How Speculators Are Causing the Cost of Living to Skyrocket
After investing in high-tech stocks and real estate loans for years, legions of speculators have now discovered commodities like oil and gas, wheat and rice. Their billions are pushing prices up to astronomical levels -- with serious consequences for ordinary people's quality of life and the global economy....
....Searching for secure and long-term returns, major investors turned their attention to the commodities indexes, investments that promised substantially higher returns than investing in the stock market. The more the funds invested, the higher the prices went, especially since the market for speculative commodities securities is very small. Even minor shifts in the portfolios of large mutual funds can quickly drive up the price of oil....
...."The flood of money from Wall Street and hedge funds is driving up prices -- and the effects are potentially destructive," says Tom Buis, president of the US National Farmers Union.
As prices become further removed from reality, another risk begins to grow: the development of another bubble similar to the one fueled by overinflated stock prices in the so-called New Economy. A crash would be unavoidable.
It would be good news for drivers in Germany and the people starving in Africa. But it would also send the financial markets into turmoil once again, causing problems for hedge funds and perhaps a few banks. Regardless of whether prices go up or down, speculation results in preposterous exaggerations, with real consequences for the economy.
Once again, it is the excesses of modern financial markets that are sending the world economy into convulsions. Indeed, German President Horst Köhler may have been right when he recently said, in an interview with the German magazine Stern, that the financial markets have developed into a "monster" that needs to be tamed.
"The financial industry," says Heinrich Haasis, president of the German Federation of Savings Banks, "has disconnected itself from the real economy." This is both correct and incorrect.
It's correct because the transactions concluded in this sector no longer have anything to do with real goods. The industry deals in expectations, and in expectations of expectations, often on borrowed money. And it's also correct because it is an industry in which obscene amounts of money are being earned....
....They are all back at the table, the hedge funds and the major investors, the ones who will place their bets on anything that promises to yield a profit. But they're not the only ones. American pension funds, such as the fund that manages the retirement pensions for Californian teachers, have also joined the fray. And then there are the countless small investors putting their money into commodities funds, into index funds that simulate commodities prices, or into certificates, that modern investment instrument that even allows the most ordinary of investors to get a tiny piece of the action.
They all speculate that commodities prices will continue to rise, partly because demand is growing while supply is limited. Oil is a case in point. Without it, the world economy would come to a standstill, and Asia's emerging economies are constantly clamoring for more. And then there is food. In China, for example, more people can now afford meat. But it takes three kilograms of feed to produce one kilo of pork. At the same time, many fields are now devoted to growing crops used to produce biofuel.
The trend is clear, and yet it offers only a partial explanation for the steep rise in prices. Living habits don't change that quickly and, as a result, neither does demand. The only thing that changes that quickly is expectations -- which keep on driving up prices.
Does connectivity in the financial system produce instability?
Some evidence suggests that free capital flows in and of themselves produce instability and crises. A recent paper by Kenneth Rogoff and Carmen Reinhart found that
"Periods of high international capital mobility have repeatedly produced international banking crises, not only famously as they did in the 1990s, but historically."
Yet the focus of policy has been to increase the cross border flow of funds. Indeed, when the post mortems of this era are in, I suspect the carry trade will be found to have been a major culprit.
Another indicator: as the financial services industry has become increasingly deregulated and boundaries between businesses become blurred or meaningless (fund managers versus brokerage accounts, hedge funds versus proprietary trading desks, investment bank versus commercial bank) bank profitability has fallen and the industry has pushed into higher risk activities to try to compensate. Indeed, not only have overall risk measures risen, but the top banks also appear to be following common strategies. Both behaviors increase systemic risk.
The Vigorish of OTC: Interview with Martin Mayer
Mayer: One of the problems I have with the OTC markets and the arguments that we mustn't cramp innovation is that a lot of what is called innovative is simply a way to find new technology to do what has been forbidden with the old technology.
The IRA: Yes, techno-regulatory arbitrage. What a lovely thought; using new technology as a means for committing financial fraud. It's kind of like the affordable housing and innovative financing games.
Mayer: Yes. Innovation allows you to go back to some scam that was prohibited under the old regime. How can you oppose innovation? The fact that the whole purpose of the innovation is to get around the existing regulation never seems to occur to regulators or members of Congress....
....Mayer: In addition to using technical innovation to evade regulatory limits, there was also a confusion of purpose at the Fed. The Fed really never wanted to exam banks. And it really didn't want to be in a admonitory position vis-a-vis the banks. The commercial banks are the mechanism by which monetary policy is conveyed to the world. And the Fed needed them very badly. But beyond just monetary policy, what got forgotten was the reason why we separated commercial banking and investment banking in the 1930s. Obviously it got more and more difficult to enforce that separation as the technology changed. But that didn't mean that there were not good reasons for the continued separation. The way I like to put it is that the commercial banker wants to know how am I going to be repaid, the investment banker asks how am I going to sell the paper. These two attitudes really do not coexist well together.
The IRA: Banks globally have been miserable failures when it comes to combining investment and commercial banking.
Mayer: Correct. It is a very different mindset. And historically, in terms of public policy, we have relied upon the commercial banks to keep the markets and the economy on an even keel. Greenspan's observation was that, after all, the banks are going to protect us because they are lending their own money.
The IRA: Yes, but in a market dominated by investment bankers, no such discipline prevails. The investment bankers rarely create value and, judging by their recent behavior, care nothing about the long-term health of the global markets or the economy.
Mayer: Well, of course that was inaccurate because commercial bankers lend other peoples money. But beyond that, the notion that people who gamble with their own money are more responsible gamblers than those who gamble with their Uncle Joe's money was always very strange to me. People who are gamblers are gamblers and they will run through anybody's money. The difference between their own money and other people's money usually does not mean much to a gambler.
Litterbin of Last Resort
Oh dear, it was not meant to be like this. The European Central Bank (ECB), widely praised for providing banks with ample liquidity during the credit crunch, now has a problem: how to encourage banks to place freshly created asset-backed securities (ABS) with investors, rather than dumping them, like so much radioactive waste, in its vaults.
The ECB accepts a wide range of assets, including those such as ABS for which there is temporarily very little trading, as collateral in its refinancing operations. Provided the tranche of securities is the most senior, and rated A- or above, the ECB will take it. No surprise then that since August a large number of banks have designed ABS tranches, backed mostly by mortgages, purely for ECB consumption. Of €208 billion ($320 billion) of eligible securities created, only about €5.8 billion have been placed with investors, according to calculations by JPMorgan. In one noteworthy deal in December, Rabobank, a Dutch institution, issued €30 billion of mortgage-backed securities, €27 billion of which were designed exclusively for refinancings with the ECB.
On the face of it there is no immediate problem. Only around 16% of the ECB's collateral so far is ABS. Banks are drinking from the liquidity fountain and keeping the cost of high-street mortgages contained at the same time, which they might not be able to do otherwise.
But it is not helping the revival of a publicly traded ABS market, and may be fostering the creation of even murkier securities. Many of today's ABS are even less transparent than those sold before the crisis—the ECB requires a rating by only one agency, not the usual two, and pre-sale reports are often sloppily prepared. That, at least, is the concern of some rival central bankers, although the ECB itself is not panicking, yet. José Manuel González-Páramo, an ECB director, urged bankers earlier this month to make “serious efforts to revive the interest of third-party investors”. Though action is needed, the bank will not do anything in a rush—the markets are still too fragile for that.
The Greatest Value Of Lehman's Loss Lies In Lessons Learned
Lehman reported a $2.8 billion quarterly loss June 9, the same day it said it had raised $6 billion in fresh capital. Investors seemed surprised, judging by the stock's 15 percent decline since then. They shouldn't have been.
Wall Street stock analysts were predicting a much smaller loss. Yet Lehman's market capitalization, at $19.2 billion, is now almost $7 billion less than the company's $26 billion book value, or assets minus liabilities. That suggests the market believes Lehman hasn't fully cleaned up its balance sheet and that the worst is still to come, management's assurances notwithstanding.
Whatever the case, let's focus on what we can take away from this mess.
When a company attacks short-sellers, run.
You didn't need to know much about Lehman's financial statements to see it was in trouble. All you had to know was that the fourth-largest U.S. investment bank was jousting in the media with fund manager David Einhorn, who had bet against Lehman's stock and told a bunch of other investors (and journalists) why.
Good management teams embrace criticism, address it and move on. Lehman attacked the messenger.
"Mr. Einhorn cherry-picks certain specific items from our 10-Q and takes them out of context and distorts them to relay a false impression of the firm's financial condition, which suits him because of his short position in our stock," Lehman said in May.
The smart read on that line, now obvious, was that there were cherries to be picked. And for a guy whose compensation last year was $34.4 million, you would think Lehman's chief executive officer, Richard Fuld, would have known better.
This is the same strategy once embraced by stock-market flameouts like Overstock.com Inc., MBIA Inc., Biovail Corp. and, yes, Enron Corp. Now you can add Lehman's name to that list.
There's no such thing as an economic hedge.
Linda Richman, the chronically "verklempt" host of Coffee Talk on "Saturday Night Live," would have loved this one. "Economic hedges are neither economic nor hedges. Discuss," she might say, if only Mike Myers hadn't left.
Lots of banks have downplayed their writedowns by stressing net figures that include gains on so-called economic hedges, or as Lehman calls them, "economic risk-mitigation strategies." In fact, the only thing these terms tell you is that the company made some bets that don't qualify as bona fide hedges under the accounting rules. The words mean nothing, because there is no uniform standard.
Witness Lehman's second-quarter results. The company said its gross writedowns were $3.6 billion. Including hedges, its writedowns were $3.7 billion. In other words, some of the hedges, uh, misbehaved. How's that for managing risk?
Don't eat the Level 3 mystery meat.
Credit ratings storm
Major securities regulators around the world have placed a bull's eye on debt-rating agencies since last summer's market debacle. Once revered prognosticators, agencies' integrity, credibility, quality and independence are at the centre of a series of examinations and investigations into the credit-market collapse which has galvanized international regulators.
The U. S. Securities and Exchange Commission, the only regulator that oversees its industry (worth US$5-billion a year), proposed new rules this week to reshape the way rating agencies operate.
In this country, the Canadian Securities Administrators, the umbrella group representing the 13 provincial and territorial regulators, is still "examining" the agencies' role in the securities market.
On Monday, Julie Dickson, the federal superintendent of financial institutions, will testify in Ottawa before the House of Commons finance committee that DBRS was partly to blame for the commercial-paper collapse. According to briefing notes circulated by her office, Ms. Dickson, who oversees banks in Canada, will argue that the rating agency, among other groups, encouraged the use of the flawed liquidity agreements that sparked the turmoil in the commercial-paper market last August.
Meanwhile, the International Organization of Securities Commissions, which represents more than 100 securities regulators worldwide, also released a list of recommended modifications to its 2003 code of conduct for rating agencies, originally issued after the collapse of Enron Corp....
....In Canada, the troubles were particularly serious. Last August, a$35-billion chunk of the ABCP market froze completely after a group of foreign banks that had agreed to provide emergency liquidity to buy up paper in the event of a market failure declined to honour their agreements. As a result, investors holding what they thought were notes backed by a bank guarantee were left on the hook for massive losses.
Perhaps most surprising to investors was that the frozen paper came with the highest rating from DBRS. Indeed, it wasn't until several days after the freeze-up that the company put the stalled ABCP under review.
Ten months later, the market is still tied up in a complex restructuring with holders unable to trade their notes.
Issuers, ratings agencies too close for comfort
The cozy client relationships in the credit-ratings business that helped lead to the meltdown in the mortgage market has an old scapegoat: the photocopier.
Worried their client lists were shrinking as non-paying investors started photocopying their bond-ratings reports, the three major U. S. credit-rating agencies started getting the debt issuers themselves to pay to have their debt securities rated.
The adoption of that business model decades ago helped give rise to the widespread practice of "ratings shopping," in which new issuers would hire the credit-rating agency willing to hand out the highest rating on their debt securities.
That financial dependence on the very entities they rate has been blamed for the doling out of the safest investment-grade ratings on what has turned out be risky securities tied to mortgages, including bundles of billions of dollars worth of now nearly worthless subprime loans.
Since the mortgage market blew up last summer after a slew of borrowers started defaulting, policy-makers have been grappling with how to address the conflict issue.
Despite early talk of a broad regulatory crackdown in the US$5-billion-a-year bond-rating industry, credit-rating agencies have gotten off fairly lightly so far, some industry observers say.
New York state Attorney General Andrew Cuomo last week reached a settlement with the three largest ratings agencies by market share, Moody's Corp., McGraw-Hill Cos.' Standard & Poor's unit, and Fimalac SA's Fitch Ratings. Under that pact, the Big Three agencies agreed to overhaul the way they collect fees, a move aimed at making it tougher for investment banks and other debt issuers to play the agencies off one another to get a higher rating.
This week, the U. S. Securities and Exchange Commission proposed new rules designed to curb conflicts of interest by, for example, prohibiting ratings analysts from accepting gifts in excess of US$25 from issuers they're rating.
The agency also is considering proposals to enhance disclosure about how ratings are determined and to attach a special symbol on the ratings of more complex securities, such as the "structured" products at the centre of the mortgage mess.
"I think these proposals are just dancing around the edges," says Jerome Fons, former managing director with Moody's who is now an investment consultant.
"There is no magic bullet that is going to eliminate the conflicts of interest. You can't eliminate it. You can only manage it," he added.
Not all publicity is good for DBRS
DBRS, which morphed into a formidable rating agency from its humble roots in 1976, has taken on the global heavyweights S&P, Moody's Investors Service and Fitch Ratings by offering boutique-style services....
....To underscore its big-league arrival, DBRS has abbreviated its name and crowned its downtown Toronto head office with the logo. The corporate journey has been a long one for the 66-year-old, Winnipeg-born Walter, who, along with son David, established DBRS into one of the most respectable rating agencies around.
But that credibility is now on the line. Swept up in the turmoil, DBRS has spent the past year meeting with stakeholders to patch up relations while staring down critics.
Lehman's Weekend Meetings Raise Questions
Wall Street executives say Lehman's current problems have taken a tremendous toll on CEO Fuld, known as the "gorilla" on Wall Street because of his tough management style that has saved Lehman from crisis in the past.
Fuld has resisted selling Lehman to bigger players in the past, and in doing, has built one of the most successful securities firm, which before the recent crisis was a darling of Wall Street.
However, many Wall Street executive believe the current fiscal crisis hitting Lehman is different that past troubles because of the size of the bad loans on the firm's balance sheet, and because Wall Street firms will likely face eroding profit margins for at least the next year.
Like most firms on Wall Street, Lehman has been cutting back on how much risk it will taking in trading and other businesses, in an attempt to prevent the firm from imploding as Bear Stearns did three months ago. While taking less risk may soothe investors concerns that the firm may lose even more money, it also means that Lehman will produce lower profits in the future.
The lower profit margins combined with the possibility of further writedowns of losses could force Fuld to sell the firm. At the very least, people close to Lehman expect Fuld to make some announcement about Lehman's future on Monday when it releases earnings.
Unusual weekend meetings at Lehman
I remain skeptical of all those glowing comments from bottom fishers, and I still question the viability of the company itself. This is not a call for bankruptcy. Rather it is a call that Lehman will not stay together in one coherent piece.
Last week was a Wild Ride In Lehman, Financials. Next week just may be more of the same. One thing I do know for certain is that the world's largest experiment in creative financing has failed miserably. The fallout has just started. Bottom fishing at this point is likely to be punished severely.
The BCE showdown
It's been one of the hardest-fought pieces of litigation ever to hit Canada's court system. Tens of thousands of pages of affidavits, thousands of exhibits, 6,000 pages of summaries, 28 days of trial and 3½ days of appeal court time. Now, the $52-billion leveraged buyout of BCE Inc. by the Ontario Teachers' Pension Plan and its partners hinges on two hours of oral argument.
Welcome to the ligation between BCE and its bondholders. On Tuesday, almost one year to the day that BCE announced its "plan of arrangement" to take the company private, the Supreme Court of Canada will hear arguments on the biggest corporate-commercial case ever to reach the top court. It's an appeal of a 5-0 Quebec Court of Appeal ruling, which found that the BCE plan did not properly consider the impact on bondholders.
Three sets of investors holding bonds in Bell Canada -- a BCE subsidiary that accounts for a significant portion of its parent company's revenue -- objected to the deal because under the plan to take the company private Bell Canada would guarantee the $34-billion needed to finance the deal. Yet, according to the bondholders, Bell itself would receive nothing in return, a point hotly disputed by BCE.
Common shareholders will earn a 40% return on their shares from the date the auction began while preferred shareholders will also receive a premium. However, the value of the bonds will drop between 18% to 23%, and strip bonds could lose 50% of their value because of the added debt and downgrade in ratings on their bonds.
Senator says loan favoritism is possible
Senator Kent Conrad, Democrat of North Dakota, said Saturday that he would donate $10,500 to charity and refinance a property loan after suggestions that he and other prominent Washington figures received preferential treatment from Countrywide Financial Corporation.
Though Mr. Conrad, chairman of the Budget Committee, said he was not aware of any favoritism shown by the lender that has come under scrutiny in the mortgage crisis, he said a review of e-mail traffic suggested that the loan fee for a beach house may have been reduced because of his status, while a second loan called for an exception by the company.
“Although I did not ask for or know that I was receiving a discount, and even though I was offered a competitive loan from another lender, I do not want to have received preferential treatment,” said Mr. Conrad, who said he was giving $10,500 to Habitat for Humanity. The amount was equivalent to estimates of what Mr. Conrad saved through a reduction of one point on a $1.07 million mortgage.
The dealings of Countrywide with Washington officials have come to light in the past week after James A. Johnson, a former head of Fannie Mae, was forced to give up an influential advisory role with the presidential campaign of Senator Barack Obama following suggestions that Mr. Johnson got special treatment from Countrywide. Mr. Johnson was leading the search for a vice-presidential candidate.
Mr. Conrad and Mr. Johnson, as well as other notable Washington figures including Senator Christopher J. Dodd, Democrat of Connecticut, were apparently beneficiaries of the mortgage lender’s V.I.P. program, known informally as the “Friend of Angelo” program for Angelo Mozilo, the chief executive officer.
Statewide teacher layoffs: It's 20,000
The number of teachers in California who have been issued notices of potential layoffs has hit 20,000, the state's education chief said Friday.
School districts are required by law to notify teachers and other certificated staff members that they could be laid off by March 15. The recent layoffs — including dozens in Placer County districts — have been spurred by $4.8 billion in cuts to education contained in Gov. Arnold Schwarzenegger's January proposed state budget.
In a statement, State Superintendent of Public Instruction Jack O'Connell blamed the layoff notices on a "priorities problem" and decried the governor's proposed budget for putting student performance "in grave jeopardy."
20,000 Teacher Layoffs In California
Laid off teachers are not going to be buying cars, eating out, or doing much shopping in general. They certainly will not be buying any houses. Some will even decide to walk away. And we are not just talking about teachers here. There will be cutbacks across the board in California's budget. And it won't be just California either.
Suicide calls jump amid economic woes, hot line says
A local hot line has seen a dramatic spike in suicide calls from people in Palm Beach County who are facing foreclosure and can't pay their bills, according to numbers released today.
Since the start of the year, 256 people in the county told operators at the 211 hot line that they were thinking about suicide. Of those, 44 told operators that their main reason was that they had lost a job, were facing foreclosure, couldn't afford to pay their bills or were homeless.
During the same period in 2007, from Jan. 1 to June 10, the hot line received 137 suicide calls from people in Palm Beach County. Only 15 of those gave economic reasons.
The callers' problems seem markedly different than in the past, said Susan Buza, executive director of 211 Palm Beach/Treasure Coast. Many callers, she said, have tried to find work for months.
Life aint easy at the RBA these days
"Back in 1989 and 1990, it was also the case that the world economy was slowing, but because Australia's export links were so closely tied to the miracle economy – Japan it was then – and the rest of Asia was strong and growing, the slump in business and consumer sentiment was put down as self interested groups complaining about a short period of economic hardship or a partial reversal of the excesses of the 1980s. What's more, the labour market was tight, there were fears of wages accelerating and the fall in house prices was merely a welcome correction to what had been a frenzied house price bubble in 1987, 1988 and 1989."
Says Koukoulas today: "What's worrying now is that the household debt to household income ratio is now around 165% (it was under 50% in 1990) and 12% of household disposable income is used to service that debt (it was 9% in 1990). With mortgage rates up 150bps or more in the last year, the consumer sector is under the pump as it uses money for debt servicing and not consumption."
Turns out Koukoulas could have hardly picked a better timing to publish his flashback: on the very same day the Australian Bureau of Statistics revealed employment in May fell for the first time in 19 months. Economists had predicted a rise, so you can imagine the head scratching that is currently going on through the country.
According to the ABS, employment fell by 19,700 in May with full-time jobs down 10,400 and part-time employment down 9,300. The unemployment rate was stable at 4.3%. The participation rate fell from 65.5% to 65.2%.
Economists, in their initial responses to the surprising fall, maintain there's no need for panic of any sorts, but one would have to be a real hardliner on interest rates and inflation to not acknowledge the odds have shifted further in favour of the Reserve Bank of Australia leaving interest rates on hold for the time being. Certainly, ANZ's prediction of two more hikes before year end seems less plausible as weaker economic indicators see the light of day, though some economists, including CBA's Monica Eley, maintain there remains a greater than 50% chance the RBA will lift official interest rates again in 2008, taking the cash rate to a likely cyclical peak of 7.50%.
China's hands tied over US government bond investments
An influential politician expressed regret on Friday that China has more than a quarter of its huge stockpile of foreign exchange reserves invested in US government bonds.
China held $US492 billion worth of US government bonds at the end of March, when its reserves totalled $US1.68 trillion, according to Cheng Siwei, a former vice-chairman of the National People's Congress, the largely ceremonial parliament.
"We have no other choice but to buy (US) bonds because we have no better options," Cheng told a conference on mergers and acquisitions.
As well as owning US Treasuries, China has substantial holdings of other US fixed-income assets including agency bonds and mortgage-backed securities, bankers and analysts say. Cheng did not give details of these.
But he said China would be better off if it knew how to manage its foreign exchange reserves more smartly, for instance by investing more in corporate M&A.
"If we have people who know how to invest the money better, there will be no need to buy US bonds," Cheng, who is now chairman of the China National Democratic Construction Association, told reporters.
China's Shangdong hikes power fees as shortage looms
"Shandong was worried about power shortages in the summer peak consumption season," said Lin Boqiang, director of the China Centre for Energy Economics Research at Xiamen University. "So it took a smart move."
State-set power tariffs have been frozen since June 2006, as Beijing worries that a hike may fuel inflation that jumped early this year to its highest in more than a decade. That capped earnings from power producers as the cost of coal mounted.
But analysts say Shandong's intent was less to aid struggling generators than to avert rolling summer brownouts. Coal inventories have become dangerously lows as power producers put off stocking up on the increasingly expensive hydrocarbon.