Friday, October 31, 2008

market outlook as of 11/01/2008

The credit squeeze is thawing and real economy is deteriorating Short Term Credit market As I expressed in the the previous blog that the Fed's liquidity measure is finally working. By taking CP directly from issuers, Fed become the largest CP investor. As a result, CP rate dropped and issuance volume increased. 30 day financial CP rate has decreased from 4.01% as of 10/09/2008 to 2.04 as of 10/30/2008. The issuance volume in the week of Oct 29th increased $100 bil compared to the previous week. Money market rates are trending towards normalcy. 3 Month Libor rate has decreased from the peak of 4.8% to 3% as of 10/31/2008. Still these levels are still at relatively high, straining the availabiliy of credit. Especially, CP and Libor rates are yet to reflect the newly cut fed rate. It has to improve further to maintain the functioning of credit market. Economy GDP dropped 0.3% in the 3rd driving by weaker consumer consumption. After dropping in two months in row, US advance retail sales declined another 1.2% in Sept, the largest plummet in 3 years. Personal consumption ins the 3rd quater furthe spelled out retrenchment. Consumers cut back on durable and even nondurable goods. Even though it is only half way through third quarte earning season, we already noted that most sectors' earning declined. the average y-o-y earning growth is 10.9%. Only energy, info technology, healthcare, and materials are holding up. As global economy is entering to recession, global commodity and oil prices are in a free fall, these sectors will soon lose their luster. More and more big companies lower their guidance for 2009 and many, like GE, Xerox, American Express, etc, are laying off employees to save cost. Yes, with the government's buttress, financial sector is getting out the ditch, but the real economy is in the ditch now. Nationawide housing market contitue to slide. Surpiringly, Mass housing market price hold up well in four months through August. But the following wave of layoffs across the state lead by Fedility and other buy side financial firms might impact the housing market. Stock Market Spurred by short term credit market improvements, stimulating monetary policy, and higher than forecast GDP growth (-0.3%), stock maket has been trending upward after dropping to hte lowest point in Monday. Still the market is fragible, daily volatility is high, gyrating between positive and negative territory within hours. The week ahead might be mixed. One the positive side, the election result will be disclosed and money market might further improve. On the negative side, more economic indicators, like unemployment rate, will be released and might increase the downside risk to the economy. Furthermore, we are half way through the earnin season. More discouraing earnings might be underway. Bond market Improvements from corporate bonds market was lukewarm. Indices from different coporate bond rating category improved a little, but stil trading at stress levels. CCC and lower tranche is trading 29.5%, higher than the peak of 27.87% as of 09/28/2001, and the implied default rate is around 24.5% assumping 30% recovery rate. This level sounded overshoot and enticing. Currently, the default rate is still approximately 3% and Moody forecast the default rate might go up to 9%. But 7% of high yield market goes to automotive and automotive suppliers. These sectors is going to a crisis. Some of them might be gone in the near future. I would suggest waiting for a while to decide whether it is an attractive deal. International Market Credit crisis is taking a toll on more emerging markets, like South Korean, Hungary, Pakstians, etc. More small economies are borrowing from IMF. Pretty soon, its 200 bil fund will be used up. Even Japan market was hammered despite its lower exposure to US subprime market. Its ongoing increasing currency value raised concern about its exports. Its cross holding resulted in collateral damage. Hedge funds margin calls and redemptions further hurt the stock market. This is not the end of global recession. It is just a beginning. Some countries' economy or stock market will be further hammered. Argentine and Iceland is in the black list for national bankruptcy.

"20% high-yield defaults? Don't underestimate the power of the autos!" - Accrued Interest On Monday the yield on the Merrill Lynch High Yield Master index reached a shocking 19.6%. That yield is admittedly enticing, but the real question is, how many of those high-yield bonds might default? In short, if we're getting 20% yield, could we wind up suffering 20% losses in defaults? According to Moody's, the largest default rate in history was 15% in 1933. In the post Depression era, there have been three years which produced double-digit default rates: 1990 (10.1%), 1991 (10.4%) and 2001 (10.6%). The average recovery rate (i.e., the amount the bond is worth immediately after default) is 32% for the three peak default years. So if a portfolio suffers 10% in defaults with 30% in recovery, it has actually suffered 7% in total credit losses. That history would seem to favor high-yield, even admits an ugly economic forecast, given the initial yield of 20%. But risks remain. First, the proximate cause of most corporate bankruptcies is either an inability to roll over debts or a demand by creditors for collateral which the company cannot obtain. Right now roll-over risk in high-yield is higher than any time since at least the early 90's. Junk-rated companies can obtain funding through one of two routes, either bank loans or the public bond market. But neither of those are open to lower-quality borrowers right now. There have not been any new high-yield issues for the entire month of October. And banks remain highly unwilling to lend to anyone, much less to high-credit risk firms. Should the credit markets thaw somewhat in the near term, new deals may be possible. But even if that happens, how many companies will be able to operate where the cost of debt is 20%? Some companies look for ways to borrow in the secured market, where companies pledge specific assets to lenders, which in effect subordinates existing bond holders. Then there is the 900-pound gorilla in the junk bond market: the autos. Ford and General Motors alone make up about 7% of the high-yield index. Recent stories in the media suggest that GM will need a loan from the government to complete a merger with Chrysler, and even then there are no assurances that the companies significant problems can be solved. There are also stories that GM sought help from Toyota. Sounds awful desparate. In fact, I'd argue that a bankruptcy would be better for the American auto industry long-term, as it would allow firms to focus on production rather than dealing with an out-dated union structure. That's the path the airlines followed in 2001-2002. If high-yield defaults follow the "normal" recessionary pattern of about 10% defaults, but GM and Ford default as well, that would bring total defaults to about 17%, disturbingly close to the 19.6% yield on the index currently. Given the extremely high rate of interest on high-yield currently, the odds are good that high yield will produce positive returns over next 3-years. Even if defaults spike in the next 12-18 months, investors will likely be well-compensated for the credit losses over a longer period of time. But if one is to take that tact, bear in mind that the near-term could be very painful, and that market-quotes (or NAV values on mutual funds) could still fall from here. Its probably best to think of high-yield as a low-beta equity investment rather than a bond investment. Go into it with the understanding that equity like gains and/or losses are possible, and size the trade accordingly.

Consumers have thrown in the towel

--Spending by US consumers dropped more than forecast in Sep, -0.3% drop, after being flat in Aug and July. --Major drivers of less consumption are durable (auto, furniture), -32.8 and nondurable consumption(clothing, drining etc), 18.3%

Accounting Change Lifts Deutsche Bank

--Deutsche Bank reported positive earning in Q3 08 by avoiding mark-to-market accounting policy, whici was allowed by European IAS --The trick might be imitated by other European banks in the Q3. Deutsche Bank AG, helped by a change in the way European banks book souring assets, posted a profit in the third quarter even as in-house trading bets in the stock and credit markets led to third-quarter losses totaling €1.3 billion ($1.68 billion). The Frankfurt bank, which has navigated around write-downs tied to loans for homes and acquisitions, reported third-quarter net income of €414 million, far below net income of €1.6 billion in the same period a year ago. A change this month by European accounting policy makers allowed banks to move souring loans to their hold-to-maturity books, limiting write-downs that would have resulted from valuing the assets at market prices. Deutsche was one of the first banks to take advantage of the change in International Accounting Standard 39, recategorizing €24.9 billion of loan exposure. For the third quarter, Deutsche avoided €845 million in write-downs, but still reported total write-downs of €1.2 billion. The accounting change meant Deutsche essentially was able to report the net income of €414 million instead of a €122 million loss. Deutsche shares rose 18% to €29.20 in Frankfurt. Jon Peace, a bank analyst at Nomura International PLC in London, said the increase reflected relief that Deutsche didn't lay out plans to sell stock on the market like many of its peers have. The bank raised €2.2 billion in capital in September to finance the acquisition of a minority stake in Deutsche Postbank AG. "People were fearful of an announcement of a big, dilutive recapitalization, and it's not come through," Mr. Peace said. The next test of the new rules will be when Switzerland's UBS AG reports results Tuesday. France's BNP Paribas SA reports Wednesday, and its French rival Société Générale SA follows on Thursday. Josef Ackermann The outlook from the German bank is seen as a barometer both for the European banking system and for financial firms dependent on the sales and trading of securities tied to stocks and bonds. Chief Executive Josef Ackermann said he expected the broader economy would hurt the global financial system, saying in a note to investors, "The credit environment is already becoming tougher. Corporate default rates are rising, as are delinquencies in consumer and credit card lending." Mr. Ackermann's comments underscore the difficult months ahead that banks globally face even after a period of 45 days that saw coordinated interest-rate cuts, capital infusions in banks, and governments agreeing to back the issuance of bank debt. Banks globally also are trying to identify how they will generate revenue in the wake of the credit crunch while also trying to sidestep money-losing in-house bets. Deutsche's investment bank, for example, reported a loss of €789 million, compared with a loss of €179 million in the year-earlier period. Traders responsible for using the bank's money to make bets in the stock market lost €386 million. At the same time, Deutsche's in-house debt traders posted trading losses of €873 million.

Thursday, October 30, 2008

Hospitals could be forced to buy back $8bn of debt

--like ARS, VRDN issue long term debt using short term rates --$400 bil VRDN usually have backstop from banks, ARS do not. By Rebecca Knight in Boston and Nicole Bullock in New,York Published: October 30 2008 02:00 Last updated: October 30 2008 02:00 US hospitals may be forced to buy back more than $8bn (£5bn, €2bn) of debt as a result of turmoil in the credit markets, adding to their burdens just as a weakening economy is draining resources. The problem for the hospitals involves so-called variable rate demand notes and other securities that they have agreed to buy back in some cases. The interest rates on VRDNs reset periodically and investors have the right to reject the new terms and sell the paper back to the issuer or a bank. An estimated $400bn in VRDNs have been issued in the US and most require banks - rather than the issuer - to buy back the debt. However, Moody's Investors Service, the ratings agency, said 24 not-for-profit hospitals in the US have issued $8.4bn of debt requiring them to buy back the paper. Lisa Martin, senior vice-president at Moody's, said three hospitals - NorthShore University HealthSystem in Illinois, North Mississippi Health System and Virginia's Riverside Health System - have had to repurchase such debts. Although they all have sufficient cash to meet their obligations, the repurchases were described as highly unusual by Moody's. In the past, hospitals could usually count on their bankers to find new buyers for such debts. "Three out of 24 might not sound very bad, but it is unprecedented," Ms Martin said. "There has rarely been a situation where a hospital has not been able to find a new buyer." If hospitals find themselves without sufficient funds to buy back the debt, they might have to default, Ms Martin said. Moody's is looking into whether hospitals that have issued these notes have sufficient resources to buy them back. The payment pressure comes at a bad time for US hospitals. A rising number of patients are falling behind on hospital bills as health insurance costs rise. "Because of the weaker economy, employers are dropping healthcare coverage, reducing coverage or requiring employees to pay more," Ms Martin said. Tigher conditions in the credit markets are making it more difficult for hospitals to borrow from other sources. Some have delayed bond sales needed to finance new construction or equipment purchases. "[Hospitals] are trying to borrow money to make much needed improvements and upgrades to their systems, such as purchasing IT equipment, but there's no lending going on, and the costs are going up," said Mike Rock, lobbyist for the American Hospital Association. "In some cases they've seen their interest rates rise from two to eight [percentage points]." The problems with VRDNs echo those of auction rate securities, which also reset interest rates at short-term intervals. The rationale for such securities is that they enable borrowers to access long-term funding at short-term rates - a strategy derailed by turmoil in the short-term debt markets. The difference between the two kinds of securities is that VRDNs have a "backstop" - a buyer of last resort. However, investors have found this feature less reassuring because of fears about the banks that provide support in most cases. "There were very few failed remarketings until we entered the credit crunch," said Philip Fischer, a Merrill Lynch municipal strategist. "In this environment, we have had a variety of them."

Securities-Lending Sector Feels Credit-Crisis Squeeze

The credit crisis is causing a contraction of the little-noticed but huge business of securities lending, and financial players including pension funds, insurers and hedge funds are paying a price. Losses are sparking lawsuits from customers who pursued securities lending as a way to squeeze additional gains with seemingly little risk. Northern Trust Corp. and Wells Fargo & Co., which run programs for institutional investors with securities to lend, were sued last week by clients who alleged that they mismanaged money and, in the case of Wells Fargo, deceived the clients about the nature of their investments and degree of losses. Both companies are defending against the suits. Securities lending programs, which combined have represented at least a trillion dollars, involve lending securities to short sellers or others and investing the collateral for gains. The strategy for many has lately backfired as once-reliable credit investments have seized up amid market woes. In recent weeks, the city of Hartford, Conn., and other institutional investors have suspended their securities lending programs. State Street Corp. and other large custodian banks have restricted investors from exiting from the programs. And insurers including MetLife Inc. and Chubb Corp. are trimming or winding down their programs; American International Group Inc., has suffered more than $15 billion in unrealized and realized losses. Kathleen Palm Devine, treasurer of the city of Hartford's $1 billion Municipal Employees' Retirement Fund, froze her securities-lending plan in August, when it had securities worth $52 million. She said the fund earned about $425,000 a year, "but we are willing to forgo that income until we know better what is going in the markets." If markets improve, it is possible fear of losses will subside and participants will resume their level of lending activity. Investors who hold large portfolios of securities such as pension funds, index funds, insurers and endowments often lend them out and profit by investing the collateral they receive in exchange for the securities. Often a custodian handles the program including the investing, which is generally done in low-risk investments. While the profit on any individual transaction is small, with big portfolios the gains add up. Securities lending is widespread but it has had critics. David Swensen, chief investment officer of Yale University's endowment, has derided these programs as "make a little, make a little, make a little, lose a lot." In Minnesota, the Robins, Kaplan, Miller & Ciresi Foundation for Children, two other foundations and a nonprofit insurance association filed a state-court lawsuit last week alleging Wells Fargo repeatedly assured securities-lending clients that their cash collateral would be invested in safe investments, such as "high-grade money market instruments." Instead, "Wells Fargo also invested in highly illiquid securities, including mortgage-backed assets with maturity dates that reach out nearly 40 years." The suit says the combined losses, going back to last year, for the four clients are at least $17 million on securities lending programs valued at about $373 million. But the suit adds that "since Wells Fargo's valuations have been based on an artificially inflated [net asset value] it is believed that these numbers substantially understate actual losses." Wells Fargo spokesman Gabriel Boehmer said: "We dispute the allegations. Like all investments, investors bear the risk of losses. We intend to vigorously defend against these charges." He added: "All the investments were highly rated and highly liquid at the time of purchase." BP Corporation North America Inc., a unit of BP PLC, filed a suit last week in U.S. District Court against Northern Trust, seeking to get its pension fund out of Northern Trust's securities lending program without incurring losses. BP alleges the bank violated federal employment law operating "the securities lending program in an imprudent manner." The suit said some of cash collateral investments had defaulted, while others "have been marked down in value and...have become so illiquid that such investments could only be sold" at substantial markdowns. Northern Trust, which has acknowledged losses, says that the BP suit "seeks to avoid safeguards that Northern Trust put in place to ensure that all the participants in those funds are treated equitably during extraordinarily difficult economic conditions." The University of Washington sued Northern Trust last month to get out of its securities lending program when the university learned it was losing money. The school agreed to accept a $6.6 million loss to exit from the program, according to an Oct. 3 settlement agreement. The school's program had been $750 million. Some insurers also have large securities lending programs, though they generally lend debt securities to Wall Street firms seeking to hedge positions. Their programs play off their expertise running huge bond portfolios. Problems with the securities lending program at AIG prompted it this month to secure up to $37.8 billion from the federal government, which had already made available $85 billion to the insurer to help it avoid bankruptcy last month. MetLife had about $45 billion of securities on loan as of June 30, the company's chief financial officer, William J. Wheeler, told investors and analysts in an Oct. 8 conference call. The total was down to about $40.4 billion as of Sept. 30, according to a regulatory filing. On its third-quarter conference call Thursday morning, executives are expected to discuss the latest cutback in the securities-lending program "I think it's safe to say we assume that the program, the overall outstandings, will probably shrink," Mr. Wheeler said on the Oct. 8 call. The three big custodian banks that run securities lending programs with a combined value of around $1 trillion could be among the bigger losers if institutions continue pulling out. State Street had $246 million in revenue from securities lending in the third quarter, or about 10% of its total revenue that quarter. Moody's Investors Service this month cited the possibility that "client interest in securities lending activities could also decline going forward" as a reason for keeping State Street's credit outlook as negative. A spokeswoman said "about 10% of our customers and 10% of the assets have left the program -- something that we believe to be temporary." Bank of New York Mellon Corp. said it had revenue of $155 million from securities lending in the third quarter, out of total revenue of $3.9 billion. The bank said on a recent conference call that about 2% of its client base, and slightly more than that in terms of assets, has exited from its securities lending program. Because of the losses in its cash collateral investments, Northern Trust says its securities-lending revenue in the third quarter was negative $4.6 million. That figure was down from $150 million in revenue from securities lending, or 15% of the bank's total revenue, in the second quarter.

Wednesday, October 29, 2008

Japan is the Victim of Collateral damage - ECO

---Japan is a victim of collateral damage caused by cross-shareholding. ---hedge funds liquidition & soaring yen value damaged its stock market and exports. Oct 27th 2008 TOKYO From Japan's banking system, until recently one of the strongest in the world, is battered UNTIL recently Japanese banks had largely avoided the agonies of the credit crunch that had caused such difficulties in much of the rest of the world. Now the misery has well and truly come to Tokyo. The culprit is not toxic derivatives and swaps, but ordinary shares held by banks in Japanese companies. These cross-shareholdings, a peculiar feature of Japanese capitalism, are having pernicious effects. As share prices fall, banks are force to revalue their assets, which in turn reduces their capital ratios. The result is a need to raise capital quickly. In the past four trading days, the Nikkei 225-share index has tumbled by 23%. On Monday October 27th the index plunged by 6.4% to 7,162.90, the lowest level in 26 years. Mitsubishi UFJ Financial Group (MUFG), Japan’s biggest bank, plans to raise as much as ¥990 billion ($10.6 billion) by issuing new common shares of perhaps ¥600 billion and preferred securities of ¥390 billion. Mizuho Financial Group and Sumitomo Mitsui Financial Group are said to be planning their own capital increases. The government is scrambling to help out. It is poised to announce a set of new measures, including spending perhaps ¥10 trillion to buy shares in companies that the banks hold (in an off-market transaction, so their values do not fall further). This was a tactic used by the Banks’ Shareholdings Purchase Corporation to respond to a banking crisis in 2002. The government may also request that pension funds and life insurance firms buy equities to support the market, though whether they would respond remains to be seen. Some institutions and bankers, including the chairman of Shinsei—once known as Long Term Credit Bank, which was nationalised a decade ago—have urged regulators to suspend accounting rules that force the banks to value assets at present market value. The use of “mark-to-market” standards may force firms to write-down the value of their assets painfully, even though the trough may be temporary. As it stands, banks must subtract around 60% of their paper losses from their core capital. The government has signalled that it may be willing to ease the rules. On Monday the Financial Services Agency also put in place a ban on “naked” short-selling, from November 4th until March 31st. Regulators in other countries have been grappling with the problem too, in an effort to stop those who, without actually taking ownership of a firm’s shares, bet on a fall in that firm’s share price. In addition, short-sellers who take a stake of more than 0.25% of the outstanding shares must disclose their position to the market. Share prices are tumbling fast largely because foreign hedge funds have been forced—by the need to meet margin calls and redemptions—to liquidate positions. Investors are also worried that a big global recession will hurt Japan’s exporters, just as a domestic slowdown hurts other firms. Exporters are battered, too, by the steep rise in the value of the yen. It has soared by 11% against the dollar and around 21% against the euro in October, as the yen carry trade unwinds and amid a general flight to safety. The G7 industrialised countries issued a short emergency statement on Monday, at the urging of Japan’s finance minister, Shoichi Nakagawa, expressing strong concern about the recent volatility of the yen. Mr Nakagawa said that Japan would “take necessary action promptly while closely watching the yen’s movement”, an indication (though not an entirely convincing one) that it might intervene in the foreign-exchange market. It marks a rapid reversal of fortunes for Japanese banks. Just a month ago, fresh from MUFG’s offer of ¥950 billion for a 21% stake in Morgan Stanley, and Nomura’s purchase of operations of the bankrupt Lehman Brothers in Asia, Europe and the Middle East, Japanese bankers felt they were once again dominant on the international financial stage. They were rich with capital and willing to spend, at a time when other institutions were desperate. Now they are victims not of contagion, but of collateral damage.

FOMC Oct 29th

--Eco actvitiy slowed markedly due to the decline in consumer, and corporate, exenpenture, and weakening global economy. The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 1 percent. The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures. Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports. Moreover, the intensification of market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit. In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate in coming quarters to levels consistent with price stability. Recent policy actions, including today's rate reduction, coordinated interest-rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth. Nevertheless, downside risks to growth remain. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

Credit Crisis is hruting Asian Trades

--Two Chiese companies went bankructpt because they could not afford debt payment. --Credit squeeze hurt trading companies, which relies on US credit letters. It benefits US dollar. --Generally Asian banking system look health except South Korea, Australia, & Pakstain.. The credit crisis is hitting Asia where it most hurts—trade ReutersLITTLE by little, the credit crisis is causing problems in the belly of Asian business. On October 20th CITIC Pacific, a Chinese conglomerate, stirred fears about the hedging strategies of companies across the region when it revealed a potential $2 billion loss caused by a bad bet on currencies. It is being investigated by Hong Kong’s authorities amid concerns that it failed to reveal the loss quickly enough. Also, two big Chinese companies, Smart Union, a toymaker, and FerroChina, a steelmaker, have gone into default this month, as have three Hong Kong retailers. Each, unable to find funding, had become increasingly slow to pay its suppliers. That problem is becoming pervasive, says the regional manager of an industrial-packaging operation, which puts an additional squeeze on business prospects. Technically, the local banking system in Asia should be healthy enough for banks to continue to lend. With the exception of those in South Korea, Australia and Pakistan, most banks can finance all their loans with deposits, which puts them less at risk from strained money markets. They are well capitalised and profitable. That, however, has not stopped fear-induced glitches. Several weeks ago, Chinese banks briefly cut off credit to international banks before the government intervened. At least one Hong Kong bank is still holding back from resuming normal credit transactions with its American counterparts. International banks are being even tougher with their clients. An executive at a big global bank says that credit lines are being trimmed, except for those to the largest and most established businesses. There are three reasons for this. The most important is that many banks do not have the funds to lend: the massive charges taken for bad loans in their home markets have reduced capital, even after the recent lifelines from Western governments and a few brave investors. Banks are also hoarding their cash, aware how precious it is. Risk, too, is being repriced, even in areas as supposedly safe as trade credit. That is where Asian companies are most vulnerable. Instead of relying on broad capital markets as is common in American and Europe, they seek credit in more traditional ways: bank loans, the sale of discounted receivables, and letters of credit. One trading company based in China says the collateral required for a letter of credit—typically a safe kind of loan because it involves merely delivering something to a customer—has jumped from 25% to 50% of the stated amount. An odd beneficiary of this squeeze has been the dollar, since orders are increasingly being settled in cash. In recent weeks, talk has grown of container-loads of goods unable to travel to America and Europe because they cannot be financed. More recently, there have been reports that traffic is stalled the other way. Several ship brokers refer to a vast order of scrap metal stuck on America’s West Coast that was bound for China. Some of the disruption is an inevitable consequence of faltering demand as the world economy slows; some traffic will be liberated as a result of the thaw in interbank-lending markets. A good measure of the environment is the spot rate for carriage on container ships; it has crashed. These same rates in the forward market suggest only the most modest recovery in years to come. There is little reason to hope confidence in Asia will rebound soon.

Iceland's deperate move to defend its currency

--Risk of capital flight spurred Iceland to raise interest rate by 6% to 18%, no comparable to Sweden's move in 1992, from 16% to 78%, and to 500% in the end. --heavily depended on import , Iceland needs a functioning currency-exchange market... Iceland's central bank raised its benchmark interest rate by six percentage points to 18%, and Hungary agreed to take a $25.1 billion loan package organized by the International Monetary Fund, as the two countries tried to rescue their currencies. The IMF on Tuesday night announced an aggressive funding package for Hungary, which had initially tried to avoid that step. The main IMF loan is for $15.7 billion, while the European Union said it would lend $8.1 billion and the World Bank promised $1.3 billion, the IMF said. Reuters Iceland Prime Minister Geir Haarde arrives in Helsinki for the Nordic Prime Ministers meeting. Hungary, which has been talking with the IMF for days, last week raised its key rate three percentage points to bolster a wilting forint. The IMF portion of Hungary's aid is expected to be formally approved in early November and "includes measures to maintain adequate domestic and foreign currency liquidity, as well as strong levels of capital, for the banking system," said IMF Managing Director Dominique Strauss-Kahn, in a statement. Iceland, which depends heavily on imports, desperately needs a functioning foreign-exchange market so Icelanders can use their kronur to buy euros or dollars, and with them the goods they need. Rate increases are generally used to cool overheating economies and lower the risk of inflation. When the economic outlook is bleak, rates are usually cut to spur investment and growth. Getting the foreign-exchange market going again comes with a big risk: Investors could use the opportunity to dump kronur and take capital out of the country. A further collapse in the krona would also kick up inflation, already running at 16% annually. The size of Iceland's rate move is extraordinary, but not record-setting. In September 1992, amid strains in the European Exchange Rate Mechanism, Sweden's central bank raised rates to 75% from 16% to ward off a run on its currency. A few days later it took them all the way to 500%. Amid other signs that countries are eager for currency stability, Poland's government approved a timetable that calls for the country to adopt the euro in 2012. President Lech Kaczynski has resisted the move, but on Tuesday he said the "finance minister made some strong arguments in favor of fast euro adoption," including that Poland would have been better insulated from the fall in Hungary's currency. The Polish zloty has lost ground against the euro since midsummer. Iceland's prime minister was in Helsinki on Tuesday, talking with his Nordic counterparts about further assistance. He is seeking $4 billion in addition to the $2 billion IMF loan, and he told reporters in the Finnish capital that Iceland also has requested help from the U.S. Federal Reserve and the European Central Bank. IMF and Icelandic officials have been worried about the krona, which slid after beginning the year at 92 to the euro. It touched 156 to the euro, according to the ECB, on Oct. 3. It has since effectively stopped trading. Investors off the island aren't much interested in holding kronur, and Iceland recently imposed restrictions on selling kronur for foreign currency. To provide a value for the krona, Iceland's central bank has been holding a local foreign-exchange auction. On Tuesday, the currency was set at 152.50 to the euro. But analysts say the krona could dramatically weaken, perhaps to 250, as offshore trade starts again. The IMF wants to avoid that. The "immediate objective" of the IMF's plan, which could be approved by the agency's executive board in coming days, is to "stabilize the krona," said Poul Thomsen, head of the IMF's mission to Iceland, in an interview Monday. "There is a substantial risk of capital flight." The rate increase is designed to encourage investors to hang on to Icelandic assets and keep krona deposits in local banks. The central bank said it believes contracting demand will swing Iceland's current-account deficit into balance or into surplus. That would boost the krona, and quell inflation. Then, "if forecasts materialize, the policy rate will be reduced," the bank said. Mr. Thomsen said the IMF wouldn't insist on immediate fiscal belt-tightening in Iceland, but would delay such measures until perhaps 2010. That is because Iceland came into the crisis with relatively low levels of government debt. Analysts say, though, that the country will have to assume, in some fashion, a portion of the debt incurred by its collapsed banks. That will change the fiscal picture. The IMF may be stricter with other countries that are seeking aid, such as Ukraine and

Barclays Capital Loan Sale Finds Few Buyers

--Leverage loan trades at 70 --more loans up for sale Barclays Capital sold more than 30% of the $970 million of mostly leveraged loans it put up for sale to liquidate positions linked to a derivatives agreement with hedge fund Black Diamond Capital Management LLC, people familiar with the situation said. The bank received bids for 75% of the loans and other debt that were largely denominated in U.S. dollars, though some were listed in euros and sterling. The sale came as hedge funds and institutional investors have been forced to sell a variety of assets to meet margin calls and redemptions from clients. Other bid lists circulated Tuesday totaling more than $4 billion, which included unsecured corporate bonds and credit-default swaps, sources familiar with the lists said. The small percentage of assets sold suggests that bidders drove too hard a bargain on the price of the assets. The loan market has fallen about 13 cents since the beginning of October, trading on average at around 70 cents on the dollar Tuesday, according to Standard & Poor's Leveraged Commentary & Data. This month, some $3.3 billion of leveraged loans have been up for sale. That is the most in a single month, outstripping the previous high of $2.1 billion in August 2007, LCD's figures show. The Barclays loans were linked to derivatives agreements, known as total-return swaps, or TRS, between the bank and BDC Finance, a fund managed by Black Diamond, of Greenwich, Conn.

Economists Search for End of Woes - WSJ

--House: vacancy rate --Consumer: consumer expectaction --Employment: weekly job loss --Company profit: S&P or South Korean Composite Stock Price Index Economists struggling to gauge the depth of the U.S. downturn are turning to more forward-looking clues, such as home-vacancy rates and foreign stock markets. The standard measures of gross domestic product and monthly payroll figures give snapshots of what has happened, but say less about what will happen next. The current downturn is shaping up to be worse than the recessions of 1990-91 and 2001 and the prolonged downturn that ended in 1982. Banks are cutting back on lending, consumers are spending less, companies are shedding jobs amid sinking profits, and the housing bust that triggered the slide persists. Here are five areas economists are watching, and the indicators they are tracking. Banks The government's plan to inject $250 billion into financial institutions as well as its guarantees on loans between banks eased some of the stress ripping through credit markets. View Full Image Getty Images Bernard Prinstein and other job seekers at an IRS open house in New York on Tuesday. Weekly jobless claims are an indicator of economic health. In a sign that banks have become less wary of lending to one another, the London interbank offered rate, a benchmark interest rate for many dollar loans, has fallen sharply over the past two weeks. It still is historically high relative to the Federal Reserve's target rate, however. Continued declines in Libor will be an important sign that the credit crunch is easing. While lower interbank rates are an important precondition for a recovery in lending markets, they won't automatically lead to a lending revival. "It doesn't matter whether a bank will lend to a bank," said Northern Trust economist Paul Kasriel. "It's whether a bank will lend to Joe the plumber." Banks are cautious about lending, in part because they have been hurt badly in the housing downturn and financial-market turmoil, but also because lending is riskier during a downturn. In the Fed's July quarterly survey of senior loan officers, a large percentage of banks reported that they had tightened lending standards. One early sign the economy is on the road to recovery, according to Mr. Kasriel, will be when more banks are easing lending standards than tightening them. Homes The housing market will play a major role in any easing of lending standards. As long as home prices continue to fall, more homeowners will find themselves owing more on their mortgages than their homes are worth. That sets the stage for more mortgages going sour and continued caution among lenders. Through this year's second quarter, the S&P Case-Shiller national index of home prices was 18% below its 2006 peak; Goldman Sachs economists forecast another 15% fall. The key to how much further home prices fall, Goldman Sachs economist Jan Hatzius said, is how fast the glut of empty homes is absorbed. At the beginning of 2005, 1.8% of nonrental homes were empty and waiting to be sold. The Census Bureau reported Tuesday a 2008 third-quarter vacancy rate of 2.8% -- even with the second quarter and just shy of the first quarter's 2.9%. With many homes on the market, sellers are lowering prices to attract buyers. "If you see excess supply coming down, Economics 101 says that house prices will eventually stabilize," Mr. Hatzius said. Consumers Worries about the economy have skittish consumers tightening their purse strings. Consumer spending represents more than two-thirds of U.S. GDP and hasn't declined on a quarterly basis since late 1991. That nearly two-decade spurt of spending growth likely ended during the July-through-September period, economists predict, dragging economic growth down with it. A widely followed index of consumer expectations, part of the monthly consumer-sentiment report from Reuters and the University of Michigan, could offer clues to where spending is headed. After hitting its lowest level in nearly 30 years in June, the gauge had begun to improve as oil and gas prices fell from their record highs. But that improvement was wiped out this month as financial and economic conditions worsened. One sign of improving attitudes among consumers will be their willingness to buy big-ticket items such as cars, furniture, appliances and electronics -- categories that have been hit hard in recent months as loan standards tighten and consumers shy away from making major purchases. "It's a natural thing to postpone spending when you're uncertain about the world," said Barclays Capital economist Ethan Harris. "What we want to see are signs that those sales are starting to stabilize and improve. That would tell you people are starting to come out of their bunker and buy things that are longer-term commitments again." Jobs Americans probably won't be inclined to make such commitments until they see improvement in the labor market. The payroll figures and unemployment rate from the monthly employment report are lagging indicators, showing changes in the jobs environment long after the fact. Many economists more closely monitor the Labor Department's weekly report on initial unemployment insurance claims, which measures the number of people filing for new unemployment benefits. A rule of thumb says that when claims stay above 400,000, the economy is slipping into recession. That started happening in July. The latest weekly claims figure is 478,000. Stocks Companies play the major role in the jobs outlook: If they are worried about losses, they are more likely to pare the work force than hire. The stock market, for all its imperfections, is one of the best indicators of corporate health. Millions of investors are devoted to figuring out where profits are headed, and their opinions get reflected in prices. But at a time when companies' health is highly dependent on the global economic environment, watching the Dow Jones Industrial Average may not give the best reading. Instead, Merrill Lynch strategist Richard Bernstein tracks the Korea Composite Stock Price index, known as the Kospi. South Korean companies are export-oriented, which makes them highly sensitive to global profit growth. The Kospi topped out a year ago. Tuesday, it was 52% below that level.

China cuts interest rate to 6.66%

BEIJING – China's central bank cut interest rates for the third time in just six weeks, moving to shore up investor and consumer confidence as the Chinese economy's once-stellar growth prospects come under an increasingly dark cloud. China moved ahead of a widely anticipated rate cut by the U.S. Federal Reserve, which is meeting Wednesday U.S. time. Other major central banks, including those of Japan, Europe and the U.K. are also expected to further lower borrowing costs in coming days as the impact of the global financial crisis continues to spread. China's benchmark one-year lending rate will fall 0.27 percentage point to 6.66%, while the one-year deposit rate will also drop 0.27 percentage point to 3.60%, the People's Bank of China said in a brief statement. The announcement came after the Shanghai stock market closed down 2.9% Wednesday, amid a string of generally soft third-quarter earnings reports from major companies. In a separate announcement Wednesday, the Ministry of Finance said the government has allocated an additional one billion yuan ($147 million) to support lending to small businesses. The government has been particularly concerned about the plight of small businesses, which account for much employment growth but tend to get hit harder in economic downturns. China's economic growth slowed to 9% year-to-year in the third quarter of this year, a more marked cooling than most had expected. Growth of exports has slowed as demand from the developed countries has weakened, while the domestic housing market is freezing up as many consumers wait for prices to fall before buying. While growth is still extremely fast by the standard of any other country, many economists now expect it to slip to 8% or even below in 2009. China's government has traditionally regarded 8% growth as the minimum necessary to maintain prosperity and stability in a nation undergoing rapid urbanization and social change.

Tuesday, October 28, 2008

The pendulum swings towards regulation - Lawrence Summers

--invest in transforming technology to increase productivity --more government intervention Published: October 26 2008 18:56 Last updated: October 26 2008 18:56 Events as well as ideas shape policy choices in democracies. Who would have predicted a year ago that a Republican ad­ministration would demand that Congress make the largest set of investments in public companies in US peacetime history? Would anyone have supposed that President George W. Bush would convene a global effort to renew Bretton Woods through strengthened international financial regulation? It reminds us that in the economic sphere, as in the national security sphere, dramatic events can make the inconceivable become inevitable. Discussions of the policy implications of the crisis have primarily focused on the immediate economic demands. The need to ensure the capital adequacy of financial institutions, maintain important credit flows, support the housing sector and the real economy, contain international spill­overs and reform regulation to prevent any recurrence of the crisis have rightly been the priority. In all these areas there will be many crucial policy choices to make in the months ahead. However, policies that contain the crisis, support the economy and generate recovery are not sufficient to meet the historic challenge of this moment. Even with the best conceivable fiscal, monetary, financial and regulatory policies, economic performance depends on deeper and more structural policy choices. Nations cannot fine tune their way to delivering a prosperity that is more broadly based. In important ways, then, the crisis creates space to address longer standing problems. Just as patients hear advice regarding diet and exercise differently after a heart attack, so recent events should make it possible for the next US administration to accomplish more than might previously have been thought possible. These broader goals depend on achieving the rapid and sustained growth that restores business confidence and generates the resources for investment. Economists do not understand what drives productivity growth very well. However, we know these facts: productivity grew rapidly after the second world war and then sometime between the late 1960s and mid-1970s it slowed dramatically only to re-accelerate to record levels in the mid-1990s. Unfortunately, even before the downturn, underlying productivity growth appeared to be slowing. The most plausible explanation is that an array of transforming investments and technologies – the interstate highway system, widespread air travel and the expansion of electronics – were spurs to growth during the postwar period. Eventually their impact dissipated and, as energy costs rose, growth slowed until the information technology revolution kicked in during the 1990s. Unfortunately, the IT supply shock that powered the economy in the 1990s and early part of this decade appears to be diminishing. So there is a need to ensure that the pressure to increase spending is directed at areas where it will have the most transformational impact. We need to identify those investments that stimulate demand in the short run and have a positive impact on productivity. These include renewable energy technologies and the infrastructure to support them, the broader application of biotechnologies and expanding broadband connectivity, an area where the US has fallen behind. The crisis has also reminded us of the lessons of the technology bubble, Japan’s experience in the 1990s and of the US Great Depression – that finance-led growth is problematic. The wealth and income gains from the easy availability of credit were highly concentrated in the hands of a fortunate few. The benefits also proved temporary. In retrospect, the fact that 40 per cent of American corporate profits in 2006 went to the financial sector, and the closely related outcome – a doubling of the share of income going to the top 1 per cent of the population – should have been signs something was amiss. Therefore we need to reform tax incentives that encourage financial risk taking, regulate leverage and prevent government policies that give rise to a toxic combination of privatised gains and socialised losses. This offers the prospect of a prosperity that is more firmly grounded and more inclusive. More fundamentally, short and longer-term imperatives come together with respect to policies that seek to ensure that any future prosperity is inclusive. The policies that are most effective in helping to support demand are those that help households struggling either because of low incomes or because they have recently lost part of their income. Recent events also remind us that individuals can become impoverished or lose health insurance through no fault of their own. This reinforces the need for people to have basic health and re- tirement security protection regardless of what happens to their employers. All of these considerations suggest that the pendulum will swing – and should swing – towards an enhanced role for government in saving the market system from its excesses and inadequacies. Policymakers need to be attentive to potential government flaws as well. For example, they need to recognise that, even as events compel larger deficits in the short run, they reinforce the need for longer-term measures to keep government finances on a sound footing. They must also be wary of measures that have a short-term superficial appeal, yet have adverse long-term consequences. It is said in all presidential election years that the choices made by the next president are uniquely important. This time the cliché is true. The gravity of our situation is matched only by the opportunity it presents.

Austria abandons its bond offering - FT

By David Oakley Published: October 28 2008 02:00 Last updated: October 28 2008 02:00 Austria, one of Europe's stronger economies, cancelled a bond auction yesterday in the latest sign that European governments are facing increasing problems raising debt in the deepening credit crisis. The difficulties of Austria, which has a triple A credit rating, highlights the extent of the deterioration, which saw benchmark indicators of credit risk such as the iTraxx index hit fresh record wides yesterday. Austria is the fourth European country to cancel a bond offering in recent weeks amid growing worries over its exposure to beleaguered eastern European economies such as Hungary. Hungary, which has been forced to turn to the International Monetary Fund to shore up its crisis-hit economy, also scrapped an auction for short-term government bills after only attracting Ft5bn ($22.5m) in a Ft40bn offering. Analysts said Austria had dropped plans to launch a bond next week because investors wanted bigger premiums to offset the credit worries and fears over lending by its banks to eastern Europe. The Austrian Federal Financing Agency did not give a reason for the move. Spain, another triple A rated country, and Belgium have cancelled bond offerings in the past month because of the turbulence, with investors demanding much higher interest rates than debt managers had bargained for. Market conditions have steadily deteriorated in recent days with the best gauge to credit sentiment, the iTraxx investment grade index, which measures the cost to protect bonds against default in Europe, widening to more than 180 basis points, or a cost of €180,000 to insure €10m of debt over five years, yesterday. This is a steep increase since Monday of last week, when the index closed at 142bp. Huw Worthington, European strategist at Barclays Capital, said: "These are difficult markets. Austria did not need to raise the money, so it has decided to hold off but, if these conditions persist, it could prove a problem for some governments as their debt needs to be refinanced." Analysts warn that the huge pipeline of government bonds due to be issued in the fourth quarter and next year could increase problems for some countries, particularly those already carrying large amounts of debt that needs to be refinanced or rolled over. European government bond issuance will rise to record levels of more than €1,000bn in 2009 - 30 per cent higher than 2008 - as governments seek to stimulate their economies and pay for bank recapitalisations. The eurozone countries will raise €925bn ($1,200bn) in 2009, according to Barclays Capital. The UK, which is expected to increase its bond issuance from the current €137.5bn in the 2008-09 financial year, will take the figure above €1,000bn. Italy, with a debt-to-gross domestic product ratio of 104 per cent, is most exposed to continuing difficulties in the credit markets. Analysts forecast that it will need to raise €220bn in 2009.

Monday, October 27, 2008

back to rudiment - barter trade - FT

Thailand on Monday said it planned to barter rice for oil with Iran in the clearest example to date of how the triple financial, fuel and food crisis is reshaping global trade as countries struggle with high commodity prices and a lack of credit. The United Nations’ Food and Agriculture Organisation said such government-to-government bartering – a system of trade not used for decades – was likely to become more common as the private sector was finding it hard to access credit for food imports. “Government-to-government deals will increase in number,” said Concepción Calpe, a senior economist at the FAO in Rome. “The lack of credit for trade could lead also to a resurgence of barter deals between countries,” she added. Officials and traders noted, however, that Iran was not typical because the US-led sanctions against its banks meant the country was facing difficulties financing agricultural trade even before the financial crisis. Bangkok’s commerce ministry said it was sending a delegation to Tehran to discuss the barter deal. Thailand is the world’s largest rice exporter, controlling a third of the global market, while Iran is one of the top 10 importers. Last year Iran bought some 600,000 tonnes of rice from Thailand, but so far this year it has bought only 60,000 tonnes as it has waited for prices to fall. The price of Thai medium-quality white rice soared to an all-time high of above $1,000 (€798, £641) a tonne in May but has since dropped to $660 a tonne on the back of a large global crop. Prices are still well above their pre-crisis average of $250 a tonne. Chaiya Sasomsab, Thailand’s commerce minister, said Thai officials planned to travel to Iran by the middle of November to “discuss the specifications of oil and rice that would be exchanged”. Agriculture officials such as Jacques Diouf, the FAO director-general, are warning that the financial crisis could deepen this year’s food crisis through its impact on credit availability. “Borrowing, bank lending . . . all may be compromised by a deepening financial crisis,” Mr Diouf said this month. With some developing countries’ official currency reserves facing serious depletion, particularly in Africa and Asia, agricultural officials said countries could barter more to avoid exacerbating their current account difficulties. Ben Savage, managing director at London-based rice brokers Jackson Son & Co, said the full effects of the credit crunch had not been felt as most of current food trade related to contracts signed before the crisis. “Trade finance has tightened sharply and, in many cases, letter of credit confirmation fees have doubled or tripled,” he said. “Exporters are reviewing the terms of payment they are ready to accept and credit they are prepared to give.” Agricultural commodities traders said that the banking cost to confirm a letter of credit – a common instrument to finance trading – has risen to 3-4 per cent of the value of the contract, up from 1-1.25 per cent before the collapse of Lehman Brothers in September.

Sunday, October 26, 2008

South Korea - Second time around

Oct 23rd 2008 SEOUL From The Economist print edition Shock, denial, anger and a massive bail-out for good measure OF ALL the Asian countries worst ravaged by the regional financial turmoil of 1997-98, South Korea has come closest in recent weeks to seeing history repeat itself—not as farce, but as renewed financial tragedy. As its stockmarket has slid downhill and the currency, the won, has fallen by nearly 30% this year, the government has been telling all-comers that the economy is sound and the banks liquid and solvent. Its officials have blamed their troubles on the ignorant or malicious refusal of foreign analysts to believe them. Yet on October 19th the government announced a $130 billion rescue for Asia’s fourth-largest economy. Of this, $100 billion is in the form of guarantees for foreign-currency debts. Another $30 billion—about one-eighth of the country’s foreign-exchange reserves—was to be available to banks suffering a drought of dollars. It followed this up two days later with a promise to spend 12 trillion won ($9.2 billion) to help the building industry—for example by refinancing debts and buying unsold houses. The president, Lee Myung-bak, described the overall economic situations as “more serious” than in 1997, because of the global sweep of the crisis. The government had already appealed to the grass-roots patriotism that helped South Korea through the late 1990s: cutting back on energy bills; buying local products; and surrendering any dollars left over from overseas jaunts. Mr Lee and his officials, however, are quite right that the economy is on a much sounder footing than in 1997. Banks are better capitalised, big companies less indebted and reserves of foreign exchange bigger than all but five other countries’. The economy has been growing solidly for a decade. Even after the recent buffeting, analysts still expect GDP to grow by more than 4% this year, and by 2.5-3.5% in 2009. That is nowhere near the 7% growth President Lee promised at his inauguration in February, but in the current doom-laden climate it looks positively robust. One reason for this relative optimism is the shipbuilding industry, one of South Korea’s great success stories. Yet it is also one cause of the financial stresses. There has been a sharp rise in foreign debt. More than one-tenth of the rise is in down-payments for ships still being built, which appear in the accounts as trade credits. And around half of the increase in short-term debt comes from banks hedging their exposure to purchases of shipbuilders’ dollar receivables in the forward market. That helps explain the way in which the global credit crunch first made itself felt in South Korea—in a shortage of dollars for the banks. Moody’s, a credit-rating agency, estimates that South Korea’s banks rely on foreign sources for 12% of their funding. As inter-bank markets worldwide clammed up, they began to look vulnerable. Standard & Poor’s, another rating agency, this month put seven of them on a “watch-list”, because of the pressure they faced. The won itself has been battered as foreign investors have fled Korean shares and bonds. Its decline also reflects the current account’s fall into deficit as the cost of South Korea’s oil and other commodity imports soared earlier this year. The government rescue stemmed the tumble in the won and the stockmarket only briefly. As elsewhere, financial catastrophe seemed to have been averted. But also as elsewhere, traders knew that the impact of the market turmoil on the rest of the economy was only beginning to be felt.

Who's next? Easter Europe is at Risk - ECO

Oct 23rd 2008 From The Economist print edition The economies of eastern Europe face stormy times, even if Western banks hold their nerve. The political fallout may be even worse WILL an ex-communist country be the next Iceland? The dramatic collapse of that country’s economy, endangering savings from hapless depositors in Britain and elsewhere, has highlighted other risky but obscure corners of the world’s financial system. The stability of the Ukrainian hryvnia, the implications of the Latvian property crash and Hungarians’ troubling penchant for loans in Swiss francs are among the exotic topics now crowding policymakers’ desks. Countries such as the ex-communist ones in eastern Europe are particularly at risk during periods of financial turmoil. First, because the counterpart of soaring foreign investment has been gaping current-account deficits (Latvia’s, for example, peaked at 26% of GDP in the third quarter of last year). Second, their central banks and governments are unlikely to be able to muster the financial firepower now being deployed in the big economies of the West. Already a couple of banks have toppled; stockmarkets have plunged, wiping out years of savings and hitting balance-sheets. The price of credit-default swaps—the market’s estimation of a borrower’s creditworthiness—ranges from the reassuring to the alarming (see map). As worries intensified, Hungary’s central bank on October 22nd raised interest rates from 8.5% to 11.5%. For countries that have benefited from big flows of outside money, delivered by a highly leveraged global financial system, the mix of problems looks scary. Those big current-account deficits in every country save Russia suggest they may be living beyond their means. Some (but not all) have public or private sectors with big foreign debts; these may be hard to refinance. Some (again, not always the same ones) have wobbly banks and large state deficits. At best, the region is in for more nasty shocks that will need external support from lenders such as the IMF. At worst, some countries face debt restructuring, currency collapse and depression; that raises the spectre of political upheaval, too. The turmoil has been most spectacular in Russia. There the stockmarket has plunged by some two-thirds since its peak in May, sending its fabled oligarchs scrambling to liquidate their portfolios to meet bankers’ demands. Oleg Deripaska, probably the richest of these well-connected tycoons—now embroiled in a British political scandal (see article)—has sold prized stakes in Western companies which he had pledged as collateral in the $4.5 billion acquisition of a 25% stake in Russia’s biggest metals producer, Norilsk Nickel. These wild shifts in fortunes reawaken memories of the 1998 financial crash, in which default and devaluation wiped out most of Russia’s private banking system. But few expect a reprise. Thanks to $1.3 trillion in oil and gas revenues over the past eight years, Russia now sits on a mighty pile of cash and liquid assets, still in excess of $500 billion, in its foreign-exchange reserves and other funds. It is unclear how well the Kremlin will organise the bail-outs and who will benefit. A lower oil price may affect the geopolitical ambitions of Russia and its allies (see article). Some oligarchs may become minigarchs. But Russia will not need to beg for cash from the outside world. In Ukraine, the next-largest country in the region, the story is quite different. The stockmarket has plunged by nearly 80% this year. The hryvnia, the national currency, recently hit a seven-year low against the dollar. The sixth-largest bank, Prominvest, suffered a run. Rating agencies have issued downgrades. Economic growth is plunging. Inflation is 25%. The outside world wants to help. Officials are haggling with the IMF about an emergency loan of up to $14 billion—around a fifth of the $55 billion-66 billion that Ukraine needs to raise by next year to roll over short-term loans, pay interest on other debts and finance the rest of its current-account deficit. That would normally require hard bargaining about banking reform, higher interest rates and a stringent public-spending regime to curb inflation. The problem is that Ukraine, even by its own awful standards, is in political chaos. The prime minister and president are at loggerheads about whether an impending general election (now postponed until December 14th) is legal. A new government able to take tough decisions will not be in the saddle for weeks, even months. Keen not to be seen as too slow to assist, the IMF may stump up a loan nonetheless. Lifelines from outside The IMF is one source of help (and may be happy to have something to do after years in which its role in the region seemed to be shrinking). For countries closer to “old Europe”, another possible provider of assistance is the European Central Bank. On October 16th the ECB provided a short-term credit line of €5 billion ($6.7 billion) to Hungary, which is not in the euro zone but has an economy closely linked to it. The foreign-exchange market there had all but seized up amid worries about debts, public finances and growth prospects. Although much richer than Ukraine, with GDP per head roughly three times as high, Hungary is in some senses even more vulnerable. Public debt is more than 60% of GDP (a lot by the region’s standards), thanks to a communist-era borrowing spree and spendthrift governments since then. In 2006 the budget deficit exceeded 9% of national income. The current-account deficit this year amounts to €6.8 billion, or 5.5 % of GDP. Recent debt auctions have been cancelled because of a buyers’ strike. Many Hungarian households and firms have taken out hard-currency loans (such loans, originally at much lower interest rates than forint-denominated ones, account for 90% of new mortgages since 2006 and 20% of GDP). In effect these were personal bets, now looking ill-judged, on the convergence of the forint with the euro. The weak forint already means higher interest payments; if that trend continues, many Hungarians risk bankruptcy. Hungary’s economy could certainly be in better shape. But outsiders give the authorities credit for efforts in the past two years to cut the budget deficit, now slightly less than 4% of GDP. The government has started cross-party talks on a further austerity programme. The Hungarian central bank is impressively well-run. The IMF and ECB are ready to lend more if needed. The huge question, in Hungary and elsewhere, is whether foreign banks will stand by their local customers. Like most of the new members of the European Union, Hungary has sold off most of its banks to outsiders. That once looked the best way to create a solid financial system, allowing countries to borrow freely and grow fast, without risking the kind of crisis suffered by emerging markets in past decades. In retrospect, it looks risky. For the past decade Western banks, such as Erste Bank and Raiffeisen (Austria), UniCredit (Italy) or Swedbank and SEB (Sweden), have piled in to the promising new markets on their doorsteps, lending boldly and buying up sometimes richly priced local banks. Now those huge loan books—in Austria’s case fully 43% of GDP, compared with 5% for Italy and 1% for Sweden—are souring at a time when wobbly banks may feel that scarce cash is better deployed at home. Such deposits abroad are not covered by home-country insurance. The foreign banks are already reining back lending, refusing to issue mortgages in foreign currency and demanding better security. That is prudent, if belated. The danger is that they may go much further, cutting off new lending or refusing to roll over outstanding loans, even to solid borrowers. That could send bankruptcies and unemployment rocketing. Another possibility is that one or more parent banks will put a troubled subsidiary up for sale, perhaps to a Russian buyer. That prospect is unlikely. But it sets nerves jangling in places such as the Baltic states. At first sight it is these economies that seem in the riskiest position. A sharp slowdown had started even before the global financial crash. Estonia and Latvia in particular had enjoyed remarkable property booms, generously financed by bank lending. That was one factor in their colossal current-account deficits. The bubbles have popped; growth, running in double digits in 2006, has come to a halt. This has been a hard but so far orderly landing. Whether it now turns catastrophic is an open question. The debts must still be repaid. Fitch, a rating agency, which downgraded all three Baltic countries this month, reckons their gross external financing requirements next year (the money they need for foreign debt repayments and their current-account deficits) are 400% of likely year-end foreign-exchange reserves in Latvia, 350% in Estonia and 250% in Lithuania. These are the highest ratios in emerging Europe. In theory, the external imbalances should unwind of their own accord. The slowdown at home is already shrinking current-account deficits. If the local banks run out of money because of bad loans, their foreign owners will send them more cash; the sums involved are big by Baltic standards, but small by the standards of rich-country banks. Swedbank, for example, has 16% of its loans in the Baltic states, (190 billion Swedish kronor, equivalent to $32 billion or €20 billion). Only 1.2% of the total look bad so far, the bank says. Sweden’s regulators say the biggest banks can write off as much as 10% of Baltic lending without eroding their own capital. Sweden launched a $200 billion bail-out plan this week to bolster confidence. Furthermore, despite the ballooning foreign borrowings of firms and households, none of the Baltic states has much public debt to worry about (Estonia even has net assets). Public finances are solid. The governments still have investment-grade credit ratings. Pegs and their dangers The problem is not so much survival, as finding the right policy mix to minimise the effects of sharp slowdown. All three Baltic states have their currencies pegged to the euro, either in formal currency boards (where the amount of money in circulation is directly linked to foreign-exchange reserves) or, in Latvia’s case, in a similar but slightly more flexible arrangement. That was a shrewd move in the 1990s, when it helped to stabilise economies left prostrate after the collapse of Soviet planning, and was a good way of keeping on track for eventual membership of the euro (something Lithuania missed by a statistical whisker in 2006). It is made safer by the fact that none of the countries is a financial centre: shorting the Icelandic krona was child’s play compared with the difficulties of speculating in the thinly traded Latvian lat or the Estonian kroon. The main disadvantage of the arrangement is that it limits policymakers’ flexibility. If outsiders suddenly pull money out of a country with a pegged currency, the money supply shrinks, risking a deep depression. A country with a floating exchange rate can try to restore competitiveness and stoke growth by devaluing the currency. For any of the Baltic states, a float would be a catastrophic humiliation. It would also not necessarily help matters: for small countries, the risks of a free-floating currency are greater and the benefits less. So the likelihood is that the three Baltic countries face, at best, big cuts in public spending and lower output, perhaps for several years, while they pay off their debts and regain competitiveness. In happier conditions the governments would run deficits to counter this. In the current gloom, more borrowing risks making outside lenders feel even twitchier. Most of the EU’s new members are in a stronger position, and should scarcely be put in the same category as the problematic countries. Poland, for example, has public debt of around 40% of GDP, while growth is nearly 6% and inflation at 4.5%. A strong economy has meant healthy tax revenues and kept budget deficits down. The zloty, like the Hungarian forint, has been wobbly, and a sharp slowdown in western Europe, the biggest export market for all ex-communist countries, will affect Poland too. But life should be at worst a bit tougher, rather than downright nasty. The price of corruption Potentially more vulnerable are the poorest new members of the EU, Romania and Bulgaria. For now, growth in both countries remains strong. But the imbalances are striking: Bulgaria’s current-account deficit is likely to be 24% this year. Bursting property bubbles and a wave of corporate bankruptcies could expose the poor quality of banks’ loan books. The question then will be how much support and attention either country will receive from outside. Whereas the Baltic states are well-regarded, enthusiasm in the EU for a Bulgarian bail-out is likely to be limited, thanks to the failure of the authorities in Sofia to fulfil commitments to clean up organised crime and corruption. And that is the deeper problem for eastern Europe: not so much financial wobbles and weaknesses, but corrupt and incompetent politics. Their leaders found it hard enough to govern efficiently even when times were good. What will happen when foreign investors are stingier and growth slows or stops? Ever since the collapse of communism in 1989, the eastern half of Europe has been struggling to reach the levels of economic, social and cultural development of the west. The ruinous legacy of one-party rule and planned economies was daunting. Everything from the rule of law to competitive companies needed to be rebuilt (in the case of the central European countries) or constructed from scratch (for those whose pre-communist experience was of autocracy or feudalism). The results were impressive. Living standards soared; foreign investment poured in; politics settled down. The richest ex-communist countries are now nearing “Western” countries such as Greece and Portugal. So the fears of some in “old Europe” in the early 1990s that the new neighbours were likely to be poverty-stricken and unstable, exporting hungry migrants and crime to the rest of the continent, looked ridiculously overblown. Expanding the EU and NATO eastward went from a preposterous fantasy to common sense. One small ex-communist country, Slovenia, has joined the euro; another, Slovakia, will do so in January. The next few years are likely to be a lot harder. A sharp recession will expose the cost of stalled reforms in previous years. In most of the ex-communist countries, the effort to meet EU and NATO requirements was a high-water mark in terms of political commitment to good government and sound economic policies. Since then, the approach has been to sit back and enjoy the weather: low borrowing costs, high foreign investment, rising tax revenues and higher living standards. Voters may not have thanked governments for this, but the political pressure to take painful decisions has been minimal. (The only real exception has been Hungary, where capital markets sent a sharp warning two years ago.) Testing democracy Now more than ever, the countries of the region need to push ahead with tough but urgent policies such as public-finance reform, especially of pensions; raising labour-market participation, particularly by reducing the numbers of early retirees; and improving productivity by modernising education, which is often still hidebound by communist-era bureaucracy. Countries such as Poland and Latvia still have shamefully bad road systems. Officialdom chokes business; corruption is stubbornly entrenched. But the chances of a big push on reform look slim. The political compass, which once sent a reliable, if often ignored, message about the needed direction of policy, is swinging wildly as Western governments break taboo after taboo in the hope of fending off financial meltdown. For countries that have been told that privatisation, liberalisation and balanced budgets are the sure path to salvation, these are confusing times. The result, says Ivan Krastev, a Sofia-based pundit, is “an implosion in the idea of normality”. The wrong kind of certainty may be even worse than confusion. The political institutions of the ex-communist countries were created in the great flush of optimism that followed the collapse of the one-party state. But voters have grown steadily disillusioned with politics. A seasoned watcher of the region in Brussels says that the coming years “will be a big test of democracy and the rule of law…will they stick to the rules?” If things get nasty, blaming economic hardship on foreign banks that have taken deposits but don’t want to make loans may prove a tempting theme for ambitious populist politicians. For countries still outside the main clubs, prospects are even bleaker. The chances of fragile countries such as Macedonia joining the EU any time soon are diminishing. So are the prospects for the more advanced countries that want to join the euro. A cash-strapped EU may think again about the money it is prepared to spend on infrastructure and public services in neighbouring non-members. In the eyes of many it is market economics, even more than democracy, that has been the big success of the past 20 years. It has brought undreamed-of freedom, choice and prosperity. In some countries, Mr Krastev notes, foreign banks have scored more highly in trust rankings than any public institution. They have become the symbolic and financial linchpins not just of economies, but of whole countries. They have a lot to lose. So does Europe.

Emerging Market Into the Storm - ECO

Oct 23rd 2008 From The Economist print edition How the emerging world copes with the tempest will affect the world economy and politics for a long time FOR much of the past year the fast-growing economies of the emerging world watched the Western financial hurricane from afar. Their own banks held few of the mortgage-based assets that undid the rich world’s financial firms. Commodity exporters were thriving, thanks to high prices for raw materials. China’s economic juggernaut powered on. And, from Budapest to Brasília, an abundance of credit fuelled domestic demand. Even as talk mounted of the rich world suffering its worst financial collapse since the Depression, emerging economies seemed a long way from the centre of the storm. No longer. As foreign capital has fled and confidence evaporated, the emerging world’s stockmarkets have plunged (in some cases losing half their value) and currencies tumbled. The seizure in the credit market caused havoc, as foreign banks abruptly stopped lending and stepped back from even the most basic banking services, including trade credits. Like their rich-world counterparts, governments are battling to limit the damage (see article). That is easiest for those with large foreign-exchange reserves. Russia is spending $220 billion to shore up its financial services industry. South Korea has guaranteed $100 billion of its banks’ debt. Less well-endowed countries are asking for help. Hungary has secured a €5 billion ($6.6 billion) lifeline from the European Central Bank and is negotiating a loan from the IMF, as is Ukraine. Close to a dozen countries are talking to the fund about financial help. Those with long-standing problems are being driven to desperate measures. Argentina is nationalising its private pension funds, seemingly to stave off default (see article). But even stalwarts are looking weaker. Figures released this week showed that China’s growth slowed to 9% in the year to the third quarter—still a rapid pace but a lot slower than the double-digit rates of recent years. Blowing cold on credit The various emerging economies are in different states of readiness, but the cumulative impact of all this will be enormous. Most obviously, how these countries fare will determine whether the world economy faces a mild recession or something nastier. Emerging economies accounted for around three-quarters of global growth over the past 18 months. But their economic fate will also have political consequences. In many places—eastern Europe is one example (see article)—financial turmoil is hitting weak governments. But even strong regimes could suffer. Some experts think that China needs growth of 7% a year to contain social unrest. More generally, the coming strife will shape the debate about the integration of the world economy. Unlike many previous emerging-market crises, today’s mess spread from the rich world, largely thanks to increasingly integrated capital markets. If emerging economies collapse—either into a currency crisis or a sharp recession—there will be yet more questioning of the wisdom of globalised finance. Fortunately, the picture is not universally dire. All emerging economies will slow. Some will surely face deep recessions. But many are facing the present danger in stronger shape than ever before, armed with large reserves, flexible currencies and strong budgets. Good policy—both at home and in the rich world—can yet avoid a catastrophe. One reason for hope is that the direct economic fallout from the rich world’s disaster is manageable. Falling demand in America and Europe hurts exports, particularly in Asia and Mexico. Commodity prices have fallen: oil is down nearly 60% from its peak and many crops and metals have done worse. That has a mixed effect. Although it hurts commodity-exporters from Russia to South America, it helps commodity importers in Asia and reduces inflation fears everywhere. Countries like Venezuela that have been run badly are vulnerable (see article), but given the scale of the past boom, the commodity bust so far seems unlikely to cause widespread crises. The more dangerous shock is financial. Wealth is being squeezed as asset prices decline. China’s house prices, for instance, have started falling (see article). This will dampen domestic confidence, even though consumers are much less indebted than they are in the rich world. Elsewhere, the sudden dearth of foreign-bank lending and the flight of hedge funds and other investors from bond markets has slammed the brakes on credit growth. And just as booming credit once underpinned strong domestic spending, so tighter credit will mean slower growth. Again, the impact will differ by country. Thanks to huge current-account surpluses in China and the oil-exporters in the Gulf, emerging economies as a group still send capital to the rich world. But over 80 have deficits of more than 5% of GDP. Most of these are poor countries that live off foreign aid; but some larger ones rely on private capital. For the likes of Turkey and South Africa a sudden slowing in foreign financing would force a dramatic adjustment. A particular worry is eastern Europe, where many countries have double-digit deficits. In addition, even some countries with surpluses, such as Russia, have banks that have grown accustomed to easy foreign lending because of the integration of global finance. The rich world’s bank bail-outs may limit the squeeze, but the flow of capital to the emerging world will slow. The Institute of International Finance, a bankers’ group, expects a 30% decline in net flows of private capital from last year. A wing and a prayer This credit crunch will be grim, but most emerging markets can avoid catastrophe. The biggest ones are in relatively good shape. The more vulnerable ones can (and should) be helped. Among the giants, China is in a league of its own, with a $2 trillion arsenal of reserves, a current-account surplus, little connection to foreign banks and a budget surplus that offers lots of room to boost spending. Since the country’s leaders have made clear that they will do whatever it takes to cushion growth, China’s economy is likely to slow—perhaps to 8%—but not collapse. Although that is not enough to save the world economy, such growth in China would put a floor under commodity prices and help other countries in the emerging world. The other large economies will be harder hit, but should be able to weather the storm. India has a big budget deficit and many Brazilian firms have a large foreign-currency exposure. But Brazil’s economy is diversified and both countries have plenty of reserves to smooth the shift to slower growth. With $550 billion of reserves, Russia ought to be able to stop a run on the rouble. In the short-term at least, the most vulnerable countries are all smaller ones. There will be pain as tighter credit forces adjustments. But sensible, speedy international assistance would make a big difference. Several emerging countries have asked America’s Federal Reserve for liquidity support; some hope that China will bail them out. A better route is surely the IMF, which has huge expertise and some $250 billion to lend. Sadly, borrowing from the fund carries a stigma. That needs to change. The IMF should develop quicker, more flexible financial instruments and minimise the conditions it attaches to loans. Over the past month deft policymaking saw off calamity in the rich world. Now it is time for something similar in the emerging world.

A taxonomy of trouble

Oct 23rd 2008 DELHI From The Economist print edition How are emerging markets suffering? Let us count the ways Illustration by S. Kambayashi EVEN now, not every central banker is terribly impressed by the gravity of the financial crisis that has spread from Western banks to the emerging world’s shares, currencies and credit markets. In India the United Forum of Reserve Bank Officers and Employees—the central bank’s staff union—decided that October 21st was a good moment for its 25,000 members to abandon their posts in a dispute over pensions. The Reserve Bank of India (RBI) denounced it as an illegal strike. The union called it mass casual leave. A few months ago, many emerging economies hoped they could take mass casual leave from the credit crisis. Their banks operated far from where the blood was being shed. The economic slowdown evident in America and Europe was regrettable, but central bankers in many emerging economies, such as India and Brazil, were busy engineering slowdowns of their own to reverse high inflation. They were more interested in the price of oil than the price of interbank borrowing. This detachment has proved illusory. The nonchalance of the RBI’s staff, for example, is not shared by the central bank’s top brass, who, a day before the strike, cut the bank’s key interest rate from 9% to 8%, having already slashed reserve requirements earlier this month. Their staff’s complaint about pensions looked quaint on the day that Argentina’s government said it would nationalise the country’s private-pension accounts in what looked to some like a raid to help it meet upcoming debt payments. The IMF, which has shed staff this year because of the lack of custom, is now working overtime (see article). The governments of South Korea and Russia have shored up their banking systems. Their foreign-exchange reserves, $240 billion and $542 billion respectively, no longer look excessive. Even China’s economy is slowing more sharply than expected, growing by 9% in the year to the third quarter, its slowest rate in five years. The emerging markets, which as the table shows enter the crisis from very different positions, are vulnerable to the financial crisis in at least three ways. Their exports of goods and services will suffer as the world economy slows. Their net imports of capital will also falter, forcing countries that live beyond their means to cut spending. And even some countries that live roughly within their means have gross liabilities to the rest of the world that are difficult to roll over. In this third group, the banks are short of dollars even if the country as a whole is not. Long before Lehman Brothers went bankrupt in mid-September, prompting the world’s money markets to seize up, the currencies of commodity exporters had already started to tumble. South Africa, a huge exporter of platinum and gold, has seen its currency fall further than any other this year except the Icelandic krona. Russia’s rouble peaked on July 16th as oil prices fell, and the Brazilian real began to slip a couple of weeks later. Brazil’s commodity exports amount to 9% of its GDP, according to Lombard Street Research, a firm of analysts. But its commodity firms, such as the oil giant Petrobras, account for over 40% of the stockmarket. Thus the fall in commodity prices has hit the bourses hard. A similar fate befell Russia, where the main indexes were already in decline after the country’s military misadventures in Georgia. India and China benefit from cheaper oil. India, for example, spent almost two trillion rupees ($48 billion) on crude imports in the five months from April to August. But even as their import bills fall, their export earnings are slowing. On October 22nd Tata Consultancy Services, India’s biggest information-technology company, announced that its net dollar profit in the latest quarter was almost 7% below the quarter before. India’s IT bosses are worried about getting paid by banks for work they have done for them. Goldman Sachs says that India’s trade deficit will subtract 1.5 percentage points from its GDP growth this fiscal year and next. India’s exports will be helped by a declining rupee. China’s yuan, on the other hand, has held its own against the dollar, even as the greenback has strengthened recently. It may find itself reprising its stabilising role during the Asian financial crisis, when it held fast to its dollar peg, even as its neighbours and competitors suffered currency collapses. Stephen Green of Standard Chartered calculates that China’s trade-weighted exchange rate, adjusted for inflation abroad and at home, is now at its strongest since 1989. Morgan Stanley reckons the shares of emerging economies have never been as oversold. But foreign investors have punished some economies more harshly than others. The market for credit-default swaps, which insure against default on sovereign bonds has, for example, distinguished between countries running big current-account deficits (over 5% of GDP) and other more abstemious places. Of the four biggest emerging markets, Brazil, Russia, India and China, India has the largest current-account deficit, which widened to 3.6% of GDP in the second quarter. It bridged most of this gap with foreign-direct investment. But its globe-trotting companies also rely on raising money abroad, borrowing $1.56 billion externally from April to June. This borrowing has since become far more expensive. Russia has a hefty surplus on its current account, not a deficit. It earned $166 billion from oil and gas exports in 2007. Its economy should be flush with hard currency. In fact, Russia’s companies and banks are now scrambling to find dollars. The overseas liabilities of Russian banks now exceed their foreign assets by $103.5 billion (excluding net foreign direct investment in the industry), according to the country’s central bank. The country is not awash with petrodollars because the state taxes its energy earnings heavily, and sequesters its dollar takings in its central-bank reserves and its Stabilisation Fund. As Rory MacFarquhar of Goldman Sachs has pointed out, Russia accumulated $560 billion in foreign-exchange reserves from 2000 to mid-2008, even as its banks and companies have added $460 billion to their external debt. Russia, in effect, lends dollars to Western governments, then borrows them back again from Western banks. Now those Western banks are suddenly reluctant to lend, which means Russia’s government will have to close the dollar-circuit itself. The central bank will deposit $50 billion of its foreign-exchange reserves in the state-owned Vnesheconombank, which will, in turn, lend that money to companies and banks faced with imminent foreign-debt payments. There is an irony here. The West’s financial institutions have long been hoping for sovereign-wealth funds, flush with petrodollars, to arrive as saviours. But Russia, at least, now needs all its sovereign wealth to save itself.

The incredible shrinking funds

The incredible shrinking funds Oct 23rd 2008 From The Economist print edition High borrowing and the credit crisis are bad enough for hedge funds. Panicky clients are worse ON THE trading floor of one of London’s big hedge funds, the banks of Bloomberg screens still flicker with life but the traders are almost silent. “None of us can quite believe what we are seeing,” says a senior manager. A year ago hedge funds were the omnipotent vanguard of financial capitalism. They were uncompromising in their search for returns, and they dominated trading activity in most securities. But the industry has been humbled. The typical fund has fallen by almost a fifth so far this year, according to Hedge Fund Research (HFR), an analysis firm (see chart 1). “Convertible arbitrage” funds—which try to exploit price anomalies among corporate bonds—have lost a staggering 46%. By some margin 2008 has been hedge funds’ worst year since HFR began compiling records in 1990. The carnage is indiscriminate. In Asia as well as London and America, hedge funds are closing some or even all of their operations. Few strategies have worked well. Ken Griffin, the boss of Citadel, a fund based in Chicago and known for its quantitative trading techniques, told investors that September was “the single worst month, by far” in its history. Even David Einhorn, an American short-seller who bet successfully on Lehman Brothers’ demise, has lost plenty. Over the next few quarters the fallout is likely to be brutal. Between 1990 and last year the industry’s assets under management grew almost 50-fold, to nearly $2 trillion (see chart 2). Now industry executives predict that assets could fall by 30-40%, as clients stampede for the exit. The number of funds, which climbed to over 7,000 as a generation of financiers headed for the gold-paved streets of Mayfair in London and Greenwich, Connecticut, could fall by half. It wasn’t supposed to be like this. After all, most hedge funds pride themselves on providing clients with positive “absolute returns”—ie, on turning a profit whatever the financial weather. Until now that promise had been largely met. In 1998, the year that Long-Term Capital Management (LTCM), a giant hedge fund, collapsed, the industry still managed a small positive return. During the previous big financial bust of 2001 and 2002, when American shares fell by over one-third, the average hedge fund was roughly flat. This time, however, it really is different. Bans on short-selling have made many strategies unworkable. Poor management by hedge funds may be partly to blame: the industry has more than its fair share of illiquid assets that have been hammered during the crisis. But it also appears that forced sales of assets by hedge funds have driven prices lower, in turn hurting performance—a typical case of contagion. The 30 core American equity holdings of the biggest hedge funds, tracked by analysts at Merrill Lynch, have underperformed the stockmarket since the end of August. What is the cause of the fire sales that seem to be at the root of the industry’s problems? The obvious answer is a withdrawal of credit, which has in turn forced hedge funds to offload assets. Sceptics have long argued that for all the skill they claim to possess, hedge funds just use cheap money to amplify mediocre returns. By this account they are simply another part of a vast, debt-dependent ecosystem that is now being starved of oxygen. Yet the role leverage has played in bringing the industry to its knees is subtler than this. And there is another prime suspect for hedge funds’ suffering: their own clients. Sweeping generalisations about the degree of leverage among hedge funds are misleading, because funds come in many different types. The term “hedged fund” was coined by Alfred Winslow Jones, who in 1949 launched a vehicle that simultaneously bought and sold short shares, thus reducing sensitivity to overall movements in the market. Since then many varieties have sprung up, from the global macro funds most fashionable in the 1980s and 1990s, which bet on the fortunes of countries and currencies, to funds which try to exploit tiny differences in the prices of bonds and derivatives. Leverage: the long and the short of it Hedge funds today do have some things in common: performance-related fees; light regulation; client lists replete with institutions and rich individuals; and a symbiotic relationship with prime brokers at investment banks, who provide them with credit, execute trades and help administer their funds (see article). But high leverage is not the unifying factor many believe it to be. According to one prime broker’s estimate, the industry as a whole has a ratio of assets to equity of about 1.3, against 1.8 a year ago. The assets themselves often contain further embedded leverage, through, for example, derivatives. A study by McKinsey, a consultancy, suggests that this might take the industry’s leverage today to two or three times equity. By the supercharged standards of contemporary finance, that is not high: most investment banks have been running with ratios of more than 20. Regulators used to worry about the danger hedge funds might pose to their prime brokers. After the failures of Bear Stearns and Lehman Brothers the risk turned out to be the other way round. The industry’s aggregate leverage has undoubtedly caused it trouble. As asset prices have fallen, margin calls have increased, and these may have been met by selling assets. But there does not appear to have been a systematic withdrawal of bank credit from hedge funds. Most prime brokers say they have not tightened lending terms overall. They have got tougher with funds using higher leverage of, say, over five times, to pursue arbitrage strategies, in convertible bonds for example. This selective withdrawal of credit helps explain why such funds have done so badly. But because these funds account for less than a quarter of total assets, it cannot explain the woe of the industry overall. A fuller explanation must include the increasingly jittery nature of hedge funds’ clients. As the industry has grown, its customer base has widened beyond the original core of very wealthy and (reputedly) loyal individuals. Institutions have put money into hedge funds in the hope of improving risk-adjusted returns. And funds-of-hedge-funds, which act as intermediaries for private banks, some institutions and individuals who are merely affluent, have become hugely important. They supply more than 40% of industry assets under management, compared with only 5% in 1990 (see chart 3). Even if institutions want to buy and hold their positions, some are being forced to raise cash. One hedge-fund manager says that pension funds have onerous commitments to private equity, which they are meeting by selling out of hedge funds. And there is a widespread feeling that money originated through funds-of-hedge-funds is liable to get jumpy at any hint of trouble and skedaddle if losses are made. One fund-of-funds manager says he rushes to be the first out if he suspects that others may desert a hedge fund. Some also argue that the behaviour of the individuals who invest through funds-of-funds most closely resembles that of mutual-fund investors, traditionally viewed as finance’s headless chickens. Despite the fidgetiness of their new clients, few hedge funds have locked in their money for long periods. Most funds allow redemptions each quarter: only those with the strongest records, such as TCI, an activist firm in London, can lock money in for several years. Funds-of-hedge-funds have marketed themselves as providing monthly liquidity, a claim that holds true only if clients don’t all test it at once. The result is eerily similar to the plight of those banks that relied too much on fickle wholesale funding. If investors ask for their money back, funds often have to sell out of illiquid positions to raise cash, which may force prices down. In September clients withdrew a record $40 billion from hedge funds, according to analysis by TrimTabs, a research firm. Fear of redemptions is just as damaging as the fact of them: if managers worry that clients will bail out, they may try to raise cash in anticipation. Merrill Lynch estimates that between July and August alone, the industry’s cash holdings rose from $156 billion to a record $184 billion, equivalent to 11% of assets under management. Since then the vicious cycle of forced sales to fund anticipated or actual redemptions has only intensified. Survival of the biggest Admittedly, hedge funds have been through difficult times before. The last full year of net redemptions in recent memory was 1994, when 1% of clients’ money was pulled out of hedge funds. By the following year the industry was growing again. But last month alone 2% of money was withdrawn. And the omens from the last real bear market for hedge funds, 40 years ago, are far less encouraging. Between the end of 1968 and September 1970, the assets of America’s top 28 hedge funds dropped by two-thirds, according to Sebastian Mallaby, an author (and a former Economist journalist). Eventually luminaries such as George Soros and Michael Steinhardt emerged from the ruins, but for the industry it was a long, hard slog. That is exactly what is in prospect again. Unless performance recovers sharply and soon, clients will continue to walk away. And even if returns do pick up, it will be a while before managers make much money, because most funds have “high-water mark” structures. These demand that big losses be recovered before performance fees can be charged again. That will be hardest for smaller funds, which have higher fixed costs relative to their assets, and which some clients already worry have poor risk controls. Firms with less than $500m under management account for about three-quarters of the world’s 7,000-odd hedge funds, although they manage less than a tenth of the industry’s assets. The outlook for start-ups without records is particularly bleak. The death of many of the industry’s tiddlers will compound a trend that started in 2006, of clients consolidating their hedge-fund holdings with a few big managers. Those firms are working hard to strip down their cost bases by shedding employees and minimising the risk of trading blow-ups over the next year. Their main ambition for the time being is to be still standing when the dust settles. What kind of world the survivors will face depends to some extent on politics and regulation. As lightly regulated private entities with lots of rich clients, hedge funds make easy political targets, and a direct attack on them remains possible: Italy’s finance minister has called them “absolutely crazy bodies” which “have nothing to do with capitalism”. Still, by any sober assessment hedge funds rank fairly low on the list of institutions that have posed a threat to the system in the past year. Nevertheless, the indirect effects of government action could make life difficult. Even if short-sale bans go, hedge funds will now think twice before betting against the shares of important industries. And if, as seems likely, bank-solvency rules are redesigned, capital charges for prime-broking operations could yet rise, causing a contraction in lending to hedge funds. At the very least, financing the most leveraged arbitrage strategies will be much harder. Yet an even greater unknown for the industry is its customers’ reaction to a year of abysmal performance. Certainly hedge funds have, just, outperformed a weighted basket of stocks, bonds and commodities—which has fallen by 22%, according to Gavyn Davies, the co-founder of Fulcrum, an asset-management firm. But relative outperformance was never the stated objective of the industry. Instead it made clients a different promise. The simple version of this was that hedge funds would produce consistent absolute returns whatever the condition of financial markets. That claim has been sunk. The more sophisticated expression of the promise was that hedge funds could produce “alpha” or returns that were attributable to skill rather than market risk. Alpha has always been a slippery concept: in theory there should not be much of it about and academics have struggled to find evidence that the industry consistently realises it for clients. That is one reason why fees were under pressure even before the crisis. Having compared actual industry performance with models that “clone” the risk profile of leading funds-of-funds, Narayan Naik, a professor at the London Business School, thinks the industry has failed to create alpha since the subprime crisis began in August 2007, despite outperforming many asset classes. That could change, says Mr Naik. After the collapse of LTCM, and amid the chaos and opportunities that it created, hedge funds did clearly produce alpha for two years. The dislocation this time round, particularly for the prices of less liquid assets, is far more severe. The dramatic reduction in the number of hedge funds should make trades less “crowded”. Other market participants, such as the proprietary trading desks of banks, may withdraw, further thinning the ranks of the competition. Some of the hot money that poured out of hedge funds could easily return at the first sign of stability. Yet if the surviving firms are to prosper in the long term, and maintain their lucrative fees, the industry will have to address the structural inadequacies exposed so cruelly by the crisis. These have made its performance highly vulnerable to financial contagion. It will have to diversify its funding away from short-term loans from investment banks. Most important, it will have to wean its clients off the notion that they can both enjoy excess returns and be free to withdraw their money at will. Hedge funds have not proven to be the systemic threat that many feared, but they have not had a good credit crisis. After all, about the most hollow achievement in finance is this: to provide absolute returns—but only when markets are going up.