The balance of power in credit markets is finally shifting

WHEN a handful of big Wall Street banks reluctantly funded part of a $26 billion takeover of First Data, a transaction-processing firm, in early autumn, there was jubilation among those eager for any sign that the chaos in financial markets was abating. It did not mean debt would flow freely again, though. Indeed, it marked the first, feeble sign that creditors were regaining the upper hand after years of bowing and scraping to borrowers.

At the end of weeks of wrangling over the terms of the loan, the banks finally managed to squeeze from Kohlberg Kravis Roberts (KKR), a private-equity group buying First Data, a concession helping them make sure that the debt would be repaid. Such “covenants” vary, but the important ones are those that either prevent a company from borrowing too much (known as leverage covenants), or force it to earn enough to pay interest (coverage covenants). These girdles were fairly common until a few years ago. Companies that broke them had to pay a penalty to their creditors or were forced into bankruptcy.

 

In recent years as liquidity expanded, banks held on to fewer of the loans that they originated, syndicating them instead to money managers such as hedge funds. Borrowers found that such creditors, in their hunger for higher yields at a time of low interest rates, were quite willing to drop safeguards altogether, leading to a surge of “covenant-lite” loans. Because banks held on to fewer loans, they relaxed their guard. According to Standard & Poor’s LCD, a research unit which tracks leveraged lending, the share of non-investment grade loans held by banks in America fell by over 30 percentage points to around a fifth between 2000 and the first six months of this year. In Europe that share fell from over 90% to well under half.

But as the credit markets have slowed and institutional investment has clammed up, banks have returned, keeping more loans on their books. And they have also brought back covenants. It may be too late in some cases—Moody’s, a rating agency, expects the proportion of lowly rated companies that default to rise from 1.3% to 3.5% globally in the next 12 months. But it is welcome nonetheless.

If credit conditions deteriorate, banks and other creditors will be far less patient with erring companies than they were. During the boom, borrowers could often get covenants waived. Not any more. Whereas covenants exist mainly to keep companies on the straight and narrow, they also earn banks a handsome fee each time they are breached. That is an incentive to be tough.

Banks have also sought to stop large borrowers, such as private-equity funds, from funnelling money to companies they own that are in danger of violating covenants. This practice, known as an “equity cure”, was used to give companies a quick bill of health even if the finances were unsound. It is likely to stop. As William May of Fitch Ratings, another rating agency, points out, companies hoping for a prepayment option on any new borrowing in order to refinance their loans at a cheaper rate, will almost certainly have to pay their lenders a premium for doing so. Finally, more exotic forms of borrowing such as payment-in-kind notes, which allowed companies to pay interest in bonds rather than cash, have faded—for now, at least.

The new conditions that the banks finally imposed on First Data after long negotiations with KKR are considered to have been quite lenient. “What we are seeing even now is a mix of the older, more aggressive form of lending coexisting with newer, more conservative types of loans,” says Kristi Colburn, of GE Capital Markets. The liberal regime may not have been toppled, but it is tottering.

By Janadas Devan, ON WORDS

FREE trade is hugely popular – in Africa. A Pew Global Attitudes survey early this month revealed that ‘more than eight in 10 people in the 10 African countries surveyed believe that trade ties are having a positive impact’ on their economies.

Unfortunately, enthusiasm for free trade is diminishing elsewhere, especially in the developed world. Half of the 35 countries Pew surveyed revealed significantly lower proportions expressing positive opinions of foreign trade compared to five years ago. The largest decline was in the United States. In 2002, 78 per cent of Americans believed free trade had a positive impact on the US economy; today, only 59 per cent believe the same.

Why should this be so? After all, the US has benefited enormously from globalisation. According to the Peter G. Peterson Institute for International Economics, trade and investment liberalisation over the past 10 years added between US$500 billion and US$1 trillion (S$1.47 trillion) to America’s annual income. A successful conclusion of the Doha Round of trade negotiations would add another US$500 billion. Why should such a country now doubt the benefits of free trade?

The explanation lies in another set of figures: Almost all the gains from globalisation over the past five years have gone to the top. The average earnings of 96.6 per cent of American workers fell between 2000 and 2005. High-school dropouts saw their earnings drop by an average of 5 per cent; and even college graduates saw theirs fall by about 3 per cent. A recent Wall Street Journal/NBC News poll showed that only 35 per cent of those with a college or higher degree – precisely the constituency one would expect to be most committed to globalisation – felt they benefited from the global economy.

Citing these and other figures, Professor Kenneth F. Scheve of Yale University and Professor Matthew J. Slaughter of Dartmouth College wrote in Foreign Affairs recently: ‘US policy is becoming more protectionist because the American public is becoming more protectionist, and this shift in attitude is a result of stagnant or falling income. Public support for engagement with the world economy is strongly linked to labour-market performance, and for most workers labour-market performance has been poor.’

In other words, the American economy as a whole is benefiting from globalisation, but the average American worker isn’t. He does benefit from free trade in the form of cheaper and more varied goods in the supermarket, but he sees no benefit in his pay cheque. This disconnect between the economy as a whole and individual lives is what is fuelling protectionist sentiments. Globalisation and free trade are perceived as rich men’s shticks.

The solution to this disconnect is fairly obvious – at least to those who perceive it as a problem. It isn’t erecting tariff barriers or bashing China or making it impossible for foreigners to invest in the US – the standard left response. Nor is it to hold fast to market fundamentalism or to cut taxes or to tell people this is the way the world turns – the standard right response. It is what Mr Bill Clinton used to call the ‘third way’ or what professors Scheve and Slaughter call ‘a New Deal for globalisation – one that links engagement with the world economy to a substantial redistribution of income’.

If there is no such redistribution – by expanding the Earned Income Tax Credit, say, the US equivalent of Singapore’s Workfare; or more crucially, containing health-care costs by moving towards a national health insurance scheme – it will become difficult to save globalisation from a protectionist backlash. An economic regime that is perceived to benefit only the top 5 per cent cannot be politically sustainable in the long run.

On the face of it, there is a good chance the US will in fact be able to construct ‘a New Deal for globalisation’. After all, the leading candidate for the 2008 Democratic presidential nomination is Mrs Hillary Clinton – the authentic heir, one would presume, of her husband’s ‘third way’. He displayed ‘a consistent, disciplined focus on long-term economic growth’, wrote former Federal Reserve chairman Alan Greenspan in his recently released memoirs, and one can expect her to display the same qualities when she becomes president. Happy days will be here again, surely.

But perhaps not. The present differs from 1992 in one crucial respect: Unlike in the 1990s, when Mr Clinton prevailed in part by emulating the right and stealing their agenda, his wife feels no compulsion to do the same. The Republicans were politically and intellectually ascendant in the 1990s, and Mr Clinton’s policies were shaped by that fact. He was able to ‘triangulate’ – on welfare reform, free trade and globalisation – and, in the process, nudge his party to the centre, precisely because there was something definite on the right for him to triangulate against.

That is no longer so. The Republicans have imploded over the past few years. The country is no longer evenly divided, as it was in 2000 and 2004. Five years ago, 43 per cent of Americans identified themselves as Republicans and 43 per cent as Democrats. Today, 50 per cent identify themselves as Democrats and only 35 per cent as Republicans. The reasons for this Republican collapse are many, but one of them is undoubtedly the growing concern over income inequality.

If present trends continue, the Democrats will not only win the presidency next year but will also tighten their grip on Congress. Polls show voters favouring Democrats in Congress by a margin of 10 to 15 per cent. If the 2006 mid-term elections were any indication, Democratic gains in Congress next year will strengthen the protectionist wing of the party. Not a single member of the 2006 class of newly elected Democrats was a pro-globalisation Clinton Democrat.

There is little doubt that unless the gains from globalisation are more equitably shared, there will be a backlash. There is little doubt that it is not possible to sustain politically a disconnect between the very real macro benefits of free trade and its effects on individual lives. What the world is waiting anxiously to learn is whether the American political process will throw up a solution to this disconnect without pulling the plug on globalisation.

By Tion Kwa, Senior Writer

ANOTHER DOOR OPENS: As the sub-prime crisis shows, there are few safe havens. But astute investors can spot opportunities in the fallout. — PHOTO: BLOOMBERG

WHENEVER someone gets jittery in the financial markets, chances are someone else stands to profit. So there must be opportunities for investors from the sub-prime mortgage fallout in the US. Because the turmoil has been a credit-market crisis, it might be worth looking in the debt market. Is it possible to lock in on higher yields as the sub-prime crisis craters bond prices? The first area that comes to mind is junk bonds – high-yield debt. Junk bonds are those that are rated below triple-B by Standard & Poor’s and under Baa by Moody’s. For a variety of reasons – including high debt – companies that issue them are considered financially less solid. Consequently, their bonds pay higher interest rates than investment-grade paper to compensate investors for taking on more risk.

There are good precedents for mulling selective junk bonds during a crisis. The interest-rate spread between junk bonds and comparable-termed Treasurys typically widens out to 600 basis points or more during financial market turmoil. This represents a significant reduction in price to reflect an even more generous yield than already available from such bonds.

Widened spreads are not necessarily because underlying fundamentals worsened (though they could and do), but mostly because of herd-instinct selling that punishes all junk, even that which is nowhere near being trash. Good junk can be picked up cheap during a crisis.

Junk bonds got a bad name in the late 1980s when investment banks lured too many small companies to issue junk. The market eventually collapsed under the weight of defaults; scandals emerged. Today, there is much more prudence in the junk market, and you can even buy mutual funds that invest in good junk.

Now, although the sub-prime turmoil has caused the spread on junk to widen out – as much as double – it is nowhere near what was seen in previous market crises. Given the depth of the sub-prime turmoil, this is curious. However, as an investment banker in Geneva says, it’s all relative. Because there had been so much leveraged investment in junk the past few years, a doubling of the spread to around 300 basis points was more than enough to badly burn a number of hedge funds. Markets are efficient that way.

So while junk bond prices dropped enough to hurt a lot of funds, they didn’t get as cheap as you would have thought. Instead, what opportunities that exist with bonds lie further up the credit spectrum.

Financial institutions have been pounded. Suspicions remain that despite disclosures and revelations, there may be yet more trouble undetected. And this is being reflected in some of their debt securities. But there is little reason to think that large banks and financial companies won’t be able to meet their debt obligations.

Dr Enzio von Pfeil, CEO of Commercial Economics in Hong Kong, says ‘banks and financial institutions are clearly one way to earn higher yields yet still stay with acceptable credit profiles’. The economist, who runs an investment advisory service, has himself seen his bond portfolio rise 260 per cent since 2000.

Another area to consider is emerging-market, investment-quality bonds. As our banker in Geneva explains it, emerging markets get sold down whenever mature markets sneeze.

‘Some Asian (corporate) bonds are going to be priced lower than they deserve. That’s because Western markets don’t know them, don’t understand them. There isn’t enough transparency from a Western perspective and (investors there) want to cut risk,’ he says.

He should know. During the Asian financial crisis a decade ago, he reckoned there were good, solid companies in South Korea that were in little danger of default, but which were still being lumped with troubled chaebols. He bought in Korea and in India and made a killing.

Recognise the bubbles

YET another area to look at is exotic sovereign debt. Sovereign debt has relatively lower risk, but in exotic, emerging nations, risk profiles might get bumped down. With a little bit of nosing around, however, an emerging-nation sovereign debt could be found – say within a mutual fund – to provide a level of comfort as well as higher-than-usual yields.

Dr von Pfeil notes, for example, that Ecuador’s sovereign bond maturing in 2030 is yielding 10.8 per cent.

Of course, it takes a strong stomach to jump into an emerging-market debt like this. While the likelihood and frequency of defaults by countries is small, they do happen. And then, they are spectacular. Russia defaulted on its domestic debt in 1998, dragging down world markets. Argentina’s default earlier this decade saw its bond yield widen to at least 20 percentage points from comparable US Treasurys. (Today, its bond maturing in 2033 yields 9.1 per cent.)

Then again, when a country defaults, there’s not likely to be many places unaffected. With linked-up markets and linked-up securities, the effects are all connected. During the Argentinian default, French carmaker Renault, which had manufacturing in Argentina, saw its shares in Paris sold down.

There’s perhaps little point in being overly conservative today when, as the sub-prime crisis shows, there aren’t many safe havens. You just want to get out well before bond spreads approach 2,000 basis points.

In a broader sense, maybe that says it all about investing. It isn’t so much about experience. A late-20-something investment banker will have loads of experience from pulling 12-hour work days. But that might not have saved him from falling into the sub-prime trap.

Instead, the memory of having lived through previous crises is perhaps more important. You begin to recognise bubbles. You’re better prepared to act (or not act) during turmoil. You have a better (but never perfect) sense of how to gain from the aftermath. Financial crises come and go and for different reasons, but the strategy to survive them has an uncanny fixity.

And as far as bonds go, you learn when to leave junk alone.

Contrary to popular belief, stocks do not always go up

IF AMERICAN investors have learned any lesson in the last 25 years, it is to buy shares on the dips. The slide in 2000-02 may have been longer and deeper than they were used to but normal service was eventually resumed, driving the Dow Jones Industrial Average to a record high on October 1st.

Among American financial commentators, it is almost universally accepted that shares always rise over the long run. And this perception does seem to be backed up by evidence; if you take any 20-year period, Wall Street has always delivered positive real returns. In addition, one ought to expect shares (which are risky) to deliver a higher return than risk-free assets such as government bonds.

Nevertheless, investors ought also to remember the world’s second largest economy, Japan. Its most popular stockmarket average, the Nikkei 225, peaked at 38,915 on the last trading day of the 1980s; this week, nearly 18 years later, it was still only around 17,000, less than half its peak. Buying on the dips did not work either. By 1994, the Nikkei had fallen to 21,000—at which point a technical analyst, after poring over his charts, told this columnist that it had to be one of the great long-term buying opportunities.

Investors who suffered through the Depression, when American stocks fell almost 90% from their peak, at least had a decent dividend yield to hold on to. But the Japanese market has offered a paltry yield throughout this period.

Japan might seem to be an exception. Arguably, America is just as much of a special case. Think back to the start of the 20th century when investors might have picked Russia, China and Germany as the rising stars of the next 100 years. Within the next half-century, investors in the first two saw their holdings wiped out by revolution while world wars and hyperinflation ruined the portfolios of those who backed Kaiser Wilhelm II’s empire.

Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School examined* the record of 16 stockmarkets which were in continuous operation over the course of the 20th century. In itself, this selection showed survivorship bias by excluding the likes of Russia and China. The academics found that only three other countries could match the American record of having no 20-year periods with negative real returns.

Other investors were far less lucky. Japanese, French, German and Spanish investors all suffered instances where they had to wait 50-60 years to earn a positive real return; in Italy and Belgium, the waiting period stretched to 70 years. It was no good following the famous advice to “put the shares in a drawer and forget about them”; the furniture would not have lasted that long.

Besides survivorship bias, there is another problem with the belief that stockmarkets must always go up; the very existence of the belief is likely to lead to its falsification. Investors will keep buying until prices reach stratospheric levels. That clearly happened in Japan in the late 1980s and with the technology-heavy NASDAQ index in the late 1990s; the latter is still, after seven years, not much more than half its peak level.

A significant proportion of the return from equities in the second half of the 20th century came from a re-rating of shares; investors were willing to pay a higher multiple for profits. But re-rating cannot continue forever. Although ratings have fallen significantly since the heady days of 2000, that is in large part due to the remarkable strength of corporate profits, now close to a 40-year high relative to national output. If profits revert to the mean, that could act as a drag on stockmarket performance. And, as with Japan, investors do not have much in the way of income to fall back on; the dividend yield on the American market is just 1.7%.

If investors want a simple parallel with share prices, they need only turn to the American housing market. Back in 2005, Ben Bernanke, then an economic adviser to the president, was asked about the possibility of a decline in house prices on CNBC, a financial-television channel. He said, “We’ve never had a decline in housing prices on a nationwide basis. What I think is more likely is that house prices will slow, maybe stabilise.”

Lots of people took the same view and were willing to borrow (and lend) on a vast scale on the grounds that higher house prices would always bail them out. They are now counting their losses. Investors in equities should beware of overcommitting themselves on the basis of a similar belief. Just ask the Japanese.

Stockmarkets are breaking records again as if the credit crisis were ancient history. If only it were

Reuters

THE news seems to go from bad to worse. In late September figures showed that the American housing market was in free fall, with both sales and prices plunging. On October 1st Citigroup and UBS, two of the world’s biggest banks, said they were writing down $9.3 billion of debt between them because of the credit crunch.

Global stockmarkets have reacted not with dismay but with euphoria. Wall Street marked the Citigroup write-downs by driving the Dow Jones Industrial Average to a record high (see chart). The MSCI emerging-markets index has soared to new highs. This summer’s turmoil seems to have been completely forgotten.

What explains this apparent insouciance? It seems that investors reckon they cannot lose. “Take your pick,” says Gerard Minack, a strategist at Morgan Stanley: “Equity markets are either behaving as if the worst is over for credit and housing problems or they remain convinced that the [Federal Reserve] can offset whatever bad news may unfold.” In other words, bad economic news means the Fed will cut interest rates and good news means recession will be avoided.

There are some signs to support the idea that the worst might be over in the credit markets. After strenuous effort, banks have managed to find buyers for $9.4 billion of the $24 billion needed to finance the takeover of First Data, a payments processor, by Kohlberg Kravis Roberts, a private-equity firm. According to JPMorgan, even the structured products that caused so much disquiet during the summer are moving again—$6.2 billion of collateralised-debt obligations were issued in the last week of September.

Risk appetite is resurfacing in currency markets, too. The “carry trade”, the borrowing of low-yielding currencies to buy higher-yielders, is back in full swing; the Australian and New Zealand dollars have been surging. Having reached a 27-year high on October 1st, gold (often seen as a safe haven for nervous investors) suddenly lost 2.5% of its value in a day.

The bullish case seems fairly simple. The American economy may be slowing but the rest of the world, particularly emerging markets, can make up for it. As a result, corporate profits can continue to be strong. Profits forecasts are being revised down, but not dramatically so. Ian Scott, a strategist at Lehman Brothers, says that in America there have been just 71 profit warnings after the third quarter, compared with 114 warnings at the same stage in 2005 and 173 in 2004. The dollar’s decline has added impetus to the earnings of American exporters and multinationals with overseas subsidiaries.

In this light, the credit crunch seems like old news. Even bank write-downs can be spun in a good light. Much of the panic in August was caused by fear of what banks had on their books; now the bad news is out, investors can relax.

In addition, many investors are looking back to 1998 when the Fed cut rates in response to a previous crisis in the finance industry—the collapse of Long-Term Capital Management, a hedge fund. The markets recovered quickly and the dotcom bubble reached its apogee. This time round, emerging markets (or even alternative energy stocks) might be the big winners. And in the short term at least, money that was pouring into the credit markets is now being invested in shares.

But not everyone buys the bulls’ arguments. Experienced observers of the debt market, such as Tom Jasper of Primus Guaranty, a credit insurer, think the crunch is far from over. According to Moody’s, a rating agency, the spread (excess interest rate) of high-yield debt over Treasury bonds has fallen from the crisis peak but is far higher than it was in June.

In the quick-to-rollover money markets, there is still a much wider spread than normal between the rate governments must pay to borrow money and the rate which big banks have to pay. That indicates investors remain nervous about the extent to which banks are exposed to losses from subprime mortgages, or large private-equity borrowers.

Problems in the housing markets are far from over, too. The latest gloomy statistic to emerge was a 21.5% annual fall in pending American home sales, a figure that is a leading indicator for actual sales. House prices will surely fall further and defaults increase, as homeowners struggle to cope with higher mortgage rates from “teaser” loans taken out in 2006.

That may well have a depressing effect on consumer sentiment, something which the Fed’s rate cut last month may do little to help. Normally, interest-rate moves take 12-18 months to work their way through the economy. In any case, mortgage rates are barely lower than they were a month ago. The American economy could yet slip into recession, an event on which Goldman Sachs now places a 40% probability.

Even the argument that corporate profits are still strong does not look completely convincing. American profits are close to a 40-year high relative to national output, according to Longview Economics, a financial consultancy. That suggests they should return to the mean, especially as the profit numbers taken from national-accounts data look a lot weaker than those reported by quoted companies. The last time such a gap appeared was in the late 1990s, an era of much creative accounting.

And while the weak dollar may be good news for American exporters, it is bad for European companies. Having been strong in the early part of this year, the latest data on European economies have weakened sharply; Nicolas Sarkozy, the French president, is not the only one concerned by the euro’s strength. There is the potential for turmoil in the currency markets, either because Europe takes a stand against the rising euro at the Group of Seven finance ministers’ meeting on October 19th, or because international investors, who have to finance the American trade deficit, become alarmed by the weakness of the dollar. Stockmarkets might be able to rise above the problems of the credit markets. But whether they could gain ground in the face of foreign-exchange market turmoil as well seems a lot more doubtful.

The case for more regulation of banks’ liquidity

Illustration by Jac

EVEN the fiercest free-market advocates would concede that governments can justly intervene to curtail businesses that become too powerful. Most would allow that dominant firms with the clout to gouge their customers should be broken up or subjected to strict price regulations. Similarly a judicious regulator should penalise polluters for imposing costs on others by taxing their activities. When markets provide the wrong incentives, because there are too few competing firms (ie, a monopoly), or no market price (ie, pollution) or for some other reason, there is a case for the state to act.

But not all regulated firms are monopolists or polluters. Commercial banks are an unusual mix of hazardous might and fragility. Long before he became the Federal Reserve’s chairman, Ben Bernanke wrote an influential research paper showing how bank failures in America were largely responsible for the depth and longevity of the Great Depression. Today, even with larger capital markets, banks are still central to the economy’s fortunes, as providers of credit and processors of payments.

Yet for all their might banks are fragile entities. What a bank owes in deposits can be quickly called in, but what it is owed in loans to businesses and households cannot easily be converted to cash. This mismatch between liquid debt and illiquid assets makes banks susceptible to sudden losses of funding.

It is partly this vulnerability that makes them candidates for supervision. In a panic, individual depositors have an incentive to withdraw their cash, even if collectively they (and the bank) might be better off if they held fast. This weakness begs for a regulatory hand to co-ordinate actions in the common interest.

There is a second and related fault-line. Banks are less than perfect in the role of providers of ready cash. Demand for liquidity is unpredictable and, for banks, holding liquid assets means forgoing more profitable investments. If there is a sudden rush for cash, banks may prove unable to supply it at an affordable price even to creditworthy enterprises.

These two shortcomings—the co-ordination difficulties that cause bank runs and the problem of sporadic cash shortages—are market failures that have spawned familiar regulatory remedies: deposit insurance and liquidity support. Deposit insurance is a standard antidote to bank runs and is typically financed by a levy on deposit-takers. Coverage has to be large and repayment swift, to deter panic withdrawals. If depositors believe that it will be hard to get their cash tomorrow, they will queue at the counter today—as the throngs outside branches of Northern Rock, a British mortgage lender, recently demonstrated.

The deposit-insurance remedy begets problems of its own. Once depositors are sure of getting their money back, whatever the circumstances, they have little incentive to monitor a bank’s business. This weakens the market discipline of caveat emptor. But a bank’s prospects are so difficult to assess for small depositors that some form of supervision might be necessary anyway.

A more fundamental problem is how deposit insurance distorts banks’ incentives. A secure deposit base encourages banks to take excessive lending risks, since the profits go to shareholders and the risks are borne by insurers. One way of mitigating this problem is to charge insurance premiums that vary according to the riskiness of each bank’s lending. The more common remedy is to put limits on banks’ assets by forcing them to increase their capital if they make risky loans.

The other main plank of state intervention is the liquidity backstop provided by central banks. The regular operations in money markets by the Federal Reserve and its brethren are designed to meet the vagaries of demand for ready cash.

Banks and government have a regulatory pact. In exchange for the stability provided by deposit insurance and the central bank, banks submit to regulatory oversight. The main thrust of regulation is to keep banks solvent by ensuring that their capital is sufficient to cover expected losses.

Solvency or liquidity?

This is fine, up to a point. But recent events suggest that it may not be enough to base a regime solely on capital adequacy. The turmoil in money markets revealed that some banks put aside too few liquid assets to meet a cash squeeze. Many were happy to extend contingent credit lines, apparently secure in the belief that central banks would provide extra liquidity if needed. The private cost to banks of being light on liquid assets was clearly too low compared with the public cost that the liquidity squeeze produced in terms of instability and high interest rates.

For that reason, central banks had little choice but to intervene. Trying to discipline banks after the fact by withholding liquidity risked damaging the economy. But it is galling that the profitability of the banks was partly founded on an excessive reliance on central banks as liquidity providers.

What is particularly worrying is that huge convulsions in money markets were caused by potential losses in subprime lending that are small relative to banks’ capital. Unless banks are forced to protect themselves, much bigger shocks in the future might require even larger interventions by central banks. Banking regulation may need to put as much emphasis on banks’ liquidity as their solvency. The Basel 2 agreement fine-tunes the risk-capital framework but, as regulators freely admit, it has little to say about provisioning for funding shortages.

Raghuram Rajan, of the University of Chicago’s business school (and a former chief economist of the IMF), believes that what is needed is consistent monitoring of banks’ liquidity position over the economic cycle. One benefit of the recent crisis, he says, is that it will provide a benchmark for assessing whether banks have enough liquidity in the future. More scrutiny may be the only way to ensure less reliance on the state.

I just can’t keep this in myself anymore. I need to complain!!!

seriously, i think there is a need to grasp the whole problem instead of trying to reiterate the error nous assumptions given by the press.
Wat do you mean by the government bears all the risk of investment? You are talking about the government as some private entity like a bank etc who generates revenues and profits. Just who is the government? The ministers? Who will pay out the losses of GIC from their own pockets? Or is the Civil service, GIC, temesek employees considered the government, whom i presume will take a year long pay cut if they make losses? IN the end, (don’t flinch, the next line is probably the most important) the citizens of singapore as the people who elected the government , pay the taxes, who  are forced to live with the GLCs will foot the bill!!
Instead of the silly analogy of the bank as stated earlier, let me given u a better one. Let the CPF be depositor A, the only depositor to Bank B. Interestingly, depositor A also happens to own Bank B. Now Bank B guarantees to return 3.5% interest risk free to Depositor A in whatever situation. Bank B takes up a risky investment and loss x dollars. But he still pays depositor A the 3.5%. So who losses? The Bank. But who owns the Bank? Depositor A. The concept is just as simple as this.THe government doesn’t make money(Although technically it can print them. ahem ahem) The revenues obtained are from taxes from Singaporeans or indirectly from them, who incidentally are the CPF holders as well.

So do you now understand what you mean when you say the government undertake all the risk?N do u now know why Singaporeans, ala CPF holders, shareholders who owns the  Bank  should have the right to clamour for better returns? Technically we are wrong to ask it through the CPF system, we should have done it through more tax reliefs, handouts etc, because the ‘bank’ WE OWN is making money.

How Nicolas Sarkozy hopes to avoid a big clash with the trade unions over reform

AFP

TWELVE years ago, an attempt by a reformist French prime minister to put an end to public-sector pension privileges brought 2m protesters on to the streets and weeks of paralysis to the railways. The plan was duly abandoned and, within 18 months, the enfeebled government of Alain Juppé had been booted out at the ballot box. Now a reformist French president, Nicolas Sarkozy, is trying again. On September 18th he promised to end the so-called “special regimes” as part of a complete overhaul of the social-security and benefit system. Might France be heading for a repeat of 1995?

A total of 1.6m people, working or retired, benefit from the special regimes. These pre-war schemes, set up in part to compensate for unusually dangerous or demanding work, allow electricity, gas, railway and metro workers, among others, to retire early on full pensions. In some cases, such as train drivers who no longer have to shovel coal into their engines, this can mean as young as 50. Elsewhere in the public sector, the retirement age is 60.

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Mr Sarkozy has said that he will end these exorbitant privileges, on grounds of “equity”. He wants to bring the special regimes into line with other public-sector workers, as part of a general review of the pension system in early 2008. In order to revamp what he calls a financially unsustainable system that discourages work, he promises also to reform the country’s rigid rules on labour contracts, to tighten the welfare rules and to review the public-health insurance system.

The most controversial plan is the end of special regimes. Despite a financing shortfall of at least €5 billion ($6.9 billion), no government since Mr Juppé’s has dared touch them. François Fillon, Mr Sarkozy’s prime minister, brought in a mini-reform to pensions as social-affairs minister in 2003, but he left the special regimes alone. Bernard Thibault, head of the communist-backed CGT, France’s biggest trade union, has promised that, if the government presents its pension-reform plans as a fait accompli there will be “sport, and not only on the rugby field” (France is hosting the rugby World Cup). After Mr Sarkozy’s speech the railway unions called a strike for October 17th.

Yet there are grounds for believing that, this time round, threats of mass strikes and demonstrations may be less menacing than they proved in 1995. For a start Mr Sarkozy, unlike Jacques Chirac in 1995, has entered office with a strong electoral mandate for change. During his presidential campaign he explicitly promised to end the special regimes in the name of “fairness”. Nobody can plausibly claim that they did not know what was coming.

Public opinion seems also to favour change. In 1995 well over half of French people said they supported or were sympathetic to strikes against Mr Juppé’s plan, according to CSA, a polling agency. Today fully 75% say they support ending the special regimes. It is far from clear that strikes, if they go ahead, will get popular backing (and other union leaders are more cautious than Mr Thibault or the railway unions). Anyway the disruptive power of French unions is not what it was. Workers are no longer paid for days when they are on strike. And in August Mr Sarkozy pushed through a law obliging public-transport workers to negotiate some form of minimum service during a strike.

Most important of all, Mr Sarkozy is taking a novel tactical approach to the unions. Mr Juppé was floored in part by his contemptuous, technocratic attitude towards union leaders. Dominique de Villepin, another former prime minister, was forced to abandon a labour-market reform in 2006 after huge street demonstrations and sit-ins, provoked in part by his refusal even to discuss the plan beforehand.

Mr Sarkozy, in contrast, has gone out of his way to court union leaders, inviting them to the Elysée Palace, and even for lunch at Paris’s finest restaurants. He was reportedly dismayed by a clumsy recent comment of Mr Fillon’s to the effect that reform of the special regimes “is ready”. Mr Sarkozy prefers to create an impression of flexibility and openness to ideas. “My door is always open to them,” he said—although he has also made clear that he is not ready to listen indefinitely. He wants a deal on pension reform by the end of the year. In separate negotiations between employers and unions over a loosening of the principal labour contract, he has imposed a deadline of December.

In short, France’s new president seems genuinely to be trying a fresh approach to the implementation of economic reforms. Does this mean that he will be able to go ahead smoothly with his plans? Nothing is less certain. For one thing Mr Sarkozy’s hands-on approach to the presidency leaves him personally exposed. If he runs into trouble, he will not be able to blame his prime minister, as Mr Chirac did Mr Juppé in 1995.

For another Mr Sarkozy, as a lawyer, is by instinct a deal-maker. But deals always involve concessions. The question is how far he is prepared to push, at the risk of provoking conflict. So far he has often sounded tough, but then made concessions. In July, before even the hint of big protests, he dropped the idea of university selection at masters’ level in the face of student resistance. More recently, he has diluted his plan to replace only one departing civil servant in two in 2008, as a streamlining measure, to two in three.

It could be that Mr Sarkozy is merely waiting to pick his battle, and that he will show a tougher hand when talks on the special regimes or the labour contract fail. But an alternative is that he might try to “buy” his reforms as part of a grand bargain, in which he takes on new liabilities for the state. This could, for instance, take the form of higher pensions in return for a longer contribution period, or more generous unemployment benefits in return for less onerous redundancy rules.

If he goes down such a road, it would create fresh problems, notably for the public finances. France has postponed its promise to balance its budget, from 2010 to 2012. The budget deficit may be 2.4% of GDP this year. A harsher world economic climate, from which Europe is by no means immune (see article), is not going to help. Even before the latest financial turmoil, the European Commission had downgraded its growth forecast for France, which has fallen well behind Germany. The next few months will test, maybe to destruction, Mr Sarkozy’s promise of a rupture with France’s past.

The credit crisis hits the high street

Sep 14th 2007
From Economist.com

AP

A CENTURY ago, the depth of a banking crisis was measured by the length of the queue outside banks. These days, financial panics are more likely to be played out through heavy selling in share, bond or currency markets than old-fashioned bank runs. That makes the sight on the morning of Friday September 14th of a queue of people waiting (patiently in most cases) to take their money out of Northern Rock, a wounded British mortgage bank, all the more extraordinary. A crisis that started in America’s subprime mortgage market where dodgy loans were made to unsound borrowers has shaken the world’s financial capitals since mid-August. Now it has landed on the high street at one of Britain’s biggest mortgage lenders.

Northern Rock faced the triple ignominy of becoming the first British lender in 30 years to be granted a bailout by the Bank of England, losing 29% of its value on the stockmarket, and having to coax savers not to withdraw their money in a rush. (Customers queuing up in its home town of Newcastle reportedly burst out laughing when bank staff asked if anyone wanted to deposit money.) Its troubles weakened the world’s stockmarkets, and sterling also fell.

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Yet Northern Rock appears to be less of a protagonist in the current credit crisis than a bad case of collateral damage. Its problems were caused not because it risked its shareholders’ money on poorly judged investments linked to American subprime mortgages, as many far bigger and more international banks have. Instead, it has been hit by a failure to borrow from other banks to fund its mortgage lending practices. The interbank market where such borrowing usually takes place has partially seized up in recent weeks because big banks are hoarding as much capital as they can to pay for the cost of their own bad investments.

Granted, Northern Rock’s racy business model exposed it more to such shocks than conservative lenders with large branch networks and steadier sources of finance, such as extensive customer deposits. It chose instead to borrow cheap funds when they were available in the markets, which enabled it to offer more attractive mortgage rates than some of its competitors. Its loan book has increased aggressively in recent years to about £17.4 billion ($35 billion).

In agreeing to bail it out, British financial authorities stressed that Northern Rock was “solvent, exceeds its regulatory capital requirement and has a good quality loan book.” The Bank of England charged the bank a penalty rate for the loans, but allowed it to borrow as much as it could provide collateral to support. That suggests the line of credit is potentially very large, but the neatest solution may eventually be its sale to a bigger bank.

The rescue has brought the crisis directly to the Bank of England’s front door. Until this month, it had stood aloof from efforts by America’s Federal Reserve and the European Central Bank to provide liquidity to banks to ease the crunch in the short-term money markets. Its governor, Mervyn King, this week made clear the importance of charging at penalty rates to prevent moral hazard. But Northern Rock is not alone among the world’s banks in funding itself in the wholesale markets. Until global interbank borrowing and lending opens up a bit, central bankers around the world will be watching anxiously for a repeat performance in their own neighbourhoods.

The problems involved in stopping a bank run

Illustration by JAC

“MOST bankers dwell in marble halls/Which they get to dwell in because they encourage deposits and discourage withdrawals.” Ogden Nash, the poet, captured the essence of banking, but how does one discourage withdrawals; in other words, avoid a run on the bank? As the turmoil at Northern Rock, a British bank, has shown, panic among depositors can lead to panic measures: in effect, the British government was rumbled into guaranteeing the deposits of any bank that suffers during this crisis.

The problem has dogged the financial system throughout history, for the simple reason that no bank can survive if enough of its depositors want to be repaid at the same time. Sometimes, subterfuge has been the only answer. In his classic study, “Manias, Panics and Crashes”, Charles Kindleberger recounts how the Bank of England averted a run on its own finances in 1720. The bank managed to get its friends to the front of the queue and arranged for them to be paid, very slowly, in sixpences (then worth a fortieth of a pound). The friends then came back through another door to deposit the coins, which had to be laboriously counted again. This delayed the ability of other depositors to withdraw money until confidence was restored.

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Another device is to close the bank altogether in the hope that depositors will change their minds in the meantime. Although a “bank holiday” in Britain is now seen as a chance to take the family to the seaside, it was once a device for calming markets. It seems unlikely, however, that steam-age delaying tactics would work in the era of 24-hour news coverage and internet banking.

An alternative is to organise a bail-out of the beleaguered bank, by urging other banks to chip in or buy it. In Britain many a small building society (a mutually owned mortgage bank) has been persuaded over the years to absorb one of its smaller competitors. As the rescues of IKB and SachsenLB showed last month, the German authorities can still pull this off.

Whether it is still possible in the Anglo-Saxon world is another matter. When the hedge fund Long-Term Capital Management wobbled in 1998, Bear Stearns, an American investment bank, refused to join in the rescue (hence the Schadenfreude at its recent travails). Global banks are less amenable to pressure from a single central bank. In addition, executives are answerable to shareholders who may question the merits of a rescue.

In the absence of a buyer, it is then up to the central bank to provide cash by acting as a “lender of last resort”. The Federal Reserve was created, in part, because of the banking panic of 1907 and unease that the crisis was solved only through the intervention of a private financier, J. Pierpont Morgan. As J.K. Galbraith remarked, the early Fed did not exactly excel at its task: “In the twenty years before the founding [of the Fed], there were 1,748 bank suspensions, in the 20 years after it ended the anarchy of unstable private banking, there were 15,502.” Milton Friedman argued that the failure of the Fed to protect the banks from failure in the aftermath of the Wall Street crash of 1929 led to a shrinkage of the money supply and prompted the Great Depression. Central banks have since taken that lesson to heart.

The tricky part lies in distinguishing between the times when a bank has run into trouble because of poor management and those where there is a general panic. When it is the bank’s fault, the purist would not rescue it at all, so as to teach investors a lesson. In an essay entitled “State Tampering with Money and Banks”, Herbert Spencer, a British philosopher, said that “the ultimate result of shielding man from the effects of folly is to people the world with fools.”

The Bank of England seemed to be heading down this path in early September, when its governor, Mervyn King, warned against “ex post insurance for risky behaviour”. The problem, as Kindleberger explains, is that “history offers a number of occasions when the authorities were resolved not to intervene but found themselves reluctantly forced to do so.” Northern Rock is just the latest example.

Unfortunately, depositors also find it difficult to tell between the problems of an individual bank and those of the system as a whole. Hence, in a version of Gresham’s law, bad banks drive out good ones. When that happens, politicians cannot withstand the backlash from angry depositors and central bankers fear the economic effects of a credit crunch.

It thus becomes difficult for central banks to follow Walter Bagehot’s famous advice in his book, “Lombard Street”, about lending money only at a penalty rate against good collateral. Indeed, Bagehot himself said that, in a general crisis: “the only safe plan for the Bank is the brave plan, to lend in a panic on every kind of current security, or every sort on which money is ordinarily and usually lent. This policy may not save the Bank; but if it do not, nothing will save it.”

Another consequence of the Depression was the creation of deposit insurance; by offering at least a partial guarantee for savers, the idea was to avoid the panic that led to a bank run in the first place. The fate of Northern Rock indicates that the British version does not do the job, because savers are unwilling to accept any loss and fear the bureaucratic delay in getting back their money. Hence the sudden guarantee for any struggling bank.

A big con, nonetheless

However, this offer is only as good as the credit of the guarantor. John Calverley notes in his book “Bubbles and How to Survive Them” that guarantees from the governments of Indonesia and Argentina over the past decade were simply not believed. A moment’s reflection suggests that the British government could not really guarantee £1.3 trillion of consumer deposits either. But, just like the sixpences, the assurance has, for the moment, done the (confidence) trick.