieter surroundings of a Dorset farmhouse. But his dance with financial innovation continues: he spends part of his time in Mayfair, running a consultancy business that advises clients on how to navigate the “credit derivatives” world that he helped create. This area of finance has exploded at such speed that outstanding trades are now put at more than $60,000bn (or, for comparison, 20 times the aggregate capitalisation of London's equity market).

But Reoch's dance has taken a new twist. Before turmoil took hold of the global credit markets last summer, his consultancy spent most of its time advising clients how to get into credit derivatives. Now he is swamped by investors who want to extricate themselves from derivatives-linked messes, or simply to understand the products that came out of the past few years of intense financial innovation.

Reoch intends to take another step: to launch a new hedge fund that would take advantage of trading opportunities created by the market turbulence. To outsiders, this tale might smack of everything that is dubious about modern finance. In the past 10 years, as an extraordinary wave of innovation has swept through the industry, many bankers have become wealthy by creating ever-more complex products.

The idea that some financiers are now profiting again - by helping clients to unravel the complexity, or to trade their way around it - might seem galling. “It's a strange business,” admits one senior banker. “First you make money by creating products no one understands, then you make money by cleaning the mess up.”

But there is another, more positive way to look at what is happening. If you believe in the concept of what Joseph Schumpeter called “creative destruction” - the idea that innovation is best served by letting market forces decide which ideas fail and which ones flourish - then the finance industry is entering a crucial phase. In the past eight months, it has experienced a brutal shake-out that has pushed some hallowed institutions, such as Northern Rock and Bear Stearns, over the edge.

This, in turn, has prompted some politicians to call for an overhaul of how finance is practised - an overhaul that would, perhaps, impose greater control. Yet some in the banking industry argue that restricting innovation is the wrong thing to do. As Reoch's story demonstrates, green shoots of entrepreneurial endeavour are already emerging from the current financial debris.

“The markets have a rhythm of their own... and are self-healing,” says Mark Brickell, CEO of swaps trading firm Blackbird and a former chair of the International Swaps and Derivatives Association (ISDA), a trade body. If you believe the bankers, the best response to the current crisis is more innovation, not less.

The issue of innovation in the financial world touches on questions that run far beyond banking alone. It even reaches the problem of whether the state should try to control the animal spirit of entrepreneurs. Reoch's story, for example, really starts a couple of decades ago when some bright young bankers on Wall Street hit upon the idea of derivatives. As the name suggests, derivatives are essentially instruments whose value derives from something else.

If you buy an equity derivative, you are not buying shares in a company but instead a contract linked to the level of a share price. Sometimes, this type of contract can be used to help investors protect themselves from risk. If you are a pension fund manager worried about share prices falling, you might, in exchange for a small fee, buy equity market derivatives that allow you to sell shares at an above- market price if the market starts to tumble. In that sense, derivatives act rather like insurance.

However, investors also use derivatives to speculate. If a hedge fund manager thinks the stock market is going to fall, then he might buy equity derivatives contracts that pay out when share prices are low - meaning that they will benefit. And since these contracts can be created electronically, in an instant and in vast size, trading derivatives is often more efficient than buying and selling actual shares.

The first derivatives were created in the 1980s and known as interest-rate swaps or foreign-exchange swaps, since they enabled investors to place bets on movements in interest rates or currencies. Then, in the late 1980s, the business proliferated and became far more complex. There is a bitter irony that stalks the modern investment banking world: while many financial institutions exude vast power, they are highly vulnerable because it is so hard to patent their ideas.

Thus, whenever a new product is invented, it tends to be copied quickly. That means that although new instruments - such as interest-rate swaps - typically start out as high-margin, bespoke products, they soon become low-margin, ubiquitous products. The only way that a bank can beat its competitors - other than having more capital or financial muscle - is to be much more creative.

However, in the early 1990s, there was another factor that made the derivatives world boom: interest rates were extremely low. That meant that the level of returns investors could achieve by holding, for example, a government bond were also low. Consequently, bankers hunted for other ways to help investors achieve good returns - such as using derivatives.

“The thing to realise about the early 1990s was that you had a falling interest rate environment for several years following the recession of late '89/'90,” recalls T.J. Lim, a Malaysian-born banker who was part of the original group of JPMorgan bankers who developed interest-rate swaps in the mid-1980s, and who went on to become one of the most senior bankers in the derivatives and debt world.

“Everyone was looking for yield - it was a period when bankers could do almost anything you could dream of and people would buy it. For example, we had structures [with names] such as Libor squared, Inverse Floater, Power options, Convexity forwards, etc. That drove a lot of innovation.” However, in an uncanny echo of what has happened over the past year, the boom of the early 1990s ended badly.

In 1994, the interest rate climate suddenly changed, unleashing wild market turbulence and causing many of the derivatives contracts to produce huge losses - or “blow up”, as traders call it. For a while everyone hated derivatives - “it became a dirty word,” says Lim. “I was very outspoken then in saying that there is nothing wrong with the product - it's just that the excesses got out of control. But it was a very humbling period. It brought down a number of traders and senior people. There was a lot of soul searching.”

As the turmoil mounted, calls emerged for derivatives to be more tightly controlled. But the International Swaps and Derivatives Association fought back furiously, arguing that a regulatory clampdown would not only run counter to the spirit of capital markets, but also crush creativity. Their aggressive lobbying campaign was effective: by the mid-1990s, regulatory pressure had died away, and the derivatives market was free to innovate - albeit under the close eye of lawyers.

“We set out to design a business guided by market discipline because we believed that it should be an even better guide to good behaviour than regulatory proscription,” explains Brickell, a principal architect of ISDA's public policy framework, which helped avert a regulatory clampdown back in the 1990s. The financial community responded to this new lease of life with a vengeance - but not quite in the way that some had expected.

In the years after the 1994 turbulence in the derivatives markets, activity in the swaps world slowly recovered. However, the business had lost much of its earlier glamour, not simply due to the huge losses on derivatives, but also because of a more mundane problem: the innovation cycle. Swaps had started life as a high-margin business, but by the early 1990s they had been copied so widely that they had turned into a mass-market product. Almost as soon as the derivatives scandals had died down, bankers started the hunt for the next big thing.

This was where the story of men such as Reoch began. In the mid-1990s, soon after he joined JPMorgan, about 80 other bankers who worked in the company's derivatives business were summoned to a plush hotel in Boca Raton, Florida, for a brainstorming session. The man who ran that team was a British banker called Peter Hancock. Hancock had taken over the derivatives team in the late 1980s, and seen the business become commoditised.

For a few days, the young JPMorgan bankers brainstormed ways of overcoming this. Eventually, the group alighted on a potentially fertile new frontier for derivatives: credit. Until that point, banks that made large loans didn't have a way of protecting themselves against the chance of a borrower defaulting. Similarly, investors who held bonds did not have any mechanism to insure against an issuer refusing to pay out. What would happen, the JPMorgan bankers asked, if somebody created a contract that mimicked that credit risk, and then sold that risk to another investor, for a fee?

The group in Boca Raton were certainly not the only ones playing around with these ideas: rival teams at institutions such as Bankers Trust and Credit Suisse were thinking along the same lines. But JPMorgan offered an unusually fertile laboratory for experimentation. One reason was that Hancock had gathered a close-knit team of young, highly creative bankers who were open to sharing ideas. Another was that JPMorgan had a vast pool of loans on its books, thus giving Hancock's team plenty of raw material with which to conduct experiments.

Most important of all, JPMorgan's top management had a compelling reason to innovate. At the time, the bank had so many loans on its books that it was finding it expensive to keep doing business: it needed large “rainy day” reserves to protect against the chance of the loans turning sour. Hancock's team believed that if they found a way to sell this “default risk” to somebody else by repackaging the loans into derivatives, then they could persuade the regulators that they did not need to post such big reserves.

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Ilargi: A topic I’ve paid attention to for a long time is the throwback by a billion years or more in the ecology of large parts of the oceans, where evolution is essentially reversed. With more complex lifeforms disappearing, the primitive re-establish themselves. Jellyfish and chips.

Apocalypse in the Oceans

Under the swells and the sparkles and the froth, fathoms down, the globe's oceans have transformed over the last several decades, transforming even as we sit here into wastelands, ghost worlds, desolate deathscapes that could be filmed in situ for sci-fi films about the post-apocalypse. You won't find this out from a day at the beach. The smiling sea captain depicted on the fish-sticks box is keeping mum.

But Canadian food journalist Taras Grescoe tells all in his important new book, Bottomfeeder (Bloomsbury, 2008). "Rather quickly, the oceans are becoming environments unlike any we have ever known," Grescoe agonizes, giving as his first example the North Atlantic, where he watches Nova Scotian fishermen exulting over a new lobster boom while apparently neither knowing nor caring about its probable cause: human greed.

Yes, climate change plays a part but it's marginal compared to the massive overfishing required to supply restaurants and stores in a world that stuffs itself on tuna sandwiches, salmon steaks, shrimp cocktail and sashimi.

"The shallow waters off Nova Scotia used to be full of swordfish and bluefin tuna, as well as untold numbers of hake, halibut, and haddock. Cod in particular were the apex predators in these parts," Grescoe writes. (Later in the book, he quotes early observers describing "cod mountains" off a once-rich Newfoundland coast where the fifteenth-century navigator John Cabot reported cod populations so thick that they actually blocked his ships' passage.)

Cod, Grescoe writes, once "prowled the gullies offshore in dense shoals, using their powerful mouths to suck up free-swimming larvae, sea urchins, and even full-grown crustaceans. But the cod were fished to collapse in the early 1990s. With the cod gone, stocks of lobsters and other low-in-the-food-chain species exploded." By wiping out predator species, the fishing industry screws up ecosystems.

As sea creatures high on the food chain disappear, their populations more than decimated in the last half-century, a lobster boom "may just be a tiny blip on a slippery slope to oceans filled with jellyfish, bacteria, and slime."

Meanwhile, overfishing has created some 150 "dead zones" -- oxygen-free patches of ocean that can sustain no life -- around the world: Some of these patches, Grescoe tells us forebodingly, "are now as large as Ireland."

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UN Conference Divided over How to Protect Biodiversity

How much money is nature worth? It's a question that economists and environmentalists have been pondering for decades in a bid to leverage market mechanisms to protect the environment.

Now experts are one step closer to answering that question after Deutsche Bank economist Pavan Sukhdev, who was charged by the European Commission and the German government to measure the value of nature, presented the preliminary results of his research at the United Nations biodiversity conference in the German city of Bonn Thursday.

According to Sukhdev's report, deforestation, should it continue at current levels, would mean the world's gross domestic product would be some 6 percent -- or €2 trillion ($3.1 trillion) -- lower by 2050 than it would be were forests preserved. Not only does deforestation mean a forest can no longer produce economic goods, he explained, but it also increases the pace of climate change and puts areas at greater risk of flooding, all of which mean additional costs.

The poor would bear a disproportional share of the costs, he said. A global system to protect all ecosystems would cost around $45 billion annually to build up and maintain, Sukhdev explained. But the returns from such a scheme would be in the range of $4.4 trillion to $5.2 trillion -- meaning that every dollar invested would be repaid 100-fold.

Sukhdev also analyzed the economic costs and benefits of protecting the oceans. Expanding protected areas in the sea to 20 percent of the total surface would cost commercial fisheries $270 million per year in losses. However in the long term, preventing over-fishing through such reserves would secure fishing incomes in the region of $70 billion to $80 billion per year. If no action is taken, the collapse of fish stocks due to over-fishing would cost up to $100 billion and mean the loss of 27 million jobs.

Although concrete numbers were few, the message was clear. "We are still struggling to find the value of nature," Sukhdev told the conference. "This lack of valuation is, we are discovering, an underlying cause for the degradation of ecosystems and the loss of biodiversity." He feels that a new approach to thinking about nature was required, saying that the world's "economic compass" needed to be re-oriented.

German Environment Minister Sigmar Gabriel explained that unfortunately more money could still be made by destroying rather than protecting nature. "Protecting nature needs to bring returns," he said. "We do not have these returns today."

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