New York City street vendor
Ilargi: I'm taking a writing holiday today. Just one quote from a Fortune Magazine article below which belatedly recognizes '... that the destruction of trillions of dollars of wealth in the collapse of the housing and stock markets will stem demand for goods of all sorts".
Combine that with China's deteriorating economy and what do you think you get? One thing’s for sure: it'll neither be jobs, nor buyers for American cars. Or homes. Detroit has burned through more cash in the past quarter than all its stock is worth, for the love of the mother of the deity.
You better believe in the Christmas spirit. You're going to need it. It may be all you have left come yuletide.
Normally I find it sort of pleasant and exciting to wonder what the world will look like in 100 days. Not today.
China heading for a severe economic slowdown
China must be radically reassessed by investors and could be lurching towards a more dramatic economic slowdown than Beijing authorities will admit, a CLSA report says. The grim assessment from Eric Fishwick, chief economist at CLSA, an Asia specialist private equity firm, argues that it will be impossible for China to achieve anything like the growth rates it is presently projecting for next year. Even with aggressive government measures, growth in 2009 could plunge to 5.5 per cent, he said.
The super-bearish forecast depends on certain weak signals that may emerge in the fourth quarter of 2008, but comes amid reports from the Chinese electricity sector that suggest the country’s mighty manufacturing engine-room is already sputtering badly. More than 70 per cent of the electricity generated in China is consumed by industry and according to reports, monthly national power output in October fell for the first time in a decade. Traders in Singapore said it could be a slump that would have a huge negative impact on global commodity demand: ferrous and nonferrous metal-processing industries are among the heaviest consumers of electricity in China and it is their slowdown that is reflected in the drop in power usage.
In the report circulated to investors yesterday, Mr Fishwick dismissed the idea that the authorities in Beijing would be able to manipulate the economy as effectively as other analysts believe. CLSA has cut its 2009 GDP forecast for China from the previously projected level of 8 per cent, citing in-house research that suggests China is suffering the sort of domestic slowdown that many investors dread. In the report, Mr Fishwick acknowledges that the 5.5 per cent growth forecast theory will be resisted: the market has come to believe that Beijing will simply “not allow” growth to slow below 7 per cent.
But he argues that while Beijing has greater influence over China’s economy than most other Asian governments have over theirs, the breakneck expansion of the private sector - now two thirds of the economy - means that large parts of China’s growth machinery are beyond Beijing’s direct control and subject to the same rules and laws as other market economies. “Investors need to analyse China as ‘Just Another Capitalist Country’ and question whether government policy will actually work,” he said. “China is revealed as extremely cyclical with the volatile expenditure components much larger compared with the stable ones. Our 5.5 per cent GDP forecast has already factored in a broad and aggressive government stimulus.”
Capitalist economies, he added, are hard to control and respond slowly and unpredictably to government policies. Although China does have more mechanisms to influence economic activity than elsewhere in Asia, because GDP composition is biased towards exports and investment, external conditions will hold sway. Also limiting Beijing’s influence on economic growth is the relatively low contribution to GDP of consumer spending and government investment - 37 per cent and 2.3 per cent respectively. In that light, said the CLSA report, both measures to boost spending and any proposed fiscal policy gambits will be of limited overall effect.
Even when China ramped up spending in 1998 in response to the Asian Crisis, it did not manage to maintain growth levels above 8 per cent. Not all analysts share CLSA’s bleak assessment. Goldman Sachs issued a report on the Chinese economy yesterday that told investors to expect it to stabilise in the second half of 2009, with a potentially strong positive effect on stocks. Deng Tishun, Goldman’s China strategist, said that the index of Chinese stocks listed in Hong Kong could rise more than 50 per cent next year.
Deflation: the new threat
Forget about inflation. The opposite threat - deflation - is what has policymakers sweating now. Central banks across Europe slashed interest rates again Thursday. The Bank of England cut its policy rate to 3% from 4.5% - a cut three times as big as the market expected - while the European Central Bank trimmed its own rate by half a point, to 3.25%. The moves come a week after the Federal Reserve cut the Fed funds rate to 1%, touching the lows it set earlier this decade before the housing bubble took shape.
The cuts are remarkable because it was only four months ago that the ECB was raising interest rates to stem inflation fears tied to the surging prices of energy and food. But since then, the deleveraging that has upended the financial sector has accelerated, and economic activity has slowed sharply. Policymakers have changed their tune accordingly, saying falling commodity prices will ease pressures for wage increases and support broad price stability.
The rate cuts are so severe, though, they suggest that the issue isn't the absence of fear about inflation. Rather, it's that bankers are worried that the destruction of trillions of dollars of wealth in the collapse of the housing and stock markets will stem demand for goods of all sorts, creating the kind of falling price environment not seen here since the 1930s. Among central bankers, there is "a real sense of concern about falling inflation," says Lena Komileva, an economist at interdealer broker Tullett Prebon in London. She says that concern is reflected in the aggressive rate cuts seen around the globe of late.
Many economists say there's no reason well-managed modern economies should ever have to fret over the prospect of deflation - a drop in the money supply that, by making cash more valuable and lowering prices, slows economic activity and increases the debt burden on people and companies. As Fed chief Ben Bernanke infamously noted in a 2002 speech, a government pushed to the brink has a surefire remedy for falling prices: the printing press. But the events of the past year have made clear that the mere threat of cranking out more currency isn't enough to restore debt-engulfed economies to equilibrium.
The Fed began cutting interest rates 15 months ago, and soon after started rolling out policies aimed at providing liquidity to cash-strapped players in the financial system. Other central banks hastily joined in the march to monetary expansion in September, when the collapse of Lehman Brothers led to the near collapse or partial nationalization of the global financial system. Since then, officials have piled on all sorts of programs - backstops for money market funds, guarantees for bank deposits, swap lines for borrowers in foreign currencies - in a bid to support financial institutions and unlock frozen credit markets.
Komileva says governments in the U.S. and Europe, after initially ignoring structural problems in the financial markets, have embarked on "a super-expansionary policy" in which government purchases aim to prop up flagging private-sector demand. But just as the Fed's interest rate cuts couldn't keep an overleveraged domestic economy from heading into its first recession in seven years, there is the suspicion that massive injections of liquidity won't be enough to avert a steep decline in global demand.
The problem, Komileva says, is a glut of productive capacity that came online worldwide during the credit boom earlier this decade. Now that credit is increasingly unavailable, demand for goods stands to fall substantially below the available supply - a mismatch painfully visible in the U.S. auto industry, for instance, where sales fell 32% from a year ago in October to their lowest level in more than two decades. Companies seeing weak demand often respond by cutting staff, which in a weak labor market leads to further declines in consumer spending, feeding additional drops in demand that call for lower prices.
Of course, the deflation thesis has no shortage of doubters, both in official circles and among economists. "What matters, if we are going to worry about it, is if we have sustained deflation," International Monetary Fund chief economist Olivier Blanchard said Thursday. "At this stage, this is something that we should worry about. But we think that the probability of such a sustained deflation is, for the moment, very small." Adam Posen, deputy director of the Peterson Institute for International Economics in Washington, writes that asset price declines almost never result in broader price declines.
He wrote a paper in 2003 pointing out that only two of 44 stock or real estate bubbles led to deflation going by the consumer price index, and that only two of 18 deflationary episodes in advanced economies were preceded or accompanied by asset-price busts. He also notes that interest rates on long-dated government bonds and inflation-protected Treasury securities show that inflation expectations remain positive, which likely wouldn't be the case if investors expected to see deflation ahead.
Still, it's worth recalling that optimists have been wrong before about this crisis. After all, a year ago at this time the short-term interest rates targeted by the Fed, ECB and Bank of England were at 4% or above, and the so-called decoupling thesis - the notion that the U.S. could have a recession without the rest of the world being affected - was alive and well. Komileva notes that trading one- and two-year U.S. inflation swaps show investors perceive a real threat of deflation. One-year swaps, for instance, currently show inflation at minus 1.9%, she says.
"Just as the real economy was 'recessionary' a year ago before GDP turned negative, the pricing backdrop is 'deflationary' today even though consumer prices have yet to deflate on a year-over-year basis," Merrill Lynch economist David Rosenberg wrote last week. The U.S., he adds, has "a credit contraction of historical proportions on our hands."
Why the jobs report is so ominous
What gives today's October employment report an unmistakably ominous twist is the almost uniformly downbeat message from nearly all of its components. No matter how deep one digs into the specifics of the data, it is hard to identify any encouraging news.
Not only did the economy lose a massive 240,000 jobs in the non-farm sector, but the previously reported declines of 159,000 in September and 73,000 in August were revised sharply lower to 284,000 and 127,000 respectively as well. As a result, the economy has now lost a total of 1.2 million jobs since the beginning of the year, with nearly half of those losses occurring in the last three months alone, pointing to an acceleration in the pace of erosion in labor markets.
Losses were widespread in all of the key categories except the government sector, which gained 23,000 last month. Manufacturing jobs were down by 90,000 for a cumulative decline of over 200,000 in the last three months, while construction jobs fell by 49,000 last month, for a total decline of over 100,000 in the last three months. Jobs in the retail trade sector declined by 38,000, down by 111,000 in the last three months. That downbeat message goes on and on in most of the other categories.
The unemployment rate hit 6.5% for the month, up by 0.4%, which was double what most economists expected and its highest level since 1994. There is little chance that the bleak numbers are a statistical fluke. Here's why: Since the payroll data and the unemployment rate are the results of two separate surveys conducted by the Bureau of Labor Statistics (www.bls.gov), those two series sometimes send a mixed message about the state of labor markets for a particular month because of the statistical noise associated with the methodology of those surveys. However, in a dramatic demonstration of consistency in October, both the jump in the rate and the sharp declines in payrolls sent a very powerful message that labor markets are deteriorating precipitously.
Other bad signs:
1) By way of comparison, in the 2001 recession and the period of sluggish growth that immediately followed in 2002-03, the unemployment rate reached a peak of only 6.3%, in June 2003. So, we have already exceeded that mark and, given that we are still in the early phase of the current recession, the unemployment rate should be expected to push toward the 7.5% range over the next 3 to 6 months, and possibly higher.
2) Given that the surveys that the BLS conducts take place during the week that includes the 12th of the month, many of the corporate layoff announcements that have made headlines in recent weeks were not captured in the October data. As a result, we should look for further sizable job losses to be posted in the employment reports for November and December - and beyond - as companies continue to adjust to the bleak economic environment.
3) Any doubt that we're officially in a recession can be put aside. Fourth-quarter real GDP is likely to contract sharply. The rapid deterioration of labor markets points to a sharp decline in hours worked and output in the fourth quarter. This is likely to lead to a decline in personal consumption to the tune of 5% or so for that period. Since that makes up about 70% of the economy, the stage has already been set for real GDP to shrink at a more than 4% rate in the fourth quarter.
AIG in talks with Fed over new bail-out
AIG is asking the US government for a new bail-out less than two months after the Federal Reserve came to the rescue of the stricken insurer with an $85bn loan, according to people close to the situation. AIG’s executives were on Friday night locked in negotiations with the authorities over a plan that could involve a debt-for-equity swap and the government’s purchase of troubled mortgage-backed securities from the insurer. People close to the talks said the discussions were on-going and might still collapse, but added that AIG was pressing for a decision before it reports third-quarter results on Monday.
AIG’s board is due to meet on Sunday to approve the results and discuss any new government plan, they added. The moves come amid growing fears AIG might soon use up the $85bn cash infusion it received from the Fed in September, as well as an additional $37.5bn loan aimed at stemming a cash drain from the insurer’s securities lending unit. AIG has drawn down more than $81bn of the combined $122.5bn facility. The company’s efforts to begin repaying it before the 2010 deadline have been hampered by its difficulties in selling assets amid the global financial turmoil. AIG executives have complained to government officials that the interest rate on the initial loan – 8.5 per cent over the London Interbank Borrowing Rate – is crippling the company.
They compared the loan’s terms with the 5 per cent interest rate paid by the banks that recently sold preferred shares to the government. One of AIG’s proposals to the Fed is to swap the loan, which gave the authorities an 80 per cent stake in the company, for preferred shares or a mixture of debt and equity. Such a structure would reduce the interest rate to be paid by AIG and possibly the overall amount it has to repay. An extension in the term of the loan from the current two years to five years is also possible, according to people close to the situation. The renegotiation of the loan could be accompanied by the government’s purchase of billions of dollars in mortgage-backed securities whose steep fall in value has been draining AIG cash reserves.
AIG is also proposing the government buy the bonds underlying its troubled portfolio of credit default swaps in exchange for the roughly $30bn in collateral the company holds against the assets.Losses on the mortgage-backed assets, which were acquired by AIG with the proceeds of its securities lending programme, and the CDSs caused the company’s collapse. Since the government rescue, they have continued to haunt AIG, which is required to put up extra capital every time the value of these assets falls. AIG and the Fed declined to comment.
100 days to save the American car industry
President-elect Barack Obama has been given 100 days to save the American motor industry from collapse. Industry executives have warned him that up to 3m jobs could be lost unless the Big Three - General Motors, Ford and Chrysler - are bailed out with fresh loans of up to $50bn (£30bn). The US industry is bleeding to death. It is haemorrhaging sales, cash and jobs.
With sales at a 25-year low, GM and Chrysler could run out of cash within months. If the Big Three "simply" halved output, 2.5m jobs would be lost and government coffers would lose $100bn over three years, analysts said this week. The impact of the credit crunch and demise of consumer confidence is so marked that the new leader's traditionally critical 100 days began on election night, rather than starting from Obama's inauguration on January 20. The first African-American president of the US, burdened with excessive expectations that he can solve the global financial crisis, has to decide whether to raid the $700bn troubled asset relief programme (Tarp) set aside for banks and insurers to rescue Detroit.
But the American industry is not alone. No carmaker - European, Japanese or Asian - is immune from the contagion of frozen credit. Toyota, the world's biggest and most profitable auto group, reported this week a 69% plunge in second-quarter earnings and warned that its full-year profits were on course for their biggest fall in 13 years. In Europe, BMW, the world's leading premium carmaker, yesterday scrapped its target of reaching a new sales record this year after October deliveries fell 8%. Daimler, which owns Mercedes, said global sales had dropped 18%. The German industry expects exports this year to be at their lowest for five years.
Anticipating an even worse market in 2009, with sales at their lowest for more than a decade, European carmakers such as Peugeot-Citroën are shutting down plants and preparing to axe thousands of jobs. Only Volkswagen, now the world's third-largest group by sales, is sticking to its targets of surpassing last year's historic highs for sales and profits in 2008. But even it is wary of promising a repeat in 2009. And Porsche, the ultra-profitable sports carmaker, is expected this month to give a bleak outlook for next year. In Britain, where sales last month fell by the greatest amount for 17 years, the industry reckons that output will fall below 2m in 2009.
There is a glimmer of hope that the pound's fall against the dollar will help exports. But Jaguar Land Rover, owned by India's Tata, is introducing short-time working and seeking 600 voluntary redundancies. Others, including GM's Vauxhall, BMW, Nissan and Honda, are curbing production through short-time working or temporary shutdowns of plants.
Thursday's 1.5% cut in UK interest rates was welcomed by the industry but, as Paul Everitt, chief executive of the Society of Motor Manufacturers and Traders, points out, the issue is whether the Bank of England's decision is reflected in rates charged to consumers. Eric Wallbank, UK head of automotive at accountants Ernst & Young, said this week: "As the UK economy contracts and both corporate and consumer confidence weakens further, the effects will be felt on the forecourts of car dealerships and on the factory floors of vehicle manufacturers and suppliers."
There are two main reasons for the global industry to be in such dire straits. First, and most obvious, the myth that emerging economies could be "decoupled" from the downturn in the developed world has exploded. US and European carmakers that flocked to the "Bric" countries - Brazil, Russia, India and China - to offset problems at home know that at first hand. Sales in Russia, where GM opened its first wholly owned, $300m plant in St Petersburg yesterday, have this year halved from 2007 as banks kept afloat by state loans stop lending to consumers. Russia was due to leapfrog Germany and become Europe's biggest car market next year. Undaunted, Carl-Peter Forster, head of GM Europe, said that Russia would still be its biggest European market in 2009.
China's once overheated market, growing at 25% a year, has now slowed to a crawl as consumer confidence follows stock and property markets into freefall. Growth will be, at best, below 10% this year and probably flat next year. Sales in neighbouring Vietnam plunged 37% in October. A second reason for the global crisis is that, as credit has frozen, consumers are no longer as tempted to pay more for the smaller, more fuel-efficient models built by the Europeans and Japanese and, belatedly, being developed by Detroit's Big Three with the help of the first $25bn "soft" federal government loan package.
Sales in France, kept up by the government's "bonus/malus" scheme that cuts the cost of "green" cars and raises that of gas-guzzlers, have begun to plummet. The German government, as part of its overall €50bn (£40bn) economic stimulus package adopted this week, is offering licence-free holidays to boost demand. But the European industry, already lobbying to relax tough new EU carbon emissions limits, now wants a more comprehensive package: a €40bn bail-out.
A year ago, in Detroit, Obama assailed the US industry for failing to meet global demand for fuel-efficient cars. "The need to drastically change our energy policy is no longer a debatable proposition," he said. "It's not a question of whether, but how; not a question of if, but when. For the sake of our security, our economy, our jobs and our planet, the age of oil must end in our time." Yesterday, as the Big Three reported billions of dollars of losses, the immediate question facing the man whose rallying call to the nation on election night was "Yes, we can" was: "Will you put that long-term perspective to one side and save us now?"
GM Says It May Not Have Enough Cash to Finish Year, Suspends Merger Talks
General Motors Corp., seeking U.S. aid to avoid collapse, said it may not have enough cash to keep operating this year and will be "significantly short" by the end of June unless the auto market improves or it adds capital. Available cash fell to $16.2 billion on Sept. 30 from $21 billion at the end of June, the largest U.S. automaker said yesterday as it reported a $4.2 billion third-quarter operating loss. Merger talks with Chrysler LLC were suspended.
"Things are clearly deteriorating more quickly than people expected," said Jill Fields, who manages $2 billion in high- yield debt as managing director at Babson Capital Management LLC in Springfield, Massachusetts. "They're either going to need aid or they're at risk for filing" for bankruptcy. GM's outlook and Ford Motor Co.'s $7.7 billion cash burn added urgency to automakers' pleas for government help after a quarter in which U.S. industrywide sales plunged 18 percent. The companies are asking for $50 billion in new loans, a person familiar with the plan said.
Chief Executive Officer Rick Wagoner, Ford's Alan Mulally and Chrysler's Robert Nardelli renewed the push for assistance in meetings with U.S. House and Senate leaders in Washington on Nov. 6. Wagoner said GM also has been in contact with the staff of President-elect Barack Obama. "We have sufficient liquidity to continue on plan," Mulally, 63, said in an interview with Bloomberg Television. Dearborn, Michigan-based Ford reported an operating loss of $2.98 billion. Ford rose 4 cents to $2.02 in New York Stock Exchange composite trading, paring the shares' decline this year to 70 percent. Detroit-based GM fell 44 cents, or 9.2 percent, to $4.36. The stock has tumbled 82 percent this year.
Yesterday's cash forecast was the bleakest yet from GM, which has lost almost $73 billion since the end of 2004. Using $6.9 billion in cash last quarter pushed GM closer to the $11 billion minimum it says is needed to pay bills. A bankruptcy filing "would be a disaster far beyond General Motors and a sad chapter in American history," Wagoner, 55, said in a Bloomberg Television interview. GM said on Oct. 24 that bankruptcy "is not an option." Should GM take such a step, the result would be 2.5 million jobs lost in the first year among automakers, suppliers and related businesses, according to a Nov. 4 report by the Center for Automotive Research, based in Ann Arbor, Michigan.
A U.S. rescue package for GM, Ford and Chrysler is likely before President George W. Bush leaves office in January, said Dennis Virag, president of Automotive Consulting Group in Ann Arbor. "Either the federal government provides money for a bailout and lets the industry retool, restructure, and move ahead, or the industry dies," Virag told Bloomberg Television. Babson Capital's Fields said GM and Ford bonds already are trading at "bankruptcy levels," so the automakers are relying on "a political decision" to avert that fate. She wouldn't say whether the holdings she manages include GM or Ford debt. GM's 8.375 percent bond due in July 2033 fell 4.3 cents to 24 cents on the dollar, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. The debt yields 34.83 percent.
Ford's 7.45 percent note due in July 2031 dropped 3.5 cents to 34 cents on the dollar, yielding 22 percent. While GM didn't specify any prospective partners in saying merger discussions were being halted, the biggest U.S. automaker had been in negotiations on a tie-up with Auburn Hills, Michigan-based Chrysler, people familiar with the plans said. Consideration of a strategic acquisition was "set aside" to focus on "immediate liquidity challenges," GM said. GM's per-share operating loss was wider than the average estimate on an adjusted basis of $3.94, based on 10 analysts surveyed by Bloomberg. Including a non-cash, $4.9 billion one-time gain related to unloading retiree medical bills, GM had a net loss of $2.5 billion, compared with a $38.9 billion year-earlier loss on a tax-accounting charge.
GM's auto sales in the U.S., its largest market, fell 21 percent. GM's cash use in the fourth quarter should be closer to the levels in this year's first and second quarters, when it was about $3.6 billion, Chief Financial Officer Ray Young said on a conference call. GM said it is trying to boost cash by $20 billion by the end of next year, an increase from a July 15 plan for $15 billion. Asset sales, a part of the strategy, have been hampered because potential buyers can't get financing, Chief Operating Officer Fritz Henderson said. GM's Hummer brand of sport-utility vehicles is among the businesses on the block.
Ford also said it was accelerating savings programs including a 10 percent reduction in salaried-job costs, expanding on a 15 percent slash this year; deeper cuts in production; and a smaller capital-spending budget. The per-share operating loss of $1.31 was wider than the 93-cent average of 10 analyst estimates compiled by Bloomberg. Revenue plunged 22 percent to $32.1 billion. The loss for Ford excluded a gain for shedding future retiree medical bills under a new union contract. Including the gain, Ford had a net loss of $129 million, or 6 cents. The net loss a year earlier was $380 million, or 19 cents. Ford's U.S. auto sales tumbled 25 percent in the quarter.
GM grapples to avoid filing bankruptcy as cash vanishes
General Motors Corp., for 77 years the world's largest automaker and an icon of American industry, revealed a dire financial outlook Friday that has the company teetering on the edge of bankruptcy. Ford Motor Co. delivered its own grim forecast -- although not immediately as dire as GM's position. Hemorrhaging cash and with sales dropping to 25-year lows last month, the Detroit automakers announced financial results that show they each are burning through more than $2 billion a month to maintain operations.
GM warned that its cash reserves could sink below the minimum level it needs to operate by year's end unless it gets federal aid or can tap other resources. GM Chairman and Chief Executive Officer Rick Wagoner said the company will take every step possible to avoid bankruptcy -- which GM continues to insist is not an option -- as the automaker attempts to survive the squeeze of a global credit crunch on vehicle sales. "We're convinced that the consequences of bankruptcy would be dire," Wagoner said. "We need to find a way to get through this, and that's really our focus." GM, Ford and Chrysler LLC are seeking federal loans to help them weather the financial crisis and move forward to retool their companies.
GM reported a net loss of $2.5 billion in the third quarter and said it burned through $6.9 billion in cash to end September with $16.2 billion in cash. That is just barely above the $11 billion to $14 billion GM said it needs to operate and doesn't include its cash burn from October. The mounting losses led GM to announce:
• It's putting merger talks with Chrysler LLC on hold.
• It will cut 3,600 hourly workers and eliminate about 2,000 more salaried jobs.
• It will cut costs by $5 billion in addition to its July plan to cut $10 billion in costs and raise another $5 billion through new debt and asset sales.
"Even if GM implements the planned operating actions that are substantially within its control, GM's estimated liquidity during the remainder of 2008 will approach the minimum amount necessary to operate its business," Chief Financial Officer Ray Young said during a conference call with analysts. By no later than next June, the automaker said, it would fall significantly short of the amount needed to operate. GM wouldn't say how much cash it had on hand at the end of October, but analysts say they believe the automaker is operating very close to its minimum level and must receive substantial government aid to avoid bankruptcy. GM shares closed Friday down 44 cents, or 9.2%, at $4.36 per share.
Top executives of GM, Ford and Chrysler and the UAW president met with Congressional leaders Thursday to discuss getting a reported $50 billion in loans to help the companies withstand the weak economy and pay for future needs. The money would be in addition to $25 billion in loans that Congress passed in September to help retool auto plants to build more fuel-efficient vehicles. GM and other U.S. automakers need such aid or the domestic auto industry will fall, taking with it nearly 3 million jobs and demolishing the retirement funds of people throughout the country, analysts said. For every job in an assembly plant, there are 7.5 jobs with auto parts suppliers and other companies.
A traditional bankruptcy wouldn't work for GM, said Jim Hall, director of analysis for 2953Analytics. "Their contingency plan is they need a government bridge loan," he said. "As soon as they announce a bankruptcy, their buyer base will dry up. Their supplier base will dry up. As soon as the sales drop, there would be dissolution." Perceptions of running out of cash can quickly turn into reality at a company like GM. At year's end, GM's outside auditors have to say whether there's substantial doubt about the company's ability to be, in business parlance, a going concern. If the auditors make such a statement, GM will violate a number of credit agreements, including at least $6 billion in loans -- which banks could call back immediately. The automaker would either have to get a waiver from its lenders or secure even more loans.
In the meantime, GM said it is doing everything within its power to conserve cash without seriously damaging the product plans it views as vital to generating future revenue. Because of the seizing of credit markets and the precipitous drop in U.S. sales in the last few months, GM has said the plan it announced in July to conserve and raise $15 billion in cash will no longer be enough for the automaker to survive through 2009. The automaker said it is on track to or has completed most of the $10 billion in cost cuts it announced in July, but the company said it is unable to borrow the $2 billion to $3 billion it planned to borrow and can no longer count on raising $2 billion to $4 billion through asset sales. The automaker is seeking buyers for its Hummer brand of SUVs, the ACDelco parts distribution division and a manufacturing plant in Strasbourg, France.
The automaker announced $5 billion in additional cost-cutting actions Friday and said it is now basing its business plan on much lower U.S. sales expectations than it did for its original July 15 restructuring plan. At that time, GM made its plans based on U.S. industry light vehicle sales of at least 14 million, which at the time seemed conservative to most analysts. In 2007, U.S. consumers purchased 16.2 million vehicles. So far this year, however, the U.S. auto industry is on track to sell only 13.8 million light vehicles. So GM has adjusted its business plan to be prepared for U.S. light vehicle sales of 11.7 million in 2009 and 12.7 million in 2010.
Based on those new projects and its dwindling cash reserves, the automaker said it amended its July cost-cutting with $5 billion more in cuts. Those include:
• Cutting another $500 million in salaried costs for a total elimination of more than 7,000 U.S. and Canadian salaried and contract employees, including the approximately 5,000 announced July 15.
• Cutting capital spending in 2009 to $4.8 billion from a planned $7.2 billion by reducing program spending.
• Slashing structural costs by $1.5 billion in addition to the $2.5 billion planned in July by further cutting things such as spending to trim the dealer network and engineering expenses.
• Reducing working capital expenses an additional $500 million.
As part of its production cuts, GM on Friday also announced plans to indefinitely lay off 3,600 hourly workers at 10 plants beginning early next year as it slows the rate of production at those plants in response to the slackened consumer demand for new vehicles. Still, absent a dramatic and unexpected turnaround in the global economy and auto industry, GM said it must have outside help to weather the credit crunch.
Why GM Says Bankruptcy Is an Impossibility
One must be careful when using the B word, as the mere mention of the word bankruptcy can be a self-fulfilling prophecy. Then there is General Motors, which posted a staggering third-quarter loss and surprised the market with the rate at which it is burning cash. The auto maker today declared that its cash position, at $16.2 billion, isn’t enough to keep it going through next year without immediate government intervention. It needs $11 billion to $14 billion on hand just to pay its monthly bills. It wants money. It needs money. And that is causing some to throw around that B word: The “third-quarter results made it clear that, without government intervention, GM is headed for bankruptcy,” Gimme Credit auto analyst Shelly Lombard said.
And yet GM executives refuse to blink, sticking to their guns when it comes to insisting that the General isn’t interested in a Chapter 11 filing to fix its problems. On Wednesday night, in a speech given to auto suppliers, GM North America President Troy Clarke said there are a few reasons the company isn’t rushing to bankruptcy court. First, obtaining debtor-in-possession financing would be practically impossible, given the state of the credit markets and the size of GM’s obligations. Clarke then went on to say that GM has worked to solve two of the issues that many companies use Chapter 11 to fix: legacy costs and capacity utilization. Last year, GM brokered a historic deal with the United Auto Workers allowing it to eventually shed health-care obligations and potentially cut labor costs, such as wages and benefits. On the capacity side, Clarke said GM has worked extensively in the past three years to shave its manufacturing footprint in the U.S. to an appropriate size.
Of course, GM has to wait until 2010 and pay out $7 billion to take advantage of that UAW deal. And, with U.S. automobile demand collapsing further each month, GM’s capacity issues look to be far from solved. Interestingly, he avoided any mention of the concern GM often attaches to bankruptcy speculation: that people won’t buy cars from bankrupt auto makers. GM Chief Executive Rick Wagoner wasn’t as circumspect Friday. During an interview with Fox Business News, he was asked why the company doesn’t just utilize the bankruptcy method to recapitalize itself, given that some observers suggest such a method would be much easier than the out-of-court headaches GM has been managing over the decade.
“The analysis is wrong,” Wagoner said. “What is left out in that is it assumes people will keep buying your cars, and unlike airlines–(where people) pay $300 for a ticket and use it three days from now–it’s quite a bit different than paying $25,000 and paying on getting service and support for the car you just purchased for the next five or 10 years. “In fact, there has been some independent research that was done as recently as June of this summer which asks for every manufacturer, ‘if this manufacturer were in bankruptcy would you buy a car from them?’ Eighty percent of the people said they would immediately take that manufacturer off their list.”
Wagoner said that, in light of people’s reluctance to shop a bankrupt car company, a Chapter 11 filing may actually be impossible for GM. “If your revenue line falls, you would not be talking about a reorganization, you would be talking about a liquidation.” In a conference call Friday, Mr. Wagoner said “this is the kind of thing we could speculate (on) endlessly.…We’re convinced the consequences of bankruptcy would be dire.” GM’s solution? “We’re going to get creative, we’re going to get creative here,” Chief Financial Officer Ray Young said.
Moody's cuts MBIA to junk status
Moody's Investors Service on Friday cut its ratings on MBIA Inc's insurance arm and also sent ratings on the holding company's debt into junk territory, citing diminished business prospects and a weaker financial profile. Moody's cut bond insurer MBIA Insurance Corp two notches to "Baa1," the third-lowest investment grade, and cut MBIA Inc's debt two notches to "Ba1," one step below investment grade.
MBIA's business has suffered from "its exposure to losses from U.S. mortgage risks and disruption in the financial guaranty business more broadly," Moody's said in a statement. Moody's said it also expects MBIA to have more losses from mortgage related securities, and that losses may also spread to other forms of debt it insures. MBIA responded in a statement that it disagrees with the downgrade, but said it will have little direct impact on the firm.
"Our policy-holders and debt holders can rest assured that we will meet our obligations to them on time and in full and that we are doing everything we can to ensure that MBIA weathers the current financial crisis," MBIA Chief Executive Jay Brown said in a statement. "In addition, as a result of the portfolio rebalancing that we began in the second quarter, we have sufficient liquidity to meet all termination payments due on our Guaranteed Investment Contracts as a result of the downgrade," he said.
Moody's on Wednesday cut its ratings on MBIA's competitor Ambac Financial Group, sparking a cash shortfall at its finance unit that required the transfer of assets from the insurance arm to cover collateral needs.
Ambac downgrade threatens solvency, CDS markets
The downgrade of Ambac Financial Group's insurance arm by Moody's Investors Service significantly increases the risk of the bond insurer failing, and also threatens large losses in the $47 trillion credit derivative market. Moody's on Wednesday cut Ambac Assurance Corp's rating four notches to "Baa1," the third-lowest investment grade, from "Aa3," following the company's third quarter loss. The downgrade required Ambac to post additional collateral against some of its contracts, which created a $2.3 billion cash shortfall at its financial services unit, according to JPMorgan.
This was only resolved after the Wisconsin insurance regulator allowed Ambac to transfer funds from its insurance unit to the financial services unit to cover the collateral needs. "The future of Ambac remains an open question," JPMorgan analyst Eric Beinstein said in a report on Friday. "We believe that access to TARP money is an urgently relevant question for the survival of the company," he added. "The risk of an Ambac credit event has thus significantly increased." Since June, when Ambac was stripped of its "AAA" ratings, the insurer's ability to write new business has come to a virtual standstill. Continuing deterioration in housing and the economy, meanwhile, makes it more likely the company will face more claims on mortgage debt it has insured.
"The company's business model is essentially broken, it's not going to be able to underwrite any significant volume of new business at any point in the foreseeable future, which probably suggests runoff as being at least the near-term and intermediate status quo for them," said David Havens, desk analyst at UBS in Stamford, Connecticut. "The credit market conditions continue to worsen and we're seeing a transition from unrealized losses into realized losses, which are going to in all likelihood adversely affect the solvency of the company," he added. Even if the company survives, the downgrade itself is likely to lead to a myriad of credit derivative losses.
Ambac sold insurance on around $60 billion of corporate, sovereign, asset-backed and other debt, mainly using credit default swaps. As concerns about the company's health increase, investors and banks that bought protection from Ambac may unwind their deals to offset the risk of Ambac's failure, JPMorgan said. The insurer itself, meanwhile, is also referenced in around 55 percent of synthetic Collateralized Debt Obligations -- structured deals backed by credit default swaps, the bank added. "Ambac's downgrade will likely lead to further rating downgrades in the synthetic CDO space, and its spread widening is causing further mark-to-market losses for these structured products," said JPMorgan's Beinstein.
Investors and dealers hedging, restructuring or unwinding these deals may send spreads on credit default swaps on individual companies and on indexes wider. Meanwhile Ambac's Guaranteed Investment Contracts (GICs) were used as collateral posted against certain types of synthetic CDOs. And these may be forced to unwind as a result of the downgrade, Beinstein said. "Even without failing to meet GIC's collateral requirements, Ambac's severe ratings downgrade will lead to synthetic CDO unwinds," he said. "As with the reference and counterparty risks, the collateral risk increases the pressure on spreads to widen across all credit derivative markets."
One potentially bright point for Ambac's liquidity would be if it makes agreements with counterparties to tear up contracts on risky residential mortgages. Ambac said in a response to Moody's downgrade on Wednesday that the rating agency failed to account for the early termination of some of its contract exposures, and for federal efforts to improve the liquidity of financial institutions. "Something that could change the game and prevent them from becoming even more unhealthy, would be to commute a substantial number of the chunky ABS CDO exposures and risks they have," said UBS' Havens. "That could very substantially improve their prospects."
Ambac Calls for Government Intervention
Continued deterioration in the housing market has taken another painful bite from the third-quarter earnings of bond insurers Ambac Financial Group and MBIA Inc. Ambac posted a net loss of $2.4 billion due to mark-to-market losses from collateral debt obligations in its asset-backed portfolio. And MBIA stomached an $806 million net loss in the quarter as mortgage default rates increased, and forced it to increase reserves for its residential mortgage-backed securities or RMBS portfolio. MBIA's revenue fell 25% to $319.8 million, while Ambac's $2.32 billion revenue was in negative territory.
The companies say the losses do not threaten their solvency, although both are hoping for federal government intervention to provide liquidity to the capital markets and stabilize the housing market. During an earnings conference call, Ambac reiterated its position that the company's problems are systemic to the financial industry, and that it's in the interest of taxpayers to include bond insurers in the Treasury Department's Troubled Asset Relief Program provisions.
'We believe absolutely that we are systemic. I'm talking about the industry. This is an Ambac begging bowl,' said David Wallis, Ambac's chief executive officer. 'Why are we systemic' Well, I think we all know our place in the municipal industry. I think also there are other effects. There are effects upon the holders of insured debt and counterparties.' Wallis argued that the Treasury Department should take more interest in companies that have a chance of surviving. 'Clearly, it's not in the interest of taxpayers'to prop up a failing institution. We think our issues are liquidity, not solvency'Treasury and others need to be persuaded of that fact because they don't want to throw good money after bad.'
Unlike Ambac, MBIA does not seek direct assistance from the government. 'As long as the government is successful in achieving its objectives to return liquidity to the capital markets and stabilize the ultimate housing market, we should experience lower losses on our insured credits,' Jay Brown, the company's chairman and CEO, said in a statement. MBIA has filed suit against two large mortgage lenders of its second lien RMBS due to alleged negligent and deficient lending standards. Brown said MBIA is hoping to 'recover a significant portion of the harm that we have already suffered' through the lawsuit.
Warren Buffett's investment firm Berkshire Hathaway reports huge losses
Berkshire Hathaway, the investment firm run by Warren Buffett, the world’s richest man reported a 77 per cent drop in third-quarter profits, as a $1.01 billion loss on derivatives and other investments combined with sharply reduced results from its operations across the board. The group announced net earnings of $1.06 billion, it’s fourth straight quarterly decline, down from $4.55 billion the year earlier as so-called operating earnings on its insurance underwriting business plummeted by 83 per cent.
Profits on investments made by Berkshire’s insurance unit fell by 12 per cent to $809 million in the third quarter, while the non-insurance businesses it owns contributed a collective profit of $1.08 billion, 7.8 per cent down. Berkshire’s operating profit fell 18 per cent to $2.07 billion, or $1,335 per share, from $2.56 billion, or $1,655. It fell short of analysts' average expectation of $1,429 per share. Revenue fell 7 percent to $27.93 billion. Last month, Mr Buffett threw his weight behind US stocks as the man who has always invested his own money in government bonds revealed that he had recently switched most of his personal account into American shares.
In an editorial published in yesterday's editions of The New York Times, Mr Buffett, the head of the Berkshire Hathaway investment group and the world's richest man, acknowledged that the economic outlook was dire and described the financial world as being in a mess. The man known as the Sage of Omaha, wrote: "Its problems, moreover, have been leaking into the general economy and the leaks are now turning into a gusher. In the near-term, unemployment will rise, business activity will falter and headlines will continue to be scary."
Mr Buffett's conclusion is to buy shares in US companies. "I have been buying American stocks. This is my personal account I am talking about, in which previously I owned nothing but US government bonds. If prices keep looking attractive, my non-Berkshire net worth will soon be 100 per cent in US equities." Although most of Mr Buffett's wealth is tied up in Berkshire Hathaway, his personal investments are thought to run into tens, if not hundreds, of millions of dollars.
Regulators shut banks in Texas, California
Regulators shut down Houston-based Franklin Bank and Security Pacific Bank in Los Angeles on Friday, bringing the number of failures of federally insured banks this year to 19. The Federal Deposit Insurance Corp. was appointed receiver of Franklin Bank, which had $5.1 billion in assets and $3.7 billion in deposits as of Sept. 30, and of Security Pacific Bank, with $561.1 million in assets and $450.1 million in deposits as of Oct. 17.
The co-founder and chairman of parent Franklin Bank Corp., Lewis Ranieri, is credited with inventing mortgage-backed securities two decades ago, but apparently was unable to save his own company from getting ensnared in the home-loan bust. The bank's failure is a bitter irony because it is the mortgage securitization business of which Ranieri is known as a pioneer — the repackaging of home loans as bonds that are sold to investors — that was at the heart of the mortgage and credit crises. Last spring, the audit committee of the company's board found in an investigation certain weaknesses in accounting, disclosure and other issues relating to residential real estate loans.
Franklin Bank Corp. just Sunday said it had received proposals for transactions to strengthen Franklin Bank's capital position and was keeping regulators informed of the talks' progress. The FDIC said all of Franklin Bank's deposits will be assumed by Prosperity Bank of El Campo, Texas. Its 46 offices will reopen as branches of Prosperity Bank with their normal business hours, including those that open on Saturday. In addition to assuming Franklin Bank's deposits, Prosperity Bank also will acquire about $850 million of the failed bank's assets. Parent company Franklin Bank Corp. just Sunday said it had received proposals for transactions to strengthen Franklin Bank's capital position and was keeping regulators informed of the talks' progress.
Meanwhile, all of Security Pacific's deposits will be assumed by Pacific Western Bank of Los Angeles. Its four offices will reopen Monday as branches of Pacific Western, a unit of PacWest Bancorp. In addition, Pacific Western will purchase around $51.8 million of Security Pacific's assets.The FDIC will retain the remaining assets of the two banks for eventual sale. The agency said depositors of Franklin Bank and Security Pacific Bank will continue to have full access to their deposits, which will continue to be insured by the FDIC.The FDIC estimated that the resolution of Franklin Bank will cost the federal deposit insurance fund between $1.4 billion and $1.6 billion, while that of Security Pacific Bank will cost the fund $210 million.Regular deposit accounts are now insured up to $250,000 as part of the new financial rescue law enacted in early October. The limit on individual retirement accounts held in banks remains at $250,000.
The 19 bank failures so far this year compare with three for all of 2007 and are more than in the previous five years combined. It's expected that many more banks won't survive the next year of economic tumult. The pressures of tumbling home prices, rising mortgage foreclosures and tighter credit have been battering many banks, large and small, across the nation.The failures this year include that of Seattle-based thrift Washington Mutual Inc. in late September, the biggest bank collapse in history. It had $307 billion in assets. In July another big savings and loan, IndyMac Bank based in Pasadena, Calif., failed and was seized by regulators with about $32 billion in assets.
The FDIC estimates that through 2013 there will be about $40 billion in losses to the deposit insurance fund, including an $8.9 billion loss from the failure of IndyMac Bank. The FDIC is raising insurance premiums paid by banks and thrifts to replenish its fund, which now stands at around $45.2 billion, below the minimum target level set by Congress and the lowest level since 2003.In addition, the FDIC may guarantee nearly $2 trillion in U.S. banks' debt and deposit accounts in an effort to break the crippling logjam in bank-to-bank lending.
Well over half of the roughly 8,500 federally-insured banks and savings and loans are expected to tap the FDIC's temporary guarantees. The agency will provide as much as $1.4 trillion in insurance for more than three years for loans between banks, guaranteeing the new debt in the event the issuing bank fails or its holding company files for bankruptcy..
Regulators Seize Bank Founded by Mortgage-Backed Securities Pioneer
Federal regulators last night seized a Texas bank founded by Lewis Ranieri, a Wall Street legend who grew rich in the 1980s as the pioneering salesman of a new investment product called the mortgage-backed security. Franklin Bank, based in Houston, described Ranieri in a securities filing last year as "the father of the securitized mortgage market."
Now the bank has become the latest victim of a crisis that began with the collapse of the market Ranieri helped to create. The bank funded billions of dollars in home mortgage loans and also loaned billions to residential developers. As defaults rose, the bank concealed some of its losses, it disclosed this spring. By fall it was out of money.
Franklin, which held $5.1 billion in loans and other assets, is the third-largest bank to fail this year, behind Washington Mutual and IndyMac Bancorp. The bank's deposits and its 46 branches were sold to Prosperity Bank of Texas. The failure is a personal setback for Ranieri, who served as the bank's chairman and then took over as chief executive in May.
Ranieri was immortalized by Michael Lewis in "Liar's Poker," which told the story of Ranieri's rise from the mailroom to the office of vice chairman at Salomon Brothers, largely by packaging mortgages into securities and finding investors willing to try something new. During the housing boom, Ranieri was celebrated for that achievement. The appetite of investors for mortgage-backed securities made it possible for almost anyone to get a mortgage loan.
Even as it became clear that too much of a good thing was not a good thing, Ranieri remained influential. Robert K. Steel, then the Treasury undersecretary for domestic finance, sought out Ranieri's advice last August, in the early days of the mortgage crisis. Ranieri told Steele that most mortgage-backed securities remained good investments, but investors had simply lost confidence. Also yesterday, regulators seized Security Pacific, a small Los Angeles bank with four branches and about $560 million in assets. The two seizures raised to 19 the number of bank failures so far this year, compared with three for all of last year.
Pending Sales of Existing Homes in U.S. Fell 4.6%
Fewer Americans signed contracts to buy previously owned homes in September, indicating the credit crisis will inflict more damage on the housing market. The index of signed purchase agreements, or pending home resales, fell 4.6 percent, more than forecast, to 89.2, the National Association of Realtors said today in Washington. The housing slump may extend well into a fourth year as banks turn away borrowers, foreclosures worsen the glut of unsold homes and job losses climb. Lower property values will keep eroding home-equity, causing consumers to retrench further and reinforcing the risk of a deeper recession.
"The outlook has deteriorated," said David Sloan, a senior economist at 4Cast Inc. in New York, who estimated a 5 percent drop. "The tightening of credit conditions will push pending home sales lower. We're in quite a sharp recession, and housing is part of it." Economists expected pending sales to fall 3.4 percent, according to the median forecast of 30 economists in a Bloomberg News survey. Estimates ranged from a drop of 6 percent to a gain of 1 percent. The jump in August was revised up to 7.5 percent from an originally reported 7.4 percent gain.
A Labor Department report today showed the U.S. unemployment rate rose to 6.5 percent in October, the highest level since 1994, and payrolls plunged by 240,000. Economists said the figures indicate the economy is heading for the steepest decline in decades. The Realtors' group, whose data on pending sales go back to January 2001, started publishing the index in March 2005. Three of four regions saw a drop, led by a 17 percent slump in the Northeast and a 7.9 percent decline in the South. They rose 3.7 percent in the West. Compared with September 2007, pending resales increased 1.6 percent.
Pending resales are considered a leading indicator because they track contract signings. Closings, which typically occur a month or two later, are tallied in the existing-home sales report from the Realtors. An earlier report from Realtors showed purchases of existing homes jumped 5.5 percent in September to a 5.18 million annual pace, the highest level in a year. Foreclosure-related sales accounted for 35 percent to 40 percent of the total, it said. Sales of new houses also increased in September, according to a Commerce Department report on Oct. 27.
Today's report signals the improvement in sales may be short-lived. The lending crisis worsened last month and persistent job losses have led consumers to retrench further. Home prices will likely keep falling, extending the housing recession well into 2009, economists predict. Housing-related companies are bracing for prolonged weakness. Illinois Tool Works Inc., the maker of Duo-Fast nail guns and Wilsonart countertops, predicts home construction won't hit bottom until 2010 because of large inventories and tight lending.
"There are too many issues to be sorted out with both the inventory of existing homes as well as the mortgage market for us to see much change," Chief Executive Officer David Speer said in a Webcast yesterday. "We're going to be in a reasonably long period -- four to six quarters -- before we would see the bottom."
As Giant Rivals Stall, Porsche Engineers a Financial Windfall
Porsche is proving you can still make lots of money in the car business, especially if you know how to wield derivatives. The German sports-car maker said Friday that its pretax profit in the fiscal year ended July 31 soared 46% to €8.57 billion euros, or about $10.9 billion. Eighty percent of that came not from making cars but from sophisticated financial instruments connected to a protracted takeover bid Porsche Automobil Holding SE has been pursuing for a company many times its size, Volkswagen AG.
Porsche's profits on those trades totaled more than the current combined market values of beaten-down General Motors Corp. and Ford Motor Co. The outsize gains were scored by a potato-loving chief executive and his Kafka-reading chief financial officer. They teamed up with the offspring of the Beetle creator to engineer an audacious takeover bid -- and outfox hedge funds at their own game. Porsche is raking in money through a form of options that helped it build up a huge stake in VW since 2005, while keeping other market participants in the dark. The strategy led late last month to a soaring price for VW shares after a Porsche disclosure showed the company, had, in effect, cornered the market on most VW shares. That put investors who had bet against VW stock in the classic bind called a short squeeze. This one was acute: VW's stock spiked so high that VW briefly was the most valuable public corporation in the world.
Hedge funds that had shorted VW shares -- borrowing them and selling them, hoping to replace them later with cheaper shares -- lost billions over a few frantic hours last week as they wrestled each other to buy the few remaining shares available and unwind their bets. Funds affected, according to people familiar with them, include Greenlight Capital, SAC Capital, Glenview Capital, Marshall Wace, Tiger Asia, Perry Capital and Highside Capital. Porsche's earnings report provided the latest evidence that the old-economy manufacturer has been taking a page from hedge funds' playbooks, and seemingly beating them at their own game. Thanks to its trading gains, Porsche's net profit for the year rose 51%, to €6.39 billion, at a time when many auto makers are churning out profit warnings, or worse. And those results don't reflect a potentially massive windfall from its trading activity last month.
The final chapter of the drama hasn't been written. German regulators have launched an investigation into whether there was manipulation of VW shares, after some investors accused Porsche of misleading markets. Porsche says that it hasn't done anything wrong and that the fault for the VW share gyrations lies with short sellers. Porsche, meanwhile, faces other obstacles as it tries to clinch control of VW, a company that boasts 15 times as much revenue and builds 60 times as many cars. Porsche's moves point to the resilience of Deutschland AG, the decades-old network of elaborate cross-holdings that kept companies in domestic hands but had been unraveling. Porsche's VW chase is a kind of corporate German reunification drama: Wolfgang Porsche and Ferdinand Piëch, the board chairmen of Porsche and VW, respectively, are grandsons of Ferdinand Porsche, who created the VW Beetle and founded Porsche before World War II.
The affair traces back to 2005, a time of concern in Germany that VW could be a takeover target of non-German investors and broken up. Private-equity firms, many from the U.S. or U.K., had snapped up more than 5,000 German companies since the late 1990s. Adding to the nervousness, the European Union was trying to strike down a decades-old "VW Law" that capped any single shareholder's voting rights at 20%. In April 2005, Franz Müntefering, the chairman of the then-ruling Social Democratic Party, called non-German financial investors "swarms of locusts" that land on companies and "strip them bare." Wendelin Wiedeking, Porsche's combative CEO, chimed in, telling a newspaper that Germany needed to stick to a "social market" economy that avoided putting shareholders' interests before those of customers, employees, and suppliers.
Mr. Wiedeking had helped steer Porsche out of trouble after taking the wheel in 2003 and pushed profit margins to industry highs. He slashed about a fifth of the work force and imported Japanese-style lean-inventory methods. Once, to drive home the point, he strode across a factory floor and smashed shelves bulging with spare parts. Mr. Wiedeking cultivates a populist persona, even as Porsche sells pricey cars such as the 911. The 56-year-old executive owns a working-class tavern and a small farm, where he harvests potatoes with the help of an old Porsche tractor, distributing sacks of potatoes to employees.
In September 2005 Porsche surprised investors by announcing it would buy a 20% stake in VW, becoming its biggest shareholder in a "German solution" that would avoid any foreign takeover. VW and its home state of Lower Saxony, which held a bit under 20%, welcomed the move by Porsche -- which, significantly, didn't signal that it was interested in a majority stake. Behind the scenes, Porsche Chief Financial Officer Holger Härter was crunching numbers. An economist, Mr. Härter had joined the company in the 1990s after Mr. Wiedeking recruited him from a floor-products firm in a town where they both lived.
Mr. Härter is known as a fan of Franz Kafka and Ludwig II, the 19th-century Bavarian king whose fanciful castles inspired Walt Disney. He also is the chairman of Stuttgart's derivatives exchange, and in the 1990s he developed sophisticated models to hedge Porsche's foreign-exchange exposure. Now he is being credited with drafting the financial road map that put Porsche, which makes 100,000 cars a year, in position to take over VW, which makes six million.
The vehicle: "cash-settled options." The buyer of regular stock options gets the right to buy or sell stock at a certain price by a certain date. But in cash-settled options, as the name implies, the buyer gets the right not to stock but the cash difference between the options' "strike price" and the market price of the shares when the options are exercised. Porsche began buying cash-settled options tied to VW stock in 2005, when VW's share price was below €100. If the price rose, Porsche could exercise the options and receive the difference between the lower strike price and the higher market price. It could then use the money to buy VW shares.
In Germany, an investor needn't disclose ownership of any size holding of options if they are the type settled in cash instead of shares. That allowed Porsche to build a large stake in VW while keeping the rest of the market unaware of its activity. Such options have one other important twist: Banks that underwrite them typically hedge their exposure by holding actual shares. That takes these shares out of circulation. By March 2007, Porsche had boosted its stake in VW to 30%. That triggered a German rule requiring it to make a full tender offer for VW shares. The company said it wasn't interested in a takeover of VW. Forced to make a tender offer, Porsche offered the legal minimum price the law let it offer, which was €100.92 for each voting share. Only 0.6% of the remaining VW shares were tendered.
That November, Porsche announced that for the fiscal year ended July 31, 2007, it had booked a pretax profit of €5.86 billion, including €3.59 billion from "the very positive effects" of VW options. Compensation for Porsche's six-person management board more than doubled, to €112.7 million. Mr. Wiedeking pocketed more than half of that. This past March, Porsche's supervisory board gave the green light to take the VW stake above 50%, and this goal was announced. For the six months ended Jan. 31, Porsche disclosed a pretax profit that included €850 million from "hedging transactions in connection with the acquisition of the VW stake." But Porsche denied growing talk that it was gunning for 75% of VW. In a news release, the company said the possibility of that was "very small indeed" and dismissed it as "speculative mind games of analysts and investors."
In mid-September, Porsche disclosed it had raised its VW stake to just above 35%. At the Paris Auto Show in early October, Mr. Wiedeking told reporters a 75% stake was a "purely theoretical option." On Oct. 24, a Friday, VW's share price closed at €210.85 on Frankfurt's stock exchange. That Sunday, Porsche dropped a bombshell: In a news release, the company disclosed that it owned 42.6% of VW's shares as well as cash-settled options linked to an additional 31.5% of the shares. Porsche also said that it planned to acquire a 75% stake in VW. When financial markets opened Monday Oct. 27, all hell broke loose. Funds that had borrowed VW shares and sold them, expecting no takeover offer and betting the stock would decline, raced to purchase shares to unwind the bets.
There weren't enough to go around. Part of the reason is that underwriters of cash-settled options typically hedge their risk by owning the shares of the company involved. The shares they owned, combined with those Porsche had acquired, added up to 74.1%, and Lower Saxony state owned 20.1%. The result was that while some 12.8% of VW shares were on loan, mostly to short sellers, those that for practical purposes were in circulation amounted to only 6% of VW shares. As hedge funds fought for the remaining VW shares, they drove the stock's price ever higher -- deepening their losses. At the height of the short squeeze on Oct. 28, VW stock briefly topped €1,000, nearly five times as high as on Oct. 24, making VW the biggest company by stock-market value for a few hours.
VW's share price, more recently, has been returning to earth. It ended at €398.21 in Frankfurt Friday, less than half its record high but still nearly twice as high as on Oct. 24. Theories abound about how much money Porsche has made in the process -- and whether its strategy might have gone beyond exercising options when the share price rose. Max Warburton, a senior analyst in London at Bernstein Research, has speculated on a multipart strategy Porsche may have executed, given the company's huge derivatives profits and the way VW's share price has continued to rise in recent months, in contrast to the rest of the auto sector.
Mr. Warburton speculated that Porsche may have lent VW shares it owned to short sellers who were borrowing in order to sell; that when they sold, Porsche may have been the buyer; that when the "shorts" desperately needed to buy shares to close their bets, Porsche may have been a seller at the elevated price; and finally, confident the price wouldn't fall, Porsche may have profited by safely selling put options that convey the right to sell at a set price. A Porsche spokesman said such theories were "not true" because they suggested Porsche broke laws or manipulated markets, and that it didn't. Porsche addressed some specifics of Mr. Warburton's speculation, but not others; it said that the company didn't lend shares -- that, in fact, it considers doing so to constitute market manipulation.
Porsche's CEO, Mr. Wiedeking, has been quiet of late, but a remark that he made in January suggests he isn't likely to get sentimental about hedge-fund losses. "This world is not a playground where children at play are pampered by friendly nannies," he told the company's annual shareholder meeting. Earlier this summer, German auto-parts supplier Schaeffler Group did something similar, secretly cornering about a third of the shares of larger rival Continental AG. Some investors complain that Porsche and Schaeffler have crossed the line of fair play, taking advantage of disclosure rules that are too loose and regulators that are too tentative.
"We need a different approach, with efficient supervision," says Christian Strenger, a board member at DWS, the asset management arm of Deutsche Bank AG, Germany's biggest financial group. But Bafin, Germany's securities regulator, the body investigating Porsche's actions, already has given Schaeffler's conduct a clean bill of health. The German finance ministry says it is considering proposing legislation that would force disclosure in the future of cash-settled options. Any such law could take several months to go into effect.
Finance Minister Peer Steinbrück last month reiterated long-standing calls by the German government for increased international regulation of hedge funds. He also has suggested that "detrimental" short-selling be banned. He has shied away from commenting on the VW case. Some 80% of Germans disapproved of hedge funds in 2005, and that hasn't changed, according to Manfred Güllner, head of Forsa, a polling firm. He also reckons that many Germans like the idea of VW and Porsche, which worked closely together in the 1930s but went their separate ways after WW II, joining forces. "It's history coming together again," he says. "It fits together."
Bloomberg Sues Fed to Force Disclosure of Collateral
Bloomberg News asked a U.S. court today to force the Federal Reserve to disclose securities the central bank is accepting on behalf of American taxpayers as collateral for $1.5 trillion of loans to banks. The lawsuit is based on the U.S. Freedom of Information Act, which requires federal agencies to make government documents available to the press and the public, according to the complaint. The suit, filed in New York, doesn't seek money damages.
"The American taxpayer is entitled to know the risks, costs and methodology associated with the unprecedented government bailout of the U.S. financial industry," said Matthew Winkler, the editor-in-chief of Bloomberg News, a unit of New York-based Bloomberg LP, in an e-mail. The Fed has lent $1.5 trillion to banks, including Citigroup Inc. and Goldman Sachs Group Inc., through programs such as its discount window, the Primary Dealer Credit Facility and the Term Securities Lending Facility. Collateral is an asset pledged to a lender in the event that a loan payment isn't made.
The Fed made the loans under 11 programs in response to the biggest financial crisis since the Great Depression. The total doesn't include an additional $700 billion approved by Congress in a bailout package. Bloomberg News on May 21 asked the Fed to provide data on the collateral posted between April 4 and May 20. The central bank said on June 19 that it needed until July 3 to search out the documents and determine whether it would make them public. Bloomberg never received a formal response that would enable it to file an appeal. On Oct. 25, Bloomberg filed another request and has yet to receive a reply.
The Fed staff planned to recommend that Bloomberg's request be denied under an exemption protecting "confidential commercial information," according to Alison Thro, the Fed's FOIA Service Center senior counsel. The Fed in Washington has about 30 pages pertaining to the request, Thro said today before the filing of the suit. The bulk of the documents Bloomberg sought are at the Federal Reserve Bank of New York, which she said isn't subject to the freedom of information law.
"This type of information is considered highly sensitive, and it would remain so for some time in the future," Thro said. The Fed didn't give Bloomberg a formal response because "it got caught in the vortex of the things going on here," said Michael O'Rourke, another member of the Fed's FOIA staff.
Goldman Faces a Lost Decade
Goldman Sachs Group faces a grim milestone. The Wall Street firm needs to fall only a further 10% to get back to the closing share price on its first day of trading as a public company in 1999. That is perfectly feasible, given how the firm's stock has underperformed even during recent market rallies -- despite Goldman being strengthened by a government guarantee on debt issuances and around $20 billion of new capital.
As Goldman probably heads for its first quarterly loss as a public company, investors appear more worried about the bank's ability to make a decent return on its capital than liquidity fears. It now trades 10% below its tangible net worth, including recent capital raisings. If Goldman believes the pessimism will pass, it may decide to soldier on with its new hoard of capital as an independent firm. Indeed, it still trades at a far richer multiple than rival Morgan Stanley, which trades at 54% of tangible book. But the risk is that the business environment gets even worse and the share price falls still further. Just as Goldman might advise clients, it also needs to consider more radical options. What might they be?
One idea being floated is to take the firm private. While that has a certain symmetry, given the share-price performance, it would be almost impossible because of the difficulty in funding a buyout and the ongoing business in today's environment. Another option would be a breakup, separating the highly regarded advisory business from more volatile trading operations and hedge-fund businesses. However, unlike two years ago, such businesses hardly command attractive valuations. And there would be no easy or cheap way to support the "black box" trading operations once they were split off.
The final option is a merger or big strategic partnership. Buying a bank might help Goldman acquire deposits to provide more stable funding. The trouble is, most banks nowadays also come with a dodgy loan book. And, given the size of Goldman's balance sheet, it would need a lot of deposits to make a difference. If it wanted to fund, say, 40% of its $363 billion of financial assets that aren't in collateralized arrangements, it would need more than $140 billion of deposits.
A merger with a big securities business, like State Street, meanwhile, might add stability. But its superior valuation multiple to Goldman would make it tough to do. That leaves Goldman putting itself up for sale. Again, there are few banks with the stomach and cash to pay $30 billion or more for Goldman right now. At a lower price they may bite. But, they would need to be pretty sure that they wouldn't destroy Goldman's powerful culture. For now Goldman is likely to try soldiering on alone. But the firm needs to map out plan B.
G-20 Urges Stimulus to Ease Impact of Global Slump
Finance officials from the Group of 20 nations will press their European colleagues to join a coordinated stimulus plan to tackle an impending recession when they meet in Sao Paulo this weekend. U.K. Prime Minister Gordon Brown yesterday urged countries to heed the International Monetary Fund's call for coordinated action, even as other European Union leaders fretted about reining in budget deficits. A coordinated package would add 50 percent more to growth than a similar amount spent in ad hoc measures by individual nations, said Carl Weinberg, chief economist at High Frequency Economics in Valhalla, New York.
"There are big areas of difference out there," Weinberg said. "The U.S. and IMF view is clearly that fiscal stimulus is needed. The Europeans are not quite so clear on this." The world's biggest industrialized economies will all contract next year for the first time in more than half a century as the financial market seizure leaves companies and consumers starved of credit, the IMF forecast last week. The G-20 meetings beginning today reunite officials for the second time in a month, after their first-ever emergency meeting in Washington in October. They'll meet again in Washington at a Nov. 14-15 summit of G-20 heads of state.
"It's very clear that to navigate a path through the current difficulties and to regain some momentum in the world economy, the biggest economies need to be working together," U.K. Treasury Minister Stephen Timms said in an interview in Sao Paulo yesterday. The push for coordinated action by the U.S., U.K. and developing nations including Brazil suffered a setback Nov. 6 when France dropped calls for a joint stimulus package. A memo prepared for the French-led summit of EU leaders in Brussels underscored the need for "macroeconomic discipline," bowing to resistance to a pump-priming program. The memo, proposing a European strategy to take to next week's global economic crisis summit in Washington, endorses "macroeconomic policies that are sustainable and oriented toward stability."
"Interest in a fiscal stimulus varies considerably from country to country," Michael Mussa, former IMF chief economist, said in an interview from Washington. "Germany is not very enthusiastic." Central banks are already coordinating their response to the financial crisis, which began with the collapse of the U.S. subprime-mortgage market. The Fed, the European Central Bank and the Bank of England led a coordinated interest rate cut on Oct. 8 and they have all followed up with further reductions in the past two weeks. More coordinated moves are likely, Canadian Finance Minister Jim Flaherty said. "There are ongoing conversations about who plans to do what when," Flaherty told reporters today ahead of the talks. "I expect that these discussions will lead to some degree of coordinated action."
"What we're going to see this weekend is some real momentum for action building up for the meeting in Washington," said U.K.'s Timms, adding that one area of focus will be "international coordination." The finance ministers of Brazil, Russia, India and China issued a joint statement yesterday calling for a coordinated push to halt the spread of financial turmoil. A stimulus plan is "essential" for the global economy, they said. Brazil has been pressing for a greater role for G-20 in resolving the crisis, which has drained capital from Eastern Europe to Latin America at a time when emerging markets are being counted on to sustain almost all of the world's projected 2.2 percent economic growth next year, according to an IMF forecast.
"This is a global crisis and demands global solutions," Brazilian President Luiz Inacio Lula da Silva said today in a speech opening the meeting. "The G-7 alone is not in conditions to conduct the world economy. The participation of the developing world is essential." Canadian Prime Minister Stephen Harper said governments and central banks face a balancing act deciding how much to stimulate the global economy. There is "a very real concern" that policy makers may overdo support for the economy, jeopardizing longer term growth, he said Nov. 6. At the same time, he said his government is not "by any means finished in terms of further steps that have to be taken."
While Europe is dragging its feet on the fiscal stimulus, the U.S. may be the main opponent to tightening up financial regulation. European leaders want to give the IMF responsibility for financial stability around the world. The U.S. opposes any international regulator with cross-border authority, according to a senior U.S. official. This weekend's meeting will explore ways "to regulate global financial transactions that are outside government's control," Brazilian central bank President Henrique Meirelles said yesterday.
One problem facing negotiators today: There will be no representatives to deal with from the incoming administration of President-elect Barack Obama. That limits the scope for a deal ahead of the Washington meeting. House speaker Nancy Pelosi said Nov. 6 that she's negotiating with the Senate and outgoing President George W. Bush a $61 billion stimulus package, the second in a year, and Congress may introduce further measures when Obama takes office on Jan. 20. "The magnitude of action taken is unprecedented in postwar era," Mussa said. "What has not happened is for them to sit in a room and decide anything in coordination."
More than 300 Brits a day file for bankruptcy
Personal insolvencies and company liquidations have surged in a further sign of the financial turmoil taking its toll on the wider economy. More than 27,000 people in England and Wales declared themselves insolvent in the third quarter of 2008, a rise of 8.8 per cent on the previous three months, while 4,001 companies went bust, up 10.5 per cent on the previous quarter and 26 per cent on last year.
The figures from the Government's Insolvency Service showed the economy worsening rapidly amid predictions that it would suffer at least as much as in the recession of the early 1990s. The number of company insolvencies is little more than half the number reached in the depths of the last downturn but with the economy only just starting to slip into recession, analysts said that the worst was to come.
Howard Archer, the chief UK economist at IHS Global Insight, said: "The marked rise in the number of individual insolvencies in the third quarter is only the beginning of the storm as recession, faster rising unemployment, higher debt levels, and more and more people being trapped in negative equity will exact an increasing toll over the coming months."
The Bank of England cut interest rates by 1.5 points on Thursday after data showed the economy grinding to a halt. The International Monetary Fund said the UK would be worst hit as a credit drought made the world's richest economies shrink for the first time since the Second World War. Companies are suffering from a combination of slowing demand, high energy and material costs and a shortage of credit from cash-strapped banks. The Government is applying pressure to banks to keep lending to small- and medium-sized companies to stop them going under.
Personal insolvencies are closely linked to employment rates and house prices. Property values have fallen about 15 per cent from last year's peak, leaving many homeowners in negative equity. Unemployment is rising at its fastest pace since the last recession. David Blanchflower, the strongest advocate of rate cuts on the Bank of England Monetary Policy Committee, has predicted more than two million people will be out of work by year-end.
Experts warned that the figures for personal insolvencies could greatly understate the true plight of debt-burdened consumers because they were turning to informal debt management plans with their creditors, which go unrecorded. There are also signs that households are turning to expensive unsecured borrowing to keep their finances ticking over, but with potentially dire results. Pat Boyden, a personal insolvency expert at PricewaterhouseCoopers, said: "Credit card debt increased by more than £1bn in September, which could point at credit cards being used to supplement normal household expenditure.
"This has the potential to add a significant sum to household expenditure, putting further strain on outgoings and inevitably leading to further insolvencies in the coming months."
Shipowners Idle 20% of Bulk Vessels as Rates Collapse
At least 20 percent of the vessels most commonly hired to haul coal and ore are sitting empty as steelmakers cut output and dwindling trade credit halts deliveries, Lorentzen & Stemoco A/S shipbroker Kjetil Sjuve said. Fifty to 100 so-called capesizes, each bigger than The Trump Building in New York, have been unable to find cargoes or their owners won't accept rental rates that have plunged 98 percent in five months, Sjuve said by phone today. Normally about 250 such carriers compete for spot bookings, he said.
"There are simply no cargoes," Sjuve said from Oslo. "It's primarily the steel market but it's even more difficult due to financial markets and letters of credit in particular." ArcelorMittal, the world's biggest steelmaker, on Nov. 5 said its global output will decline by more than 30 percent. Cia. Vale do Rio Doce, the world's biggest iron-ore producer, last month said it will cut production. Of the $13.6 trillion of goods traded worldwide, 90 percent rely on letters of credit or related forms of financing and guarantees such as trade credit insurance.
Letters of credit are centuries-old instruments that transfer payments internationally from buyer to seller once shipments have been delivered.Capesizes that were attracting rates of $233,988 a day as recently as June are now available for $4,793, according to the Baltic Exchange in London. That's below the cost of paying for crew, insurance, maintenance and lubricants. Capesizes are the second-largest commodity transporters, after very large ore carriers. The Baltic Dry Index, a measure of shipping costs across different ship sizes, has slumped 93 percent from a record in May.
The number of empty capesizes in the spot market may climb to as many as 150 in the next two weeks, said Sjuve, who is a capesize broker. The precise number at anchor is "very difficult to pinpoint" because owners don't often announce it, he said. There are 105 capesizes indicating their status as "at anchor," according to data compiled by Bloomberg. The data doesn't differentiate between ships that are hired and those that haven't got cargoes. On June 30, there were 43. Zodiac Maritime Agencies Ltd., the shipping line managed by Israel's billionaire Ofer family, said last month it was considering idling 20 of its largest ships. Ukraine's Industrial Carriers Inc. filed for bankruptcy protection last month and London-based Britannia Bulk Holdings Plc was placed into administration under U.K. insolvency laws.
As many as 20 percent of shipping lines are at risk of breaching their loan accords because the decline in rents has caused a similar plunge in ship prices, Tufton Oceanic Ltd., the world's largest shipping-hedge fund group, said last month. The 12-member Bloomberg Dry Ships Index has plunged 76 percent from its peak in May, taking its combined market capitalization to $6.7 billion from $27.8 billion. Global ship orders tumbled 90 percent last month, Richard Sadler, chief executive officer of Lloyd's Register, said in an interview yesterday. The full-year order tally will likely fall more than the 15 percent previously predicted, he said.
Key Canadian ports face 'global tsunami' as commodities traffic slows
Canada's ports face challenging months ahead as a global slump in shipping and weakening economies cut into traffic coming in and out of cities such as Vancouver, Montreal and Halifax. The slump will likely be a double blow, hitting inbound and outbound activity. Outbound traffic is lessened as global demand for commodities such as coal, potash and oil falls and inbound traffic, including containers carrying retail goods, gets hit by reduced demand from lower consumer spending in North America.
Port Metro Vancouver, the country's largest port, is already seeing fewer containers arriving in what's normally a busy season ahead of Christmas. The port also expects there could be decline in containers next year. "Needless to say, the second half of this year isn't as good as the first half, and we expect easing off as we head toward Christmas, particularly in the container business," said Christopher Badger, chief operating officer of Port Metro Vancouver. One ominously negative indicator is the Baltic Dry Index, which tracks the cost to ship commodities by sea. The index peaked in May and is down about 90 per cent since then. It has ticked up slightly over the past two days after falling every day for a month.
"It's a relatively good barometer for the economy and the signal it's sending is that we've gone from potentially overheating to ice-cold in the space of six months," said Douglas Porter, deputy chief economist at BMO Nesbitt Burns. The latest figures for ports across North America already show container traffic sliding. The amount of electronics arriving in October was down 9.6 per cent from a year ago and clothing was down 7.8 per cent. Yesterday, the International Monetary Fund cut its forecast for global economic growth in 2009 to 2.2 per cent, down from a prediction of 3 per cent one month earlier. The new forecast is effectively a "global recession," said Jock Finlayson, executive vice-president of the Business Council of British Columbia. The IMF also projected recessions in the United States, Japan and Europe.
"This has got nothing to do with local matters under our control. This is a global tsunami and it's hitting Canada and many businesses," Mr. Finlayson said. "The ports are just another sign of a deteriorating economic picture." About $140-billion worth of goods moves through Canada's ports each year, according to the Association of Canadian Port Authorities. That traffic, in turn, generates more than $20-billion in economic activity and supports 250,000 jobs. Even before the financial crisis this fall, economic cracks were beginning to show at some ports. Port Metro Vancouver saw total tonnage moved in the first half of the year fall 5 per cent, compared with the corresponding period last year. Container traffic was still rising, up 6 per cent.
In Halifax, the port saw a 16-per-cent drop in cargo volumes in the first half of 2008, a trend that remains in place, said George Malec, vice-president of business development and operations for the Port of Halifax. In Prince Rupert, a new $170-million container terminal has capacity to handle 500,000 containers annually but has been slow to fill up, with just 102,775 TEU (20-foot equivalent units - the industry's standard measure) tallied for the first nine months of the year. Some ports are still doing well. The Port of Montreal this week reported container traffic up 9.9 per cent in the first nine months of this year, a trend chief executive officer Patrice Pelletier said remains generally intact. The port is forecasting growth for next year, although Mr. Pelletier said it was trimmed to 5 per cent from 7.
The port is forging ahead with a multiyear expansion outlined in April. A first $185-million phase is under way to handle more containers and a second $250-million phase to build a new container terminal was approved by the port's board of directors in October. "There's obviously problems with the economy and the financial crisis," Mr. Pelletier said. "We also know crises don't last forever. Expanding a port like Montreal is a long undertaking, longer than any crisis."
Magazine Ad Slump Sends Publishers Into Freefall
Magazine publishing, an industry that outpaced U.S. economic growth by 30 percent last year, is now in freefall. Time Inc., publisher of People and Sports Illustrated, will cut 6 percent of its 10,200 employees and incur costs of as much as $125 million to restructure, parent Time Warner Inc. said today. Last month, Hearst Corp.'s CosmoGirl folded and the independent Radar shut down. Conde Nast Publications Inc. ordered companywide job cuts and scaled back Men's Vogue and Portfolio.
The ad slump that hit newspaper publishers last year has spread. Magazine revenue declined 8.8 percent in the third quarter, after rising 6.1 percent in all of 2007, according to the Magazine Publishers of America. Publishers are in a double- bind because they offer discounted subscriptions to attract readers and boost their ad base. "It's time for magazines to look at the model they've worked on, because it's completely broken," said Samir Husni, chairman of the journalism department at the University of Mississippi in Oxford. "Unless it's fixed, we'll see more magazines fail."
Magazines' problems stem from the slowdown of the economy and the travails of Wall Street, Time Inc. Chief Executive Officer Ann Moore said at an Audit Bureau of Circulations conference Oct. 30. U.S. gross domestic product contracted 0.3 percent in the third quarter, its biggest decline since 2001. "By October, it was looking like 1931," said Moore, whose group publishes 24 titles. "We've never had so many advertising clients in trouble at the same time." The economy is only part of the problem, said Husni, who edits the Mr. Magazine Web site. Most U.S. magazines subsidize subscriptions to lure advertisers, who provide up to 80 percent of revenue at some titles, he said.
European magazines charge subscribers more and have smaller staffs, Husni said. The Economist, based in London, costs $116.79 a year, while subscribers pay an average $42 for New York-based BusinessWeek, according to the two magazines. The Economist has about 100 editorial staffers, to BusinessWeek's 200, said Paul Rossi, publisher of the Economist's U.S. edition. "We're about 50-50 in terms of revenue" from subscriptions and ads, Rossi said. "And we've been able to raise our advertising rate base because we've been growing."
Many magazines can't easily recoup ad dollars from circulation because they've trained consumers to expect low prices, said Linda Brennan, BusinessWeek's vice president for worldwide circulation. "Do I think magazines could change their price to $120 from $20 overnight? No," said Brennan, whose publication has raised its average price $2 in the past year. Time Inc.'s Fortune has cut its annual price to $20 in recent years, she said. "They'll never get it back to $40, let alone $120." People is one magazine that can charge a premium, Time Inc. spokeswoman Dawn Bridges said. The company's largest magazine charges $101 a year for subscriptions and rarely gives discounts. "We'd like every magazine to show the growth characteristics of People," Bridges said.
In the U.S. newspaper industry, print ad sales fell 9.4 percent in 2007, according to the Newspaper Association of America. This year, declines accelerated to 16 percent in the second quarter after a 14 percent drop the first. Internet ads aren't helping to recoup the lost revenue, having dropped in the second quarter. About 80 percent of ad-industry magazine sales go to five companies, Husni said. Time Inc. is the largest, followed by Conde Nast, publisher of the New Yorker and Vanity Fair. Esquire publisher Hearst, Elle owner Hachette Filipacchi and Ladies Home Journal publisher Meredith Corp. occupy the next tier.
Ad sales have dropped most at publications serving cyclical industries such as cars, fine dining and home repair. Automobile Magazine, Hearst's Country Home and Conde Nast's Bon Appetit all saw third-quarter ad pages drop 29 percent, the Magazine Publishers of America said Oct. 14. Third-quarter ad pages fell as much as 29 percent across Conde Nast's 26 titles, the New York-based MPA said. "In an economy where marketers want to show short-term results, there's a wariness," about magazines, said ad buyer Jeff Fischer, senior vice president at Universal McCann in New York, part of Interpublic Group of Cos. Monthly magazine ads can take more than two months to generate sales, he said.
"There's no disputing magazines have been hit hard, but marketers are still spending a tremendous amount of money," Fischer said. "Marketers don't doubt the value of an engaged audience." The question is whether that alone will restore profit, Husni said. More than 175 new magazines that publish at least four times annually have opened this year, and the average cover price of startups is twice that of older titles, he said. The pilot issue of Hearst's Food Network magazine went on sale last month with a $1.50-per-copy subscription price and 50 ad pages. Portfolio's first issue last year had 185 ad pages and a 24-issue subscription cost $19.97. The move away from advertising is part of the industry's life cycle, according to Husni. "Give me something I want, and I'll pay for it."
Two or three times a week, Laurence Humeau trudges to the jobs centre near her home in southeast Paris and waits her turn to scroll through the offerings at one of the countertop computers. She has been coming for eight months and never has the wait been longer. “Welcome to the economic crisis,” said Ms. Humeau, a 29-year-old former barmaid, cashier and telemarketer who had to move back in with her parents after her last temporary job ended. “Every day it's more crowded here because every day more of us are being put out on the street.”
The busy Tolbiac neighbourhood jobs centre, a cheerless place of harsh fluorescent lights and bare walls, is a bellwether of the recession settling over France and the rest of the Europe. Financial and economic misery stretches across the length and breadth of the region. While much of the global concern has focused on Wall Street and the U.S. economy, the situation in Europe is even worse. No country has been spared, as the credit crisis has burst bubbles created by cheap debt, flattened business and consumer spending, and compounded existing structural problems. The depth of the European crisis hit home this week as the International Monetary Fund reported that euro zone economies will contract by a combined 0.5 per cent next year and said the damage could be worse than it estimates.
Both inside and outside the shelter of the euro zone umbrella, some countries have fared far worse than others. But the rain is pelting down on everyone, even as panicky governments and the oft-criticized European Central Bank scramble to recapitalize battered banks, free up credit and restore a measure of market confidence. And the umbrella has begun springing serious leaks under the worst strains it has faced since its inception a decade ago. The severity of the slump in the hardest-hit countries is spurring resentment in their better-off neighbours, such as Germany, France and the Netherlands. Taxpayers in those countries have no desire to bail out their weaker currency partners.
The economic pain in the 15-country euro zone is not being spread equally, which is a major source of tension. Countries that grew rapidly thanks to easy credit, such as Spain and Ireland, have been run off the prosperity highway by the collapse of the housing bubble. Some face years of painful restructuring that might have been easier if they had control over their own monetary policy. Others, such as Germany and the Netherlands, have fared notably better, which makes it all the more difficult to apply the euro zone's one-size-fits-all monetary policy. The stresses could end up breaking apart the world's most ambitious currency union. “The euro zone is about to go through the most traumatic time since it came into being,” said Howard Archer, chief European economist with IHS Global Insight in London.
Bond investors are showing their concerns about the zone's future, as spreads between euro bonds issued by the weaker sisters such as Italy and Greece and those of healthier countries such as Germany widen. Speculators aren't wagering that the euro zone will collapse, bond analysts said. But they are making bets that the cracks will widen. But for its member countries, the failure of the monetary union would have such disastrous consequences that it's almost unthinkable. The costs would be astronomical. It would also mean a return to the days when even minor crises could trigger volatile currency swings, undermining economies and putting government balance sheets at risk. “You would have the mother of all financial crises,” said Richard Portes, a professor of economics at the London Business School.
So far, no one is talking of abandoning the euro, and most of the newer members of the European Union from the old Soviet bloc are clamouring to join. Even the Western European members of the EU that chose to retain independent currencies – Denmark, Britain and Sweden – may be having second thoughts about embracing the relative stability of the euro after the beating they have absorbed. Tiny Iceland, which is not part of the EU, certainly wishes it had adopted the euro after its savaged currency become almost worthless. Even the eccentric pop star Bjork has joined a growing Icelandic chorus calling for membership.
Some might wonder why the euro zone is still so attractive to those on the outside looking in. The economies under the umbrella face a world of pain. Spain, for example, is in such bad shape that it faces a prolonged depression, analysts say, with collapsing domestic consumption, a massive current account deficit and unemployment rising above 20 per cent. At the other end of the euro misery scale sit countries like Germany, the Netherlands and France, which managed to avoid a Spanish-style housing explosion but still face tougher economic times ahead. Germany's once-booming, export-driven economy, the largest in the euro zone, has come to a standstill this year. Industrial output fell 3.6 per cent in September, the biggest decline in 14 years. And the economy is expected to contract by as much as 0.8 per cent next year.
On Thursday, French Finance Minister Christine Lagarde gave her most pessimistic prediction yet for France's economy, saying it is now likely to grow by at most 0.5 per cent in 2009. Just last month, she had forecast 1-per-cent expansion. The world financial crisis, she said, “is starting to be felt and is going to last several trimesters.” French unemployment, which only this summer had dropped to its lowest rate since the 1980s, is now expected to rise to 7.4 per cent by the end of the year. At the same time, consumer confidence has dropped to an all-time low. Ms. Lagarde also told the parliament that the country's fiscal deficit would likely reach 3.1 per cent of gross domestic product this year, exceeding the EU's threshold of 3 per cent for euro zone members.
Yet for all that, France is still better off than it was before the euro was introduced, said Jérôme Boué, an economist with Global Equities in Paris. “It's a plus.” Both the financial crisis, and the economic weakness that has flowed from it, would have been considerably worse without the currency and interest rate stability provided by the European Central Bank, Mr. Boué and other analysts said. The situation in the U.S., Britain and Japan is evidence that “it's false to say that you can do better with having an independent national monetary policy,” said Anton Brender, director of economic studies with Dexia Asset Management in Paris. “The question to be asked,” he said, “is how to improve and evolve the European institutions.”
It has been 10 years since the euro zone was launched with great fanfare, no little trepidation and considerable disapproval from a gaggle of vocal critics, including the likes of famed U.S. monetarist Milton Friedman. But the criticism became more muted with the passing years, as the Europeans proved better disciplined than they had been given credit for, and the euro gained entrance into the exclusive club of the world's most trusted currencies. Indeed, the euro became one of the flavours of the decade, soaring nearly 80 per cent against the U.S. dollar between early 2002 and March, 2008, and prompting dreams in Brussels of becoming the leading engine of global growth and wielding the power and influence that would come with such economic clout.
Now, those dreams have been washed away by a tidal wave of gloom, and the question becomes whether the flaws baked into the very structure of the euro zone will sink it as well – or if the Europeans will take advantage of this crisis to make the system more efficient and effective. The policies of the ECB have tended to fall into line with the preferences of the strongest and most influential members, namely Germany and France. In the early years, the ECB ran a loose monetary ship, keeping interest rates low for the sake of the then-stumbling German economy. The excessively low rates, combined with a global credit boom, triggered bubbles in some of the fastest-growing, but weaker, economies.
Inflation was not a problem in Germany and France, but in less wealthy and less structurally sound economies, such as Spain, Ireland and Greece, prices rose dramatically. The ECB couldn't intervene, and the credit bubble ballooned in some countries, but the currency remained strong, masking the problem. Derek Scott, a former economics adviser to then-British prime minister Tony Blair, argues that the very nature of the euro zone played a key role in the creation of the credit bubbles and debt mountains that have blown up so traumatically. “Whatever may have been the mistakes in the United States, it seems to me that the euro zone itself is a structure that, almost by definition, creates asset bubbles, on top of anything that might have been exported by the United States or China.”
Spain, Portugal, Ireland, Greece and a couple of other European countries expanded rapidly thanks to a housing and construction boom, high domestic demand and debt-fuelled consumption. Although they suffered from inflation, a drop in competitiveness and widening current account deficits – all weaknesses a central bank would normally try to address – everything seemed manageable. But then the global credit freeze hit with a vengeance. Lenders worried about being repaid and domestic consumption quickly fell off a cliff. The same thing happened in Britain and the U.S. Central banks in those countries could – and did – intervene dramatically.
The U.S. Federal Reserve has led the world in rate slashing since the crisis worsened this fall. On Thursday, the Bank of England finally responded with a surprisingly deep cut of 1.5 percentage points. On the same day, the ECB reduced rates by only a third of that, bold by its standards. Anything more aggressive risks triggering a dangerous bout of inflation in better-off economies such as Germany's. The ECB won high marks in some circles for its prompt action, at least on the capital front, since the credit squeeze first hit home in August, 2007. But on other fronts, cracks were emerging. On the interest rate side, it remained tightly focused on inflation. And it lacked the capacity to make such central bank moves as adjusting the amount of currency in circulation.
And the most serious flaw in the euro zone design quickly became apparent as conditions deteriorated: There is no institution capable of co-ordinating fiscal policies or taking other emergency measures in the event of a once-in-a-century financial catastrophe. As long as many of the policy options available to governments and central banks in Canada, the U.S. and elsewhere are not in the euro zone playbook, Europe faces “a much longer, harder, more complicated slog to pull out of this,” said Peter Zeihan, vice-president of analysis with Stratfor, a global intelligence firm based in Austin, Tex.
Every European crisis prompts soul-searching about whether it's better to be part of a large entity than going it alone. This time, despite the strains, the union could end up stronger. Worried national governments, shaken by the unexpected near-collapse of financial institutions once viewed as pillars of their economies, could finally yield some of their jealously guarded fiscal and banking authority and promote a euro-zone-wide regulatory regime. Historically, every European crisis “has been used as an opportunity to bring about ‘more Europe,'” said Mr. Scott, the former Blair adviser, referring to the EU's widening of powers. “That is a potential result of this.”
It's understandable that troubled Denmark and a handful of Eastern European countries such as Hungary, which have been pushed to the brink of bankruptcy, might be looking for safety in the euro. “But the notion that a Denmark would be safer inside the euro zone I don't really buy. You gain some security perhaps. But against that, you're locked into a system, where if you get into difficulties, you can't get out,” Mr. Scott said. There's a price to be paid for gaining the stability of a stronger currency, Mr. Scott and others critics say. Joining a monetary union could weaken an already troubled economy. “Far from being a mechanism for convergence of economic performance, it's a mechanism for divergence,” he said. Within the euro zone, “that's what we're seeing. And it's now exaggerated because of the wider international problems.”
The future of the currency zone may have already been determined by the design flaws in its creation. Amy Verdun, a political science professor at the University of Victoria who has written extensively about European monetary policy, argues the EU's big mistake was setting up an “asymmetrical” economic and monetary union. The monetary side, in the hands of the ECB, is responding to the current crisis. But it has no political counterpart – just the finance ministers of the member countries who gather from time to time to co-ordinate policies. Unlike national governments, the euro zone has no mechanism for directing attention to a problem sector or struggling country. And that is unlikely to happen, because it would mean transferring more authority to the European Union. As it is, “people don't trust the existing EU institutions,” Prof. Verdun said.
Euro zone members can and frequently do act unilaterally, without regard to the consequences for their fellow euro zone partners. Early in the banking crisis, for example, Ireland hastily guaranteed all deposits, causing a furor and setting off a race among governments seeking to out-do each other in national assistance. Only belatedly did they realize it would be considerably more effective to enact common policies. Whether the euro zone can continue with its flawed model of a powerful central bank and a weak, informal arrangement on the economic side remains to be seen, Prof. Verdun said. “They are heavily dependent on ad-hoc co-ordination. There's no authority to say: ‘You have to.'”
And there will always be a conflict between the interests of the heavyweights and the peripheral members. Even EU officials recognize that a single monetary policy is bound to be inappropriate for certain countries at least some of the time. Are there sufficient strains to call into question the euro zone's survival? Prof. Portes, of the University of London, dismisses such a question out of hand. “I think it's nonsense,” he said. “The stakes are much too high. Even Germany recognizes that you couldn't allow the euro zone to break up in any way. The consequences for any country to drop out would be horrendous. Its financial system would be destroyed.”