Saturday, December 30, 2006

The market is climbing a wall of money

Ever hear of a dram shop? Guambat hadn't when he first came across the term early in his legal education some few decades back. He'd been in them, mind you, but didn't know them as such. He came across the term in the context of so-called "dram shop acts".

The term was new, but the basic notion is old: if a barman keeps selling liquor to an obviously drunken customer, the barman must share in the responsibility for the harm the drunken fool may cause. Since courts were slow to afix that liability, states began enacting dram shop acts to do the job.

In the world of finance there are no dram shop acts to put the onus on the purveyors of the market's tonic of choice, easy credit. If there were such laws, you'd think some very big names might end up in the clink, starting with the Central Bankers like Alan Greenspan, he of the Greenspan put legacy, who have continually spiked the punch to make sure the markets get all the liquidity/punch/accommodation they can handle -- and more.

Central banks should pull back monetary growth, writes Samuel Brittan

Monetary analysis has recently made a comeback because of many signs that, in their efforts to avert recession early this century, central banks permitted an excessive expansion. One of the best explanations is given by Andrew Smithers, the City of London economist, in his report World Liquidity. He notes that the ratio of US broad money to GDP is higher than at any time, with the exception of the 1930s slump and the second world war. Eurozone money supply growth is well above its "reference range" and British annual broad money growth is at its fastest since 1990. The Organisation for Economic Co-operation and Development has just published estimates of "global liquidity" based on both money and credit measures that show it is "abundant and continuing to grow".
The rush is on, the ride is wild by Kirsty Simpson and Rod Myer
A TIDAL wave of money has swept through financial markets in 2006 [see]. Driven by surging profits, cheap debt, low corporate gearing levels, vast pools of superannuation and rising interest from private equity, Australian companies are falling like ninepins. Qantas is just the latest in a long, long list.

The new millennium's corporate raiders have been able to find ways around regulatory impediments: clever reshuffling of assets can conquer Australian Competition and Consumer Commission commitments and issues such as national interest tests. Foreign ownership caps are but intellectual exercises to be conquered by an army of merchant bankers, advisers, accountants, lawyers and their financial backers.

Australian assets are being bought, sold, merged and carved up at an unprecedented rate, with competitors seeking to consolidate and private equity groups roving across the corporate landscape.

Compare this with another legendary boom, that of the mid 80s: In 1986, $9.6 billion-worth of M&A deals were announced, rising to $11.7 billion in 1987 ahead of the October sharemarket crash.

But the financiers and advisers behind the current boom insist the differences between the two eras are substantial and the good times rolling today are on a more solid footing, thanks to the health of the corporate sector.

Goldman Sachs JB Were chief operating officer Craig Drummond says there is a greater depth to financial activity now, both in the number of sectors involved and a broader number and style of raiders. [Safety in numbers?]

"In the 1980s it was a relatively narrow group of bank-funded entrepreneurial groups," he says. "Today, it's a lot broader (with) both the acquirers and the companies. The other issue is that the corporate and economic fundamentals remain quite robust, and again it's somewhat different to the 1980s.

"In the past we have seen one or two sectors alight, but here we've got (activity) from financial services to infrastructure through to transport, healthcare … It seems to be very broad-based corporate activity at this time. If you go back to 1986-87 when there was also significant corporate activity, it's quite different now.

"One, the private equity phenomenon is more prevalent. Two, corporate balance sheets are still considerably less geared than they were at that point in time. Three, we are seeing more genuine cash flow in pension funds. But also because of stock buybacks, large dividend payouts and the amount of corporate activity we are seeing a lot of that cash going back into the market or back into corporates."

Analyst Ian Greer of credit ratings agency Standard & Poor's agrees, saying the seeds of a crash may already be growing.

"They (private equity) are pushing the boundaries now. Things are very good in the debt markets. There's a lot of money available at low cost with few terms and conditions. It's pretty hot out there and the good times won't last. But you can't predict a turning point."

When the tide changes, it will be swift, Greer says, although there are far better risk management tools used now than in the 80s.

"My expectation is that any swing will be pretty harsh," he says.

This sort of prognostication is causing alarm amongst those financial editors whose job it is to sell papers, so they always have their fingers on matters of alarm, whilst keeping a careful eye always on their sponsors.

On a roll by Malcolm Maide
THE rise and rise of the sharemarket has inspired a new dinner party game — Guess What Year This Is. It's a game that gives grey-hairs an advantage, because the object is to place a boom that delivered a total gain of almost 19 per cent in 2006 in the context of the 1982-1987 bull market, when share prices soared, and then imploded.

That the game is being played at all underlines the similarities between this bull market and the one that ended traumatically in October 1987. Like the '80s boom, the current one began because company earnings could be bought cheaply, and continued as they expanded strongly. The sheer weight of investment money pouring into the market was a factor in the '80s, and is again today: baby boomers saving for their looming retirement are the new liquidity fountainhead, and the capital they are investing is being turbocharged by cheap loan money to finance a wave of leveraged takeovers led by private equity buy-out funds that again echoes the '80s.

Most observers think this resembles a 1986 market. After rising by 109 per cent since March 2003, share prices are high, but not yet nonsensically so, as they became in the first nine months of 1987, when Wall Street's S&P 500 leapt by 37 per cent, and Australia's All Ordinaries surged by 56 per cent.

A rise as substantial as that posted for 2006 may not be achieved in 2007, but a sharemarket meltdown is not yet being heralded.

Wall Street strategist Abby Cohen almost perfectly picked Wall Street's advance in 2006 for clients of her firm, Goldman Sachs, and she says more gains are in prospect. [Guambat has the suspicion she has picked every bull market that has come along, as well as a few which didn't.]

Cohen expects Wall Street's Dow Jones Average and the broader S&P 500 Index to both advance by about 10 per cent in 2007, building on gains of more than 16 per cent and 18 per cent respectively in 2006. She sees the market pushed higher in the new year as fund managers chase prices higher, adding momentum of their own, as private investors continue to bale out of housing investment and into shares, and as high cash levels in the market keep funding takeover activity, by private equity groups and corporate players.

The private equity funds here and overseas are a crucial new element. Their debt and equity reserves for takeovers and agreed purchases now exceed $US1500 billion ($A1905 billion), and investment money is still being heavily subscribed. Local deals including this year's unsuccessful $A18.2 billion tilt at the Coles group by a private equity consortium led by Kohlberg Kravis Roberts and a private equity-backed $A11.1 billion takeover of Qantas are promoting the theory that few large listed companies are not potential targets.

"There are similarities with the 1986-87 market," Citigroup analysts Adrian Blundell-Wignall, Alison Tarditi and Richard Schellbach told Citi's Australian clients late last month. "Moral hazard problems associated with private equity and the ready availability of liquidity, both here and globally, are driving up equity prices beyond reasonable returns, primarily in the industrial sector. Greed has become a factor … industrials are relatively very expensive."

The trio acknowledge, however, that the weight of money pouring into the market is a major, bullish, counterbalance. Australia's superannuation system is generating net flows of about $A48 billion a year, a third of which is being invested in shares. This is a pillar erected [by and for Wall Street] since the '80s boom and crash. Company dividends, cash takeover payments and share buyback payments are meanwhile generating record amounts that also need to be redeployed, and the share buybacks and private equity takeovers are simultaneously reducing the number of shares available. The Federal Government's new superannuation tax holiday is also attracting savings to the market, and the new Future Fund has injected liquidity. Citigroup's estimate is that about $A92 billion will flow into Australian-based managed funds in 2007.

Investors simply "cannot afford to be maximally bearish" when the weight of money is so heavy, Blundell-Wignall, Tarditi and Schellbach say, adding that in the absence of an external shock, the share price surge "could go on".

Meanwhile, the biggest sector in the Australian market, inspite of the dot-commodity boom, is the banking sector, particularly the big four. And the blush is coming off that bloom, according to some.

Dream run for big banks may be over by Richard Gluyas
FOR 15 years, the nation's banks have feasted on a diet of uninterrupted growth, increasingly benign credit conditions and, currently, a 30-year low in unemployment.

In recent weeks, warning bells have begun to sound about bank earnings, starting with a profit downgrade in late November from Adelaide Bank - the industry's first since National Australia Bank's currency options crisis of 2004.

Then, in mid-December at the ANZ annual meeting, Mr McFarlane warned that profit growth would be crimped because of higher bad-debt provisions and less demand for credit, with mortgage growth of around 20 per cent several years ago sliding into the low teens.

Goldman Sachs JBWere nominates a rise in bad and doubtful debts as the biggest risk to bank earnings over the next three years. To put it in perspective, it has been estimated that a return to a normal level of bad debts would slice 5 per cent from the industry's earnings per share.

However, the potential is there for greater damage, given the record level of household debt and rising interest rates.

JP Morgan analyst Brian Johnson downgraded the entire banking sector at the end of the profit reporting season in November from overweight to underweight.

As justification, he points to "valuation extremes", or very high price-earnings ratios, as well as the risk to earnings posed by the mortgage slowdown, increased competition, a realisation that loan losses must rise, and growing capital expenditure requirements as the banks invest in more staff and improved branch networks.

"To some extent," Mr Johnson said, "the premium rating of Australian banks relative to banks in other countries can be justified, given the oligopoly industry structure, which should continue to deliver strong earnings growth and superior asset quality.

"However, this oligopoly pricing structure is under serious pressure from politicians, regulators, new entrants, increasing third-party origination and predatory pricing amongst the banks themselves."

And the pressure on the new globally connected system of finance is building with no evacuation plans on the books.

Institutions can't cope with a crisis * The world's outmoded financial structures were not designed to meet the needs of globalisation, writes economics correspondent David Uren
NATIONAL Australia Bank chief executive Michael Chaney put Reserve Bank governor Glenn Stevens on the spot at his recent speech to Committee for Economic Development of Australia.

"If you think about the international interdependence of financial institutions now, of the counter-parties all over the world in all sorts of transactions, I wondered whether you could tell us about the international institutional structures that exist to be able to react that quickly in the event of a crisis?" he asked.

Glenn Stevens could not.

"As far as I know, I'm not sure there is a terribly well developed set of protocols that we know that's in the top drawer and we get it out and just follow it."

"We know who to call and who are our opposite numbers," he added hopefully, but he conceded there was much more work to be done.

Chaney identified a problem that is troubling finance leaders around the world. Institutions designed to manage the demands of globalisation do not exist.

It is significant that the institutions we have were built immediately after the economic and social catastrophes of depression and war, not the sunny prosperity we enjoy today.

The institutions built from the rubble of World War II are no longer fit for the purpose, and are losing commitment both from the nations that were their creators and from those who have joined since. This was a theme picked up by Bank of England governor Mervyn King in a speech to the Melbourne Centre for Financial Studies last week.

King has characterised the past decade as "the great stability". Inflation and unemployment have been low around the world. Interest rates, both long and short, have fallen while profitability and growth have soared.

Financial market volatility has been eerily low, bar the odd perturbation - such as one in May this year when long-term rates briefly rose, knocking emerging markets and currencies like the Icelandic krona and the New Zealand dollar for six.

There are some who argue that the world is working just fine without the interference of global institutions. [Unless, of course, we refer to global institutions the likes of Goldman Sachs or JP Morgan, Citigroup, etc.]

Central banks are committed to inflation targets and, for the most part, floating exchange rates. Current account imbalances, which were an overwhelming preoccupation in the immediate post-war era, appear to be consistent with sustained growth.

The argument is that markets work. Even the much-maligned hedge funds may be contributing to global stability, providing liquidity and absorbing shocks.

But the mere fact that the chairman of NAB is worried about the implications of counter-party risk, and that the Reserve Bank governor is unable to provide reassurance, suggest that the stability of the world financial system may be more apparent than real.

"The frenetic activity of international meetings and the flattering illusions of a stream of communiques do not add up to a coherent set of commitments," King says.

The G20 has been styled as a group that could co-ordinate action in the event of the financial crisis feared by Chaney, but it really delivers no more than personal relationships between financial leaders.

The problem is that the great stability has made nations complacent about the risks, just as the Reserve Bank frets it has contributed to the myopia of individual investors. [And thus the reference to dram shop acts at the beginning of this post.]

But while the handwriting may be going up on the wall, the partying is still going on down the hall.

Rate rise not impacting on credit demand
Higher interest rates have so far made little impression on consumers with the annual pace of credit demand remaining at a three-and-a-half year high in November.

The central bank raised interest rates for a third time this year in November as it continued to grapple with inflation as the consumer price index remained well above its 2-3 per cent target.

Total credit grew 1.1 per cent in November after climbing by 1.2 per cent in October following revisions, keeping the annual growth pace at 15.0 per cent for a second consecutive month, the highest level since mid-2003.

"Today's strong credit data demonstrates continued resilience in new lending," said Westpac analyst David Goodman.

Credit for the purpose of housing rose 1.0 per cent in November, to be 14.5 per cent higher than a year earlier, and down slightly from the 14.6 per cent recorded in the year to October.

Personal credit rose 1.1 per cent in the same month, lifting the annual rate to its highest level in just over a year at 11.4 per cent, up from 10.8 per cent as of October.

November business credit was up 1.2 per cent for an annual rate of 16.6 per cent, after growing by 16.7 per cent in the year to October.

This may help to sustain the Australian banks as they head into 2007, but it raises questions about how they might end 2007 if the UK is any guide.

Creditors write off UK record 1.4 bln stg of personal debt
The bad debts were written off after people signed up for Individual Voluntary Arrangements (IVAs) -- a formal agreement between a debtor and a creditor setting out repayment arrangements, usually lasting five years -- according to a study by accountancy group KPMG.

People as young as 21 are running up debts that are typically three times their annual income, with the average IVA debtor owing 52,000 stg proposing to repay only 39 pct of this sum, KPMG said.

KPMG estimated that more than 3,000 people entered into IVAs with debts exceeding 100,000 stg in 2006.

'Too many people have debts that they have no realistic hope of repaying,' the group said.

Canada losing its cool

Arctic ice shelf collapse poses risk: expert
An ancient ice shelf the size of 11,000 football fields that broke off Ellesmere Island could be dangerous when it starts to drift in the spring, a scientist says.

The collapse of the ice island's northern coast represents the largest breakup of its kind in the Canadian Arctic in 30 years, the head of a new global ice lab at the University of Ottawa said on Thursday.

Luke Copland, an assistant professor at the school's department of geography, said scientists are surprised at the speed of the collapse of the Ayles ice shelf, about 800 kilometres south of the North Pole. It took less than an hour.

He said the new island formed by the 66-square-kilometre fragment, which could be up to 4,500 years old, could present a serious risk to oil platforms in its drift path in the spring.

The collapse of the Ayles shelf — one of six that still existed in Canada — occurred 16 months ago, on Aug. 13, 2005, but because it is so remote, no one saw it.

The researchers suspect climate change may have played a role in the collapse but said they cannot definitively say it is a result of global warming.

Ice Mass Snaps Free From Canada's Arctic By Rob Gillies


And on the science front we learn that ...

Friday, December 29, 2006

Happy Holidays

Saturday, December 23, 2006

Guambat does Eeyore

Wow! Guambat would like to say "thanks for noticing me" to Felix Salmon at Economonitor.

I hope he doesn't think Guambat only reads him to rip him off. We just like the meaty bits of info he often mentions; the Stew needs some good meat pieces thrown in it from time to time. Making Stew and passing it around is what Guambat likes to do in his little burrow.

"It's not much of a [tale], but I'm sort of attached to it."

Friday, December 22, 2006

Dear Prudence

You wouldn't be a prudent manager of a large company these days for quids. (Quidzillions, maybe, but not quids.)

Guambat will relate a story to that thought in a moment, but first consider the "prudent man" theory. Admittedly, the prudent man theory is a notion most particularly applicable to the world of trusts, not companies, where risk taking is part of the business of management and protected by its own "business judgement" rule in most US jurisdictions and something akin to that elsewhere.

But in its widest expression, the prudent man rule would not be unfamiliar in the board rooms of prudently run businesses. You can find plenty of references to it on the web, but there is a very good concise discussion by the Federal Deposit Insurance Corporation in its Trust Examination Manual:
There are two fiduciary standards governing the prudence of the individual investments selected by a fiduciary: the Prudent Investor Act and the Prudent Man Rule. The Prudent Investor Act, which was adopted in 1990 by the American Law Institute's Third Restatement of the Law of Trusts ("Restatement of Trust 3d"), reflects a "modern portfolio theory" and "total return" approach to the exercise of fiduciary investment discretion. This approach allows fiduciaries to utilize modern portfolio theory to guide investment decisions and requires risk versus return analysis. Therefore, a fiduciary's performance is measured on the performance of the entire portfolio, rather than individual investments.

The Prudent Man Rule is based on common law, stemming from the 1830 Massachusetts court decision -- Harvard College v. Armory, 9 Pick. (26 Mass.)446, 461 (1830). The Prudent Man Rule directs trustees "to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested." Id. A copy of the Prudent Man Rule, also known as the Restatement of Trusts 2d, together with explanatory notes, is included in Appendix C.

Under the Prudent Man Rule, when the governing trust instrument or state law is silent concerning the types of investments permitted, the fiduciary is required to invest trust assets as a "prudent man" would invest his own property, keeping in mind: the needs of the beneficiaries, the need to preserve the estate (or corpus of the trust) and the amount and regularity of income. The application of these general principles depends on the type of account administered. This continues to be the prevailing statute in a small number of states.

The Prudent Man Rule requires that each investment be judged on its own merits. Thus, a fiduciary could be held liable for a loss in one investment, which when viewed in isolation may have been imprudent at the time it was acquired, but as a part of a total investment strategy, was a prudent investment in the context of the investment portfolio taken as a whole. Under the Prudent Man Rule, speculative or risky investments must be avoided. Certain types of investments, such as second mortgages or new business ventures, are viewed as intrinsically speculative, and, therefore, prohibited as fiduciary investments.

The Prudent Investor Act differs from the Prudent Man Rule in four major ways:

* A trust account's entire investment portfolio is considered when determining the prudence of an individual investment. Under the Prudent Investor Act standard, a fiduciary would not be held liable for individual investment losses, so long as the investment, at the time of acquisition, is consistent with the overall portfolio objectives of the account.
* Diversification is explicitly required as a duty for prudent fiduciary investing.
* No category or type of investment is deemed inherently imprudent. Instead, suitability to the trust account's purposes and beneficiaries' needs is considered the determinant. As a result, junior lien loans, investments in limited partnerships, derivatives, futures, and similar investment vehicles, are not per se considered imprudent. However, while the fiduciary is now permitted, even encouraged, to develop greater flexibility in overall portfolio management, speculation and outright risk taking is not sanctioned by the rule either, and they remain subject to criticism and possible liability.
* A fiduciary is permitted to delegate investment management and other functions to third parties.

Since the Prudent Man Rule was last revised in 1959, numerous investment products have been introduced or have come into the mainstream. For example, in 1959, there were 155 mutual funds with nearly $16 billion in assets. By year-end 2000, mutual funds had grown to 10,725, with $6.9 trillion in assets (as reported by CDA/Wiesenberger). In addition, investors have become more sophisticated is more attuned to investments, since the last revision. As these two concepts converged, the Prudent Man Rule became less relevant.

So, now, let's consider the conundrum faced by poor old Don Mercer.

Everyone's a target by George Lekakis
ORICA chairman Don Mercer has warned that more companies with low debt levels were in the sights of private equity groups.

The warning came after Orica yesterday rejected suggestions it had been approached by private equity groups seeking to buy the business but warned that any low-geared company could come under takeover pressure.

Speaking after the company's annual shareholders' meeting in Melbourne yesterday, Mr Mercer warned that more companies with low debt levels were in the firing line.

"One of the characteristics of all these takeovers is that conservatively geared companies are taken over, geared to the hilt, and their equity stripped," he said.

"I think that any company which is properly conservatively geared is looking as though somebody might put the ruler over them."

The prospect of an avalanche of takeovers in Australia next year has stoked the local stockmarket, with share prices of rumoured targets such as Fosters and CSL soaring through records.

Stockbroker Bell Potter recently included Orica on a list of ASX 100 companies most vulnerable to takeover activity.

The list also included BHP Billiton, Tabcorp and Woolworths.

Deutsche Equities has highlighted David Jones and Metcash as companies in the firing line of private equity.

The next private equity play is likely to come from a syndicate of former Patrick Corporation executives which will invest around $250 million in a logistics joint venture with DP World.

Your attention is also directed to Let's party like its 1987 and these.

Wednesday, December 20, 2006

Get baht, Jojo

Confusion may not be as hurtful as currency controls, but not far from it when it comes to markets and their "certainty" lodestone. And confusion is the state of play at the moment in the Thai baht markets following yesterday's surprise move to clamp down on baht convertibility.

Felix Salmon at Economonitor has a few posts, which alerted Guambat to the flux, and Bloomberg has been working whilst Guambat slept to keep the story updated. Guambat still has grit in his eyes, arising early for a slow flight to neighbouring islands, but wishes to keep track, as best as he might, of the developments. Still, it is more confusing than clear at the moment.

Bank of Thailand Struggles with Baht Speculators
The government seems to have backed away from the currency controls, and prices may recover tomorrow.
The flip-flop shows the chaos of government in Thailand, where a military regime was established after civilian politics led to a stalemate. But the fact that the markets had not suffered earlier, as the political chaos grew, shows the very high risk-tolerance of international investors.
That willingness to absorb risk will, at some point, seem foolish, and the rush to the exits, when and if it comes, may lead other countries to quickly impose currency controls of their own.

Thailand proves that policymakers still get things spectacularly wrong
What on earth is going on in Thailand? First the government tried to implement draconian capital controls; when the stock market plunged, it changed its mind, and now everybody is just confused:
Personally, I just find it refreshing that occasionally policymakers can still get things utterly, spectacularly, obviously, wrong. I was beginning to think that the whole world was being run by boringly predictable technocrats, but evidently there are still pockets of the emerging markets where crazy decisions can still result in decimated markets. Anybody fancy an Ecuadorean default?

Thailand Abandons Limits on Foreign Stock Investments (Update6)By Suttinee Yuvejwattana and Margo Towie
The government lifted a requirement that banks lock up 30 percent of new foreign-currency deposits for a year for funds earmarked for stocks, Finance Minister Pridiyathorn Devakula said in Bangkok.

"The surprising speed and responsiveness of this policy reversal should help forestall a deep and lasting impairment of Bank of Thailand credibility," Michael Kurtz, a strategist at Bear Stearns Asia Ltd. in Hong Kong, wrote in a note to clients. "We expect Thai equities on Wednesday to undo a large portion of Tuesday's decline."

Thailand's government exempted stocks from the central bank rule that international investors must pay a 10 percent penalty unless they keep funds in the country for a year. The policy reversal illustrates Thailand's dependence on foreign investment and the degree to which investors resent restrictions on their investment decisions.

"The stock market has fallen too much today," Pridiyathorn told reporters at a press conference. "This is the side effect of the central bank's measure, but we have fixed it already."

Tuesday, December 19, 2006

Priced for perfection, but performance pretty ordinary

Dirty Wall Street Secret: Hedge Funds of Funds Pay T-Bill Rates By Katherine Burton and Christine Harper
Pennsylvania's 200,000 public employees are paying Morgan Stanley some of the money-management industry's steepest fees to get returns that aren't much better than yields on U.S. Treasury bills.

Securities firms will collect more than $1 billion in fees this year to keep clients such as the New Jersey and Philadelphia pension plans invested in funds of funds. Those who assumed that Goldman Sachs Group Inc.'s Global Tactical Trading LLC would provide the best returns for the lowest risk in the hedge fund industry were mistaken. They got 1.7 percent through October -- a situation all too common on Wall Street, where every firm selling funds of funds is a winner even when their customers aren't.

"For these large institutions gathering assets is the name of the game, not performance," said Edward Bowman, a partner at Veritable LP, the Newtown Square, Pennsylvania-based consulting firm that oversees $8 billion for wealthy families.

Sarah Gardner doesn't make enough as an associate director at the Center for Environmental Studies at Williams College in Williamstown, Massachusetts, to be an individual investor in Goldman's funds of funds. Most of her retirement money is in a stock fund run by New York-based TIAA-CREF, which charges a 0.48 percent management fee and doesn't keep a slice of the profits. It's up almost 18 percent this year.

The Vanguard 500 Index Fund, which levies a 0.16 percent fee to track the Standard & Poor's 500 benchmark index of U.S. stocks, has returned 16.3 percent through Dec. 15.

Goldman spokeswoman Andrea Raphael said Hedge Fund Partners has underperformed other funds of funds because it invests with managers who trade futures contracts and others who employ so- called macro strategies, which bet on global stocks, bonds, currencies and commodities.

Jeffrey Slocum & Associates Inc., a Minneapolis-based consultant to pension plans, doesn't recommend any Wall Street- managed funds of funds because they tend to underperform, said Sean Goodrich, the firm's director of alternative investment strategy research.

All told, nine of the world's biggest banks and securities firms -- Goldman, Morgan Stanley, JPMorgan Chase & Co., Citigroup Inc., UBS AG, Societe Generale SA, Credit Suisse Group, Credit Agricole SA and Royal Bank of Scotland Group Plc -- rank among the 50 largest operators of funds of funds, managing a collective $140 billion, according to a survey by Institutional Investor's Alpha magazine.

Investors pay twice to invest in funds of funds. The charges by the firms come on top of fees levied by the hedge fund managers themselves, typically 1.5 percent of assets and 20 percent of investment gains.
"The layering of fees makes it difficult to produce the type of returns that investors are hoping for," said Geoff Bobroff, an industry consultant in East Greenwich, Rhode Island. "With the underlying fund fees, and the fund of funds fees, you nail investors."

It's no surprise that Wall Street has its eye on funds of funds. Not only do they require fewer investment professionals to run than a traditional hedge fund, institutional investors are flocking to them. Of the $7.6 billion that U.S. pension funds farmed out to hedge fund managers this year, 62 percent went to fund of funds, according to Louisville, Kentucky-based Eager, Davis & Holmes LLC.

The fees for overseeing hedge fund assets are so lucrative that Goldman's money-management unit reported a 19 percent increase in fourth-quarter revenue. Goldman's so-called incentive fees, the slice of investment gains it keeps, plunged 78 percent in the quarter as some its own hedge funds, such as Global Alpha, declined.

Goldman's clients would have done better investing in the firm instead of its funds of funds. Goldman shares have gained 56 percent this year, after rising 23 percent in 2005.

``This is a great business for brokerage companies,'' said James Ellman, president of Seacliff Capital LLC in San Francisco, which manages more than $100 million in financial-services stocks. ``The market likes asset management more than investment banking because the booms and busts are much less pronounced and the more that brokers can make their earnings stable, the higher their stock price multiples will be.''

While funds of funds spread the risk of investing in hedge funds, they aren't immune to the industry's periodic blowups. Returns at funds managed by Goldman, Morgan Stanley and Deutsche Bank were hurt this year by the implosion of Amaranth Advisors LP, the Greenwich, Connecticut-based hedge fund manager that lost 70 percent of its $9.6 billion in assets in September because of wrong-way bets on natural gas.

New York-based Morgan Stanley had $6 billion in fund of funds assets as of June 30, according to data compiled by Alpha magazine. Owen Thomas, 45, runs Morgan Stanley's asset-management division.

Morgan Stanley CEO John Mack, who has made five hedge fund acquisitions this year to close a $80 billion gap in so-called alternative assets with Goldman, was awarded a $40 million bonus for 2006 -- the biggest in Wall Street history -- after putting the firm on track for record earnings.

Some investors aren't as concerned that Wall Street-managed funds of funds are dragging down returns for pensioners. New Jersey entrusted Goldman to invest some of the state's $79 billion in public savings in a customized fund of funds three months ago. "I have an extremely high regard for the quality of service at Goldman," said Orin Kramer, chairman of the New Jersey State Investment Council.

Metals slip off the pedals of the super-cycle

Metals Evoke Bear Market as Output Gains, Funds Sell (Update1) By Claudia Carpenter and Christopher Donville
While everything from aluminum to zinc has risen at least 25 percent this year and as much as 157 percent, no one is forecasting a continuation of the five- year bull market.

"The cost of taking copper out of the ground is so low, I don't know how we can justify these prices," said Warren Gelman, 73, president of distributor Kataman Metals Inc. in St Louis. "$4 overwhelmed me. $3 copper is way overpriced."

The retreat may be abetted by rising production, a slowing economy and speculators, including hedge funds, who eight months ago began borrowing money to sell copper on the so far- successful assumption they could buy it back at lower prices, according to U.S. government data. Builders began construction of U.S. houses at the slowest pace in six years in October just as global production of copper is poised to increase 4.7 percent in 2007, more than double this year, the International Copper Study Group in Lisbon says.

Even Jim Rogers, chairman of New York-based Beeland Interests Inc., who insists the bull market in commodities will last at least another decade, now says copper prices are "correcting" as a U.S. recession "slows demand for everything."

Rogers, in an interview, said any decline would be a good time to buy because the broader bull market has years to run, led by demand from China, the world's biggest consumer of most metals.

ABN Amro Holding NV metals analyst Nick Moore in London expects a global surplus of 100,000 tons of copper next year, compared with a deficit of 50,000 tons in 2006. The bank forecasts aluminum production will outstrip demand by 150,000 tons in 2007, along with surpluses for lead and zinc.

The price of copper, a leading indicator of the global economy because of its use in everything from water pipes to industrial motors, may be the most vulnerable to a slump. ABN forecasts prices, which reached a record $4.04 a pound in May, will average $2.75 in 2007 and $2.25 in 2008. Copper's last drop of a similar magnitude was in 2001, after the bubble in technology stocks burst.

For the first time since 2001, production of copper next year will surpass orders for wiring and plumbing. BHP Billiton Ltd., the world's biggest mining company, and Codelco of Chile will help ship more than enough of the metal to meet demand.

Metal stockpiles are swelling as mining companies raise production. Spending on exploration this year increased by 47 percent to $7.13 billion, Halifax, Nova Scotia-based Metal Economics said Nov. 8. Joy Global Inc., a maker of mining equipment, today reported record orders for machinery such as shovels, drills and draglines.

Supplies of copper in warehouses monitored by metals exchanges in Shanghai, London and New York rose to a high of 233,220 metric tons last week, compared with 72,773 tons on July 13, 2005.

Metals demand is suffering as the U.S. housing market loses steam. The average U.S. single-family house uses 439 pounds of copper, according to the Copper Development Association in New York. A refrigerator uses almost five pounds of the metal.

Peruse this and this and this and this....

Bulls by the dozen

Stock Strategists Raise Alarms With Call for Rally (Update2)By Daniel Hauck
Strategists at 12 of the biggest Wall Street firms agree that U.S. stocks will rally next year. The last year that happened was for 2001, when the Standard & Poor's 500 Index dropped 13 percent. The last time Wall Street unanimously predicted an advance for the S&P 500, in 2001, preceded a 33 percent slump over the next two years.

Merrill Lynch & Co.'s Richard Bernstein and Bear Stearns & Co.'s Francois Trahan, two of the most bearish forecasters in the current four-year rally, both estimate the S&P 500 will surge to a record next year.

The unanimous view among the strategists tracked by Bloomberg that have made 2007 forecasts is just one signal of growing complacency about the market. An option-based index of investor concern dropped to a 13-year low last week, when the S&P 500 rose to its highest since November 2000. A survey of newsletter writers showed the least pessimism this year.

Strategist Tobias Levkovich of Citigroup Investment Research raised his 2007 forecast for the S&P 500 to 1600 last week, while Jason Trennert of Strategas Research Partners LLC did the same today. Prudential Equity Group LLC's Ed Keon, who had been tied with them, today increased his estimate to 1630, becoming Wall Street's most bullish forecaster.

The average estimate of the 12 strategists is 1539, above the index's record of 1527.46 on March 24, 2000. The projection amounts to a 7.8 percent advance from last week's close, in line with their forecast of an 8.2 percent increase in 2006.

This year, the index has risen 14 percent. The index's gain this year may exceed the average forecast of strategists for the third time in four years. They predicted a 16 percent climb in 2003, when the S&P 500 rallied 26 percent. They foresaw gains of about 3 percent in 2004, when the gauge added 9 percent, and last year, when the estimate was on target.

"Strategists have been a little bit too conservative," said Laszlo Birinyi, president of Birinyi Associates Inc. in Westport, Connecticut.

Option investors may share the strategists' optimism. The Chicago Board Options Exchange's SPX Volatility Index, or VIX, slid last week to 9.39, a level not seen since December 1993.

They can't all be wrong?

Bahting the hand that feeds you

Thailand to lock up 30% of new fund flows
Thailand's regulators required banks to lock up 30 percent of new foreign exchange deposits for a year to curb currency speculation, causing the baht to slump by the most in almost three months.

Overseas investors buying baht starting tomorrow will only be able to invest 70 percent of what they transfer, and only recoup all of their funds if they keep the money in Thailand for more than a year, central bank Governor Tarisa Watanagase told a briefing in Bangkok today. Those who withdraw the reserved amount in less than a year will be penalized 33 percent of that 30 percent portion, she said.

"They're getting pretty aggressive, as when a central bank starts withholding money it's pretty serious," said Steve Rowles, a Hong Kong-based analyst at CFC Seymour Ltd. "This is really going to put the brakes on the baht."

54 against the dollar as of 6:18 pm in Bangkok, its biggest daily fall since September 20, when it plunged 1.4% after military leaders seized power in the overnight coup.

Asian markets slide on new risk fears By Chris Oliver
Asian stocks fell sharply in afternoon trading Tuesday with share indexes in Singapore, Malaysia and Indonesia leading the decline, as regional markets paced a stock market rout in Thailand after the central bank moved to impose tough capital controls to stem a rise in its currency.

Thailand's leading stock index plunged 10.14% after the central bank announced new capital controls which take effect Tuesday.

"It is group contagion with people worried that other central banks like the Philippines and South Korea, which have also seen strong currency appreciation this year, may adopt similar draconian measures," said Shahab Jalinoos, head of foreign exchange strategy at ABN Amro in Singapore.

"If you own a stock and you know in the future the likelihood of a foreigner buying that stock is massively reduced, you would probably want to sell."
The Nikkei fell 1% to 16,789.30 in afternoon trading.

Singapore's Straits Times Index fell 1.6%.

Australia's S&P/ ASX 200 fell 0.6% and South Korea's Kospi was down 0.3. Malaysia's KLSE Composite fell 1.7% and Indonesia's JSX Composite fell 1.6%., Taiwan's Weighted Price Index erased earlier gains to trade 0.2% lower and China's Shanghai Composite fell 0.2%.

In Hong Kong the blue-chip Hang Seng Index ended the morning session down 2.3% to 18,955.37. The Hang Seng China Enterprises Index, a gauge of 37 China-incorporated companies listed in Hong Kong, fell 1.8% to 9,068.65.
Emerging-Market Stocks Slump on Thailand's Investment Controls By Chen Shiyin and Mahmoud Kassem
The MSCI Emerging Markets Index has rallied 33 percent since reaching its low for the year on June 13 as the Federal Reserve stopped raising interest rates after 17 consecutive increases and commodities prices rebounded.

"On the back of this new restriction by Thailand's central bank global investors have to recognize risk again," said Soichiro Monji, who helps oversee about $47 billion as senior strategist at Daiwa SB Investments Ltd. in Tokyo. "Investors might shift from developing markets to other safer markets."

"There is a general question about who might be next in following Thailand's move," said Adrian Mowat, JPMorgan Chase & Co.'s regional equities strategist in Hong Kong.

Is this one of those X-factor things that snowballs to a much larger problem? The whole Asian-crisis thing in 1998 started in Thailand with a run on the baht.

Hyperventilating over hyperlinks

Guambat fears the following, foregoing and everything about this blog is illegal. Guambat is hyperventilating so hard he can hardly blog. Whatever you do, do not click on any hyperlinks on this blog.

Copyright ruling puts hyperlinking on notice Asher Moses
A court ruling [by full bench of the Australian Federal Court] has given the recording industry the green light to go after individuals who link to material from their websites, blogs or MySpace pages that is protected by copyright.

Ms Sabiene Heindl, general manager of Music Industry Piracy Investigations (MIPI), said similar action could be taken against individuals who, like mp3s4free, used the internet to link to copyright-protected material.

Ms Heindl said that this could apply even if a person had embedded a copyright-infringing YouTube clip in their blog or MySpace page.

"We don't make any distinctions between big websites or small websites", she said, adding that MIPI would consider individual blogs on a "case-by-case basis as to whether it would be appropriate to take action".

Ms Heindl's message to Australians is clear: "If you are linking to copyrighted material in an unauthorised fashion, then you can be held liable for copyright infringement."

In yesterday's Cooper judgment, the ISP that hosted the website, E-Talk, was also found to be guilty of authorising copyright infringement.

It's a tanled web we are weaving.

The debt diet

American household debt has been getting a bit pudgy in recent times. But unlike their body fat, households are doing something about their debt obesity. They have to. They are all big loosers. Whether they want it or not, the trough they have their collective snout in will be taken away.

Festivus Flow-of-Funds Stocking Stuffers By Paul Kasriel

Relative to nominal GDP, nonfinancial domestic borrowing (i.e., the annualized dollar change in debt outstanding) peaked at 19.7% in Q4:2005, moving down to 13.9% in Q3:2006 - the lowest percentage since Q4:2003.

Although not the only nonfinancial sector accounting for this slowdown in borrowing, the household sector was the principal one. Chart 2 shows that after hitting a post-WWII high of 14.6% in Q3:2005, household borrowing relative to disposable personal income (DPI) dropped to 8.8% in Q3:2006 - the lowest since 7.6% in Q3:2001, when the economy was in a recession. Notice in Chart 2 that precipitous declines in this percentage tend to be followed by the onset of economic recessions (indicated by the shaded areas in the chart).

Just to demonstrate how precipitous the current fall off in household borrowing has been, I had Haver Analytics calculate the year-over-year change in household borrowing relative to DPI. This is shown in Chart 3. Wow! The percentage is down from year-ago by 5.8 points - the largest decline since Q2:1980, when President Carter urged us to don sweaters and tear up our credit cards.

But in the current situation, households have not been cutting up their credit cards but rather sharply scaling back the growth in their mortgage credit as the housing market recedes. This is shown in Chart 4. The most recent year-over-year decline in household mortgage borrowing as a percent of DPI is unprecedented in the post-WWII period.

Unlike households, corporations can issue equity. So, the liabilities of corporations consist primarily of credit market debt instruments and equities. Household liabilities consist mainly of credit market debt instruments. As I have discussed in previous commentaries, corporations have been in engaged in the "retirement" of massive amounts of their equities, either through stock buybacks or through mergers.

Back in the late 1990s, as I pointed out back in the late 1990s, corporations were borrowing in the credit markets to fund their equity retirement. That is, corporations were levering themselves. Today, corporations are using more of their profits than borrowed funds to retire equity.

In sum, in the past few quarters, we have seen a sharp slowdown in household borrowing and a sharp increase in corporate equity retirement funded out of current profits. At the same time, we have seen continued strong growth in funds being advanced to the U.S. This helps explain both the rallies in the bond market and the stock market. With regard to the bond market, this also helps explain the inversion of the yield curve. The supply of credit from abroad has continued to grow rapidly as the growth in the U.S. demand for credit has slowed sharply.

Despite the fact that household mortgage borrowing has slowed in recent quarters, the leverage in owner-occupied residential real estate reached a record high 46.4% in Q3:2006, as shown in Chart 8. If mortgage borrowing slowed, why the increase in leverage? Because, as shown in Chart 9, there has been a sharp slowdown in the growth of the total market value of residential real estate.

With the sharp slowdown in the growth of housing values, it is quite natural that there also would be a sharp slowdown in the growth of homeowners' equity. This, combined with higher adjustable rate mortgage financing rates, has resulted in a sharp slowing in mortgage equity withdrawal (MEW).

As shown in Chart 10, MEW peaked at an annual rate of about $730 billion, or 8.1% of DPI in Q3:2005, slowing to an annual rate of only $214 billion in Q3:2006. Along with corporate stock retirement, MEW has been an important source of funding for household deficit spending in recent years.

Therefore, this slowdown in MEW would be expected to slow the growth in household spending, which, as shown in Chart 11, has begun. On a year-over-year basis, growth in the sum of real personal consumption and residential investment expenditures has slowed to 2.0% in Q3:2006, the slowest growth since the past recession.

Household liquidity fell to a post-WWII low in Q3:2006 (see Chart 12). I am using as a measure of liquidity household deposits and money market mutual funds as a percent of total household liabilities.

Some might respond that with all the different sources of credit available to households today, they do not need to hold as large a ratio of liquid assets as in the past. To this I would respond with three counter-arguments.

Firstly, households already have borrowed so much that their leverage ratio is at a post-WWII high (see Chart 13).

Secondly, households have already borrowed so much that their debt service burden is at a 25-year record high (see Chart 14).

And thirdly, residential real estate, which accounts for 30.5% of the total market value of household assets (see Chart 15), is the single largest asset in households' portfolios compared with deposits, credit market instruments, corporate equities (about 44% of which are held on their behalf in pension funds and insurance companies) and other tangible assets. Of these other asset categories, residential real estate probably is the least liquid, aside from used refrigerators (other tangible assets).

In sum, households have never been as highly levered as they are now or as illiquid as they are now, and their single largest asset is in danger of actually falling in value.

If the Fed had to resume raising interest rates in this environment, it would be "Katy, bar the door" for household finances!

In praise of high taxes

A new study from, of course, California suggests that marijuana is America's largest cash crop and that we should legalize it so as to tax it and better regulate it.

Pot is called biggest cash crop By Eric Bailey
For years, activists in the marijuana legalization movement have claimed that cannabis is America's biggest cash crop. Now they're citing government statistics to prove it.

California is responsible for more than a third of the cannabis harvest, with an estimated production of $13.8 billion that exceeds the value of the state's grapes, vegetables and hay combined — and marijuana is the top cash crop in a dozen states, the report states.

Jon Gettman, the report's author, ... argues that the data support his push to begin treating cannabis like tobacco and alcohol by legalizing and reaping a tax windfall from it, while controlling production and distribution to better restrict use by teenagers.

Gettman's report cites figures in a 2005 State Department report estimating U.S. cannabis cultivation at 10,000 metric tons, or more than 22 million pounds — 10 times the 1981 production.

Using data on the number of pounds eradicated by police around the U.S., Gettman produced estimates of the likely size and value of the cannabis crop in each state. His methodology used what he described as a conservative value of about $1,600 a pound compared to the $2,000- to $4,000-a-pound street value often cited by law enforcement agencies after busts.

In California, the state's Campaign Against Marijuana Planting seized nearly 1.7 million plants this year — triple the haul in 2005 — with an estimated street value of more than $6.7 billion. Based on the seizure rate over the last three years, the study estimates that California grew more than 21 million marijuana plants in 2006 — with a production value nearly triple the next closest state, Tennessee, which had an estimated $4.7-billion cannabis harvest.

California ranked as the report's top state for both outdoor and indoor marijuana production. The report estimates that the state had 4.2 million indoor plants valued at nearly $1.5 billion. The state of Washington was ranked next, with $438 million worth of indoor cannabis plants.

California also is among nine states that produce more cannabis than residents consumed, Gettman estimates. According to the National Survey on Drug Use and Health, the state's 3.3 million cannabis users represent about 13% of the nation's pot smokers. But California produces more than 38% of the cannabis grown in the country, the study contends.

Nationwide, the estimated cannabis production of $35.8 billion exceeds corn ($23 billion), soybeans ($17.6 billion) and hay ($12.2 billion), according to Gettman's findings.

Tom Riley, a spokesman for the White House Office of National Drug Control Policy, cited examples of foreign countries that have struggled with big crops used to produce cocaine and heroin. "Coca is Colombia's largest cash crop and that hasn't worked out for them, and opium poppies are Afghanistan's largest crop, and that has worked out disastrously for them," Riley said. "I don't know why we would venture down that road."

Running a presidential campaign at BP

Mutterings at the court of Lord Browne by Carl Mortished
BP needs a cultural shift because whoever wins the race for the top job will be leading a company built in Lord Browne of Madingley’s image — a highly centralised organisation with a presidential style of office that keeps its senior management on a tight leash and projects its public image from the chief executive’s podium.

BP has suffered greatly in its year of crisis because no one can speak but Lord Browne. Internally, his lieutenants bridle at the tight control kept over public communication. The people who lead BP’s core businesses are in charge of companies of FTSE 100 scale but, if they are not gagged, they are shepherded and actively discouraged from speaking to the media, even on a non-attributable basis.

It raises the question of who will be trusted to speak when Lord Browne finally gives up his job in 2008. More importantly, it asks: how will his successor learn to speak convincingly?

[L]ieutenants — Mr Hayward, John Manzoni and Iain Conn — have been put in an invidious position, forced to toe the line in an absurdly public but mysteriously silent race for the top job.

It is a moot question for BP, where the senior executives are beating their chests — Tony Hayward, head of exploration and candidate for the chief executive’s job, recently told an internal audience in Houston that the top of the organisation was not listening.

He said that management was too directive and too fond of making a virtue out of doing more for less. “(BP) has lived too long in the world of making do and patching up this quarter for the next quarter,” he said.

Mr Hayward’s passionate plea for management to listen and reject the penny-pinching approach to resources would sound more persuasive if he had not been an arch exponent of the BP cost mantra in previous years.

Lord Browne, more than anyone, ought to be keenly aware of the dangers of not listening. Fourteen years ago, the oil company was in a different management crisis, groaning under excessive debt and its staff in near-open rebellion over redundancies and an abrasive style of management. In June 1992, the board ganged up and asked Bob “Hatchet” Horton to go.

The key issue was his refusal to cut the dividend but his style of top-down leadership did not help. In the end, his successor, David Simon, completed and extended the redundancy programme initiated by Mr Horton.

The hatchet was passed to John Browne, who quickly set about abolishing fiefdoms like those that did so much damage at Shell. In the early years, he was fascinated by Enron and he admired Exxon’s discipline. He benchmarked BP against it, setting cost-reduction targets like skittles to knock down.

When BP expanded in mergers with Amoco and Arco, it formalised the central command in the so-called Green Book, a manual that described BP’s management framework, for the avoidance of any doubt.

Lord Browne’s presidential office is a streamlined way of running a business but it leaves the organisation a bit helpless when errors multiply.

It is the antithesis of the former Shell. While the Anglo-Dutch company was run as a collection of independent and sometimes warring businesses, BP was transformed into a very tall pyramid with Lord Browne sitting alone at its apex.

In an interview with The Times in 1996, the BP chief suggested the group was like a living creature. He said: “It’s a society as well as a company and it corrects itself when it becomes uncivilised.”

Time to review Unrepresentative Swill (Part 3).

Old fashioned private equity

Shoe company sold at massive loss
Loss-making shoe retailer Dolcis was sold today for a fraction of the price its owner paid for the business seven years ago.

Alexon, which owns Bay Trading and brands such as Ann Harvey, will receive £2.7m (€4m) following the deal involving retail entrepreneur John Kinnaird.

The former Sports Division director is among a group of investors preparing to take on the business, which in the summer traded from 67 UK shops and 132 concessions.

It made half-year losses of £2.4m (€3.6m) in the summer, but Alexon said sales and margins continued to decline since then. It said the disposal of the business would enable management to better focus on its remaining operations.

You smell, Guambat smells, we all smell

Our Sense Of Smell Is Underestimated by: Christian Nordqvist
[I]t seems our ability to follow a scent is not that much different to that of a dog's, say researchers from the University of California Berkeley, USA.

Scientists asked 32 blindfolded volunteers, male and female, to follow 10-meter scent trails in a field from one end to the other. The trails were scented with chocolate oil. As well as not being able to see, the volunteers had to wear gloves and earplugs - making them dependent on their sense of smell. Two-thirds of the participants accurately followed the scent trails. The volunteers could be seen crawling on their hands and knees with their noses close to the ground.

To make sure it really was their sense of smell that was guiding them, the scientists made them try to follow a trail again, but this time with their noses plugged (blocked up) - everyone failed.
Everyone who succeeded was slower than animals. However, after a bit of practice all the humans improved significantly. The scientists also found that both nostrils are needed in order to follow the directions of a trail - "scent-tracking is aided by inter-nostril comparisons."

Guam could give Australia a better connection to the world

Pipe Networks and VSNL plan Australia-Guam fibre link By Stuart Corner
Pipe Networks (ASX: PWK) has signed a MoU with Indian international carrier and global network operator, VSNL International, to build a new submarine cable linking Australia to Guam, in a bid to break the near monopoly for direct links to the US held by Southern Cross.

Pipe Networks will be responsible for arranging the necessary funding and structure of the cable vehicle and says it will not proceed with the project until its strict investment philosophy is satisfied.

VSNL International will provide expertise in submarine cable systems as well as access to critical infrastructure and onward connectivity from the planned Guam landing station. VSNL International will benefit from having the new cable directly interconnected with its global network, enabling a significant improvement in service offering’s to Australia, according to Pipe Networks.

VSNL International, part of India's giant Tata group, purchased the former Tyco Global Network. It now owns the world’s largest designed global backbone capacity network, spanning four continents and comprising of major ownership in 206,356km of terrestrial network fibre optic networks and sub-sea cables. It is also one of the largest carriers of wholesale voice globally.

Let's party like its 1987

Costello warns of risky boom-bust climate by Katharine Murphy
[Australia's Treasurer] PETER Costello has compared the current business climate with the boom-bust cycle of the 1980s, delivering his sharpest warning about the risks posed by private equity raiders.

"Other than the change in interest rates it does not seem to me as if there is all that much difference between what is happening in some of these companies and what happened in the late '80s," Mr Costello told the ABC.

The 1980s saw a rush of risky corporate takeover activity by Australian entrepreneurs, including Robert Holmes a Court and Alan Bond.


The deals were financed by cheap debt, but the cycle turned when interest rates rose, sending the boom crashing down into a bust.

Mr Costello said yesterday he had no in-principle problems with private equity, but he warned high corporate debt levels associated with heavily geared deals "can be unsustainable".

The Treasurer's remarks follow recent concerns by Reserve Bank governor Glenn Stevens, and other leading private sector bankers, about the consequences to the economy of excessive corporate debt.

Mr Costello also warned the Macquarie Bank-led private equity consortium behind the $11 billion takeover of Qantas that there would be no bail-out from Canberra if the company got into financial trouble.

"They are on their own. Any suggestion that you could take over an airline, get yourself in trouble, then ask the taxpayer to bail you out is not on," Mr Costello said.

Mr Costello's stance was backed by Prime Minister John Howard, who said the company would not get help from Canberra if fortune turned against it.

"We won't be engaging in any economic bail-outs," Mr Howard said yesterday.


U.S. Current-Account Gap Widens to Record $225.6 Bln (Update2) By Joe Richter
[A]nd the country paid more interest to overseas investors.

The shortfall in the current account, the broadest measure of trade because it includes transfer payments and investment income, followed a revised $217.1 billion second-quarter gap, the Commerce Department said today in Washington.

The gap amounted to 6.8 percent of the economy, the second- biggest proportion ever, up from 6.6 percent in April to June, according to Commerce Department figures. The deficit reached an all-time high of 7 percent of gross domestic product in 2005's fourth quarter.

U.S. investors received less income on their holdings of overseas investments than foreigners received here. [Which is a roundabout way of saying they earn more off us than we earn off them, which is not exactly the rosy picture we get from those who say the deficit doesn't matter because we have all those overseas factories making money for us over there.]

Income on overseas assets held by U.S. investors rose to $160.8 billion from $156 billion. Foreign earnings on U.S. assets, including wages and other compensation, rose to $164.6 billion....

That [still] left $3.8 billion deficit on income payments, the largest ever, compared with a $2.2 billion shortfall in the second quarter.

U.S. government payments to foreigners and other private transfers abroad registered a $21.5 billion deficit, compared with the $21.9 billion deficit in the prior quarter.

Monday, December 18, 2006

I wish I'd never followed this thread

Having started down this CPDO path, Guambat doggedly - no guambatedly - tracks along behind, no thanks but full credit to Felix Salman, who has carried the story all the way.

His latest explanation of it is that, near as Guambat can understand, which is like Saskatchewan being near to Tierra del Fuego, the CPDO is a ten year triple-A bond paying LIBOR plus 200 bps which bowls strikes every time yet goes down the lane sort of like those wonky pet toys which roll haphazardly around the floor to amuse bored pussies.

Says the Economonitor:
A CPDO is rated AAA, and all that means is that there's an extremely high (greater than 99.2%, or thereabouts) chance that all the coupons and the principal of that particular issue will be paid in full and on time. The amount of money in the structure can decline precipitously, to well below the amount of money that needs to be repaid at final maturity. But so long as the interest and principal payments are made, there's no default. [Well at least Guambat understands that last sentence.]

The CPDO has promised to pay out a certain coupon, and then par at maturity. The combination of spread widening and coupon payments is damaging to the value in the CPDO, which can drop significantly. But even if spreads gap out from 40bp to 190bp, the instrument still makes its money back by maturity. There's volatility along the way – and the CPDO certainly couldn't issue new triple-A debt at say year two, as a plain-vanilla triple-A issuer like France can. So a CPDO is not, and does not pretend to be, a proxy for other triple-A debt. But if you buy your CPDO, go to sleep, and then wake up in 10 years' time, you can be very confident that all your coupon and principal payments will have arrived in full and as scheduled.

All of the criticism of CPDOs misses the really clever thing about them: the fact that, contrary to what many commentators are saying, they're largely immune to corporate defaults. If a lot of investment-grade companies suddenly were to start defaulting, that would be very bad for the markets, and spreads would widen. But as spreads widen, so does the income on CPDO structures. So one of the only ways to break a CPDO is for there to be a lot of defaults along with spread tightening. Which is something I'm happy to bet will never happen. (Remember we're talking about investment-grade defaults here: think Enron. They happen, but they're not very common. And there would need to be a lot of them in a very short time, since CPDOs incorporate 250 different credits.)

A CPDO which starts out with 15x leverage is not intended to stay at 15x leverage for long. If things stay relatively normal, the CPDO will end up in risk-free securities with no leverage relatively quickly. On the other hand, if things go to pot, then the CPDO will have to keep that leverage for longer in order to make all of its scheduled payments. That's why it has a ten-year maturity: to be very safe on that front. The large leverage doesn't only increase the coupon rate; it also increases the amount of losses that the structure can recoup.

It's true that a triple-A security paying 200bp over Libor seems a bit unnatural; it's also true that with leverage often comes increased risk. But those are just lessons learned from experience. Maybe the experience of CPDOs will help to change those lessons.

Are we clear on that?

You gotta give 'em credit

John Succo, over at Minyanville, wonders if we will be as good at paying back our debts as we are in taking it.

The Land of Credit
[L]iquidity can come from two sources: income or borrowing.

Real disposable income has actually fallen over the last five years.

U.S. consumers are borrowing to consume. A total credit to GDP of 3.6 times (the next highest was 2.9 in 1929 and has averaged maybe 1.5 times over the last decades) the lowest equity levels in homes ever, the highest percentage of disposable income going to service debt ever, government budget deficits of over $300 billion and a public debt figure approaching $9 trillion (not even counting the war costs of $500 billion so far not added in) etc., all confirm this fact.

Few people really understand the ramifications of this or the process by which the bureaucrats in Washington accomplish the harm all this debt will eventually do by creating more of it.

The Fed just did a $1.3 billion dollar coupon pass, which is like a permanent REPO. The Fed calls up JP Morgan (JPM) and purchases its bonds with credit, credit created from nothing. They just tell JP Morgan, "we owe you money."

JP Morgan now has funds (credit) it can lend out. But because of margin requirements it can lend out much more than $1.3 billion. In fact it lends out about twenty times that amount. So let’s say they call up 20 regional banks and let them borrow $1 billion each. In turn, each regional bank then lends out $5 billion to various mortgage borrowers. These borrowers refinance their house and spend the extra cash while the equity in their home drops.

The original $1.3 billion of credit the Fed created yesterday will in a few days turn into $100 billion of money borrowed by consumers. In fact these numbers are born out by the Fed’s activity over the last year. The Fed’s balance sheet has grown by about $30 billion over that time, while total credit market instruments outstanding grew by $3.5 trillion.

But that is just traditional pyramiding.

Today we have the derivatives markets where JP Morgan can take some of that credit and lever it 100 to one by underwriting derivatives (I don’t mean to pick on JP Morgan, although it is by far the largest derivatives dealer in the world; others like AIG or other large Broker Dealers are doing the same). So of the $1.3 billion, let’s say JP Morgan keeps $300 million and then sells options to customers. It uses that credit as capital to support the trade; the trade itself is $150 billion in notional contingent liabilities. The notional amount of derivatives over the same period of time has grown by a scary $88 trillion. Derivatives are lending on steroids.

All this liquidity is driving nominal asset prices higher and higher. And ironically they must in order to keep the borrowing bubble bubbling.

But risk is increasing exponentially and threatens our very country’s solvency. The only reason things seem great is because other central banks around the world are willing to keep creating credit themselves and lending it to us. Todd calls this the elasticity of debt: how much debt will the market accept before it can’t take anymore. I don’t know the answer to that, but when it occurs there will be no escape.

We are really, really good at creating credit. Are we good at paying it back?

See, Giving credit where credit is easy

Also see, And then the recession started ...

Where was I?

Life intervenes and the blog goes begging for attention. Birthday, kids starting to arrive for the holidays. The stuff that, if I had more of, would cure this blogmania.

Anyway, the following truncated items were noted over the last few days and are probably stale already. This may be the standard until the new year. Bare with me.

HONEST ABE: Abe says sorry and forfeits pay after helping to rig meetings This story got my attention as Baby Bat and fiance flew in from Japan, and because, well, could you imagine this even being controversial in Australia or the US?? Taking responsibility? Oh,please - ministerial responsibility is soooo yesterday.
The Prime Minister of Japan has apologised to the nation and agreed to work for three months without pay after admitting that he helped to rig dozens of town meetings to give the impression that voters were overwhelmingly sympathetic to official policy.

Promising to forfeit about £22,000, Shinzo Abe said that it was “very regrettable that these kinds of goings-on occurred”. Four senior members of his Cabinet also agreed to forfeit months of pay.

The town meetings were supposed to inject grassroots democracy into a political system driven by backroom deals and an old guard ruling party that has held power for decades.

But yesterday it emerged that most of the 174 meetings were staged, with officials posing as ordinary citizens to put simple questions to their paymasters.

An investigation, triggered by media claims that the meetings were rigged, found that “citizens” were paid Y5,000 (£20) to ask questions intended to help to forge government policy on education.

Government stooges were instructed to make sure that they did not start off by saying “I was told to say . . . ” Their comments strongly backed Mr Abe’s plan to overhaul education law to promote patriotism and civic virtue.

The town meetings were introduced in 2001, long before Mr Abe became Prime Minister. However, he was seen as instrumental in organising them in his previous role as Chief Cabinet Secretary.

Yesterday Yasuhisa Shiozaki, the current Chief Cabinet Secretary, who is also giving up three months’ pay, said: “We began [these town meetings] to carry out candid reciprocal dialogue with the public. In consideration of the gravity of the situation with discoveries of staged questions to the sloppy use of taxes, I think this is the proper way to take responsibility.”

TWILIGHT TIME: Stardust may be basis of life on Earth
The first analysis of samples that Nasa's Stardust mission brought back to Earth from a comet earlier this year has revealed that comets contain a richer range of ingredients than previously thought, including the complex molecules needed to kick-start biology.

The findings will force a re-evaluation of the traditional thinking on comet formation. "We think we know what these things are made of and then suddenly we find that, no, we don't," said Monica Grady, an astronomer at the Open University who worked on the Stardust samples.

Nasa launched Stardust to test the standard concept that comets are just dirty balls of snow left over from the early solar system. It was sent to examine the comet Wild 2 in February 1999.

The probe flew through the tail of dust and debris the comet had emitted and, after travelling 2.88bn miles, returned to Earth earlier this year with a payload of thousands of tiny particles from the comet.

The results of the first investigations of the trapped dust were presented yesterday at the American Geophysical Union's autumn meeting in San Francisco and simultaneously published in the journal Science.

To their surprise, scientists found a huge range of minerals in Wild 2. In particular, the samples showed evidence of aluminium- and calcium-rich minerals that could only have.

OF SEA CHANGES AND BEACH FRONT PROPERTIES: Oceans may rise up to 140 cms by 2100 due to warming
The world's oceans may rise up to 140 cms (4 ft 7 in) by 2100 due to global warming, a faster than expected increase that could threaten low-lying coasts from Florida to Bangladesh, a researcher said on Thursday.

"The possibility of a faster sea level rise needs to be considered when planning adaptation measures such as coastal defences," Stefan Rahmstorf of the Potsdam Institute for Climate Impact Research wrote in the journal Science.

His study, based on air temperatures and past sea level changes rather than computer models, suggested seas could rise by 50-140 cms by 2100, well above the 9-88 cms projected by the scientific panel that advises the United Nations.

A rise of one metre might swamp low-lying Pacific islands such as Tuvalu, flood large areas of Bangladesh or Florida and threaten cities from New York to Buenos Aires.

"The computer models underestimate the sea level rise that has already occurred," Rahmstorf told Reuters of a rise of about 20 cms since 1900. "There are aspects of the physics we don't understand very well."

Sea level changes hinge on poorly understood factors such as the pace of the melt of glaciers and of ice sheets in Greenland and Antarctica. Water also expands as it gets warmer but the rate of penetration of heat to the depths is uncertain.

"My main conclusion is not that my forecast is better but that the uncertainty is much larger because of the different results you get with reasonable methods," he said.

BANKING ON AUSSIE BANK STOCKS: Days of big bank profits 'over'
Dwindling mortgage growth and increased pressure on margins may well force bank profits down, said ANZ chief executive John McFarlane.

"There was some years we had mortgage growth well over 20 per cent. We're now seeing mortgage growth in the low teens and still heading downwards," Mr McFarlane said after the bank's annual general meeting in Sydney today.

"They're still pretty good circumstances.

"But given that environment and given that margin pressure has been pretty constant across that period, all other things being equal, you must see an attenuation of the underlying profits in the industry."

: Housing, Auto Slumps May Defy Usual Role as Recession Harbingers By GREG IP and CHRISTOPHER CONKEY (need a ticket to read)
New home construction is plummeting. Car sales are weakening. Investors have driven long-term interest rates well below the short-term rates set by the Federal Reserve. All these factors are present today, and all have been precursors of past recessions.

But the U.S. central bank and much of Wall Street are now betting that the old rules don't apply, and that a recession next year, while possible, is unlikely.

"This time will be different," Ed Leamer, who heads the forecasting center at the University of California at Los Angeles's Anderson School of Management, predicts in a report. "This time the problems in housing will stay in housing." It's a prediction, he admits, that "keeps us up at night."

To be sure, the economy has slowed. Economists expect it to grow at an annual rate of 2% to 3% over the second half of 2006 and all of 2007, after averaging 3.8% for the prior three years.

Moreover, both the Fed and Wall Street have a dismal record on predicting recessions. Ed Hyman, chief economist at New York investment dealer ISI Group, said, "I don't buy the view that because the housing correction hasn't done much to the economy so far, we've seen the worst." He said both the Fed's rate increases over the past two years and last year's rise in oil prices are hitting the economy with a lag. He expects a slowdown, not a recession, but sees more downside than upside risks to that forecast.

BUT MAYBE NOT SO DIFFERENT THAN 1999: Party Like It's 1999
"So where," I asked Phillipa, "is all the strength in retail sales coming from?" The short answer is, because we are partying like it's 1999.

Bullish analysts would correctly point out that incomes are rising. Disposable income was up 6% in the third quarter, partly from rising incomes and partly from reduced tax payments. The third quarter was the first time in two years that income growth exceeded spending growth.

But income growth does not come close to explaining how we can see huge drops in Mortgage Equity Withdrawals, yet no apparent effect on sales. So where are we getting the cash? From savings. Phillipa writes:

"Our tax contacts in states prone to heavy exercise of stock options report a big upsurge this year. Individuals have been sellers of stocks forever, but the levels in the Q3 Flow of Funds report are at record highs. The first 3Qs of 2006 average $770B at an annualized rate; in 2000 it was $630B, and no other year comes even close. It's currently 11% of DPI; previous peak was 9% in 2000.

"(Net financial investments, basically savings less borrowing, has been positive since 1952 when the series started. In the 1950s it was about 5% of DPI rose to its peak of 11% in 1982, went negative in 1999 and now is -9.7% of DPI. This is another way of saying the savings rate is negative, but the levels are stunning to us.)

"In Q3 households sold $166B in treasuries, $139B in corporate bonds, and $757B in stocks, totaling about $1.1 trillion, and net purchases of financial assets was an unusually low $250B.

"Putting it all together, we have decent income growth, but households are still doing a lot of dissaving to keep up their spending. We keep looking to credit card debt to cover loss of mortgage equity, but perhaps people are also selling assets to finance spending. Eek."

But what does it matter if we sell assets to finance spending if the total value of the assets in our portfolio keeps rising? We are back to 1999. It really does look like Goldilocks this time.

Oh, there are some rumblings here and there, but overall, Mr. and Mrs. Consumer Investor are quite happy to party on. Equity markets are going for new highs. Credit spreads are tighter than ever (except for sub-prime debt). Mergers, buyouts, and new debt issuance are at all-time highs. What's not to like?

So should we be concerned? Why even think of comparing today to 1999 or 2000? Perhaps because of the half-dozen forward-looking indicators which typically (and up to now reliably) forecast recessions, like the inverted yield curve and slowing housing. I have written about them for the past few months. New readers can read those letters in the archives section at Now comes Dr. John Hussman to give us yet another reason: valuations may not be as low as you think. (

I quote at length because this is so good:

"Charles H. Dow, who edited the Wall Street Journal a century ago, once observed 'It is impossible to tell in advance the length of any primary movement, but the further it goes, the greater the reaction when it comes, hence the more certainty of being able to trade successfully on that reaction... The best way of reading the market is from the standpoint of values. To know values is to comprehend the meaning of movements in the market.'

"Dow's successor at the Wall Street Journal was William P. Hamilton, who was also a brilliant observer of the market. Hamilton observed that bull markets generally occur in three phases. As Richard Russell summarizes: 'Phase one is the rebound from the depressed conditions of the previous bear market. Here stocks return to known values. In the second and longest phase, shares advance in recognition of improving business and a rising economy. During the third phase they spurt skyward on the hopes and expectations of a continuing rosy future... The low-priced 'cats and dogs' historically make great moves in this third phase...'

"As another follower of Dow, Robert Rhea, once wrote: 'the final stage is sometimes recognizable because people then buy stocks simply because they go up, and because other people are buying them.'

"With the S&P 500 currently trading at nearly 18 times fresh record earnings, on record profit margins, it seems clear that the current bull market is well into its third phase. To anyone who examines more than one or two decades of market history, even a multiple of 18 is very rich by historical measures, and can't be reconciled simply by reference to interest rates or inflation.

"On closer inspection, of course, valuations are even more hostile. Over the past three years, profit margins have widened to record levels, which has detached P/E ratios from other fundamental measures - such as price/revenue, price/dividend, and price/book ratios. The S&P 500 is currently about double its historical norms on those metrics. That isn't a forecast that stocks have to eliminate that valuation gap, but it certainly does suggest that stocks are priced to deliver unsatisfactory long-term returns from these prices.

"It bears repeating that if profit margins were at normal levels - even on the basis of profit margins that prevailed during the 1990's (indeed, anytime prior to the past 3 years) - the price/earnings ratio of the S&P 500 would currently be nearly 25. Unless investors want to speculate on the notion of a 'permanently high plateau' in profit margins, the stock market is strenuously overvalued at present. Neither current earnings nor 'forward' earnings should be considered - in themselves - as anything close to robust or reliable metrics of value here."

Hussman's reference to a "permanently high plateau" is from that famous quote:

"Stock prices have reached what looks like a permanently high plateau. I do not feel there will be soon if ever a 50 or 60 point break from present levels, such as (bears) have predicted. I expect to see the stock market a good deal higher within a few months." - Irving Fisher, Ph.D. in economics, Oct. 17, 1929, a few days before the big crash and the beginning of the Depression.

Maybe I just don't get it. Scratch that. I clearly don't get it. I simply don't see the risk versus reward of the broad stock market at these levels, with all the warning signs we can see today. To argue for higher market levels, as almost every economist is (Barron's in their recent roundtable forecast had not even one bearish participant), is to believe that this time it's different. It almost never is.

I admit to the possibility. But I find it hard to risk capital in long-only stock investments, my own or clients', in what looks and feels like1999. Party on, Garth!