Archive for 2008

With the ripples of the fallout in the US financial crisis spreading all over the world, many are questioning how did all this happened. A majority of people are saying that it all boils down to greed. Though it may be true that greed played a major role in this crisis, another which many overlooked is transparency. A decade ago, a young British trader was dealing with complex financial derivatives in Singapore. As a direct result of his trading activities, Baring Bank lost $1.4 billion in the futures market and closed its doors after 233 years of banking traditions. The doors also closed on Nick Leeson when he was sent to prison for four and half years for the fiasco.

That incident begs the question why a twenty eight years old trader was allowed to deal with such complex and exotic financial instrument like derivatives without any supervision. The main reason was that no one knew any better. The bosses in London just knew the books were showing a huge profit. None of them actually knew anything about derivatives except its name. What Nick Leeson serves to highlight is the generational gap between the top management and those at the trading desk. As long as everyone was making money, everything was okay.

Today the same situation is repeating itself on Wall Street with the proliferation of exotic instruments like CDOs and MBS. Besides the financial institutions themselves having difficulties knowing what they have on their assets portfolios, the Federal Reserve Board and US Treasury are also hard pressed to find a mechanism to value these “toxic assets”. The situation has resulted into this mess as there is a total divorce in corporate responsibility from one’s action. This is a classic case of what “ignorance is bliss” all about. It’s a great excuse for greed.

Five years ago, the US economy faced a similar crisis though on a smaller scale as compared to today. The issue at hand then was the Enron scandal. Hailed by Fortune Magazine as the most innovative in the US for six consecutive years (1996 to 2001), it later became an icon to symbolise American corporate excesses. It also represented the largest bankruptcy in US history back in 2001. Enron collapse played a major role in shaking up investors as it was able to hide its losses for five years through creative accounting. Due to lack of disclosure about its corporate activities, the audit committee of Enron was unable to fulfill its responsibility. In addition, the auditors of Enron also had close ties with the management and this gave them little incentives to pursue further questioning to discover the true nature of Enron‘s financial health.

Besides hiding its losses from investors, Enron’s management was also involved in insider trading and was excising their stocks options just before the collapse of the company. The irony was that, they were also encouraging their employees to invest further into Enron’s’ shares with their pension funds. The result was that a majority of the employees lost their life savings. On February 22 2005, the Bush Administration met with senior Federal financial officials to discuss what to do with the situation. The majority of those at the meeting were against the idea of holding corporate chiefs responsible for the activities of their companies. Most were contented to let the market sort its own problems out by doing nothing. The only two dissenting voices that were speaking out against corporate corruption were Alan Greenspan, the ex Federal Reserve Chairman and Paul O’ Neil, then the Treasury Secretary for the Bush Administration.

The result of that meeting was a half measure adopted by Congress as the Public Company Accounting Reform and Investor Protection Act. The problem was that the Act was more towards holding auditors of the company liable for the accuracy of their client’s balance sheet rather than holding top management responsible. Today, the Bush Administration is asking Congress to approve a “blank cheque” of $700 billion so that the omnipotent Treasury Secretary Mr. Paulson can buy toxic assets from financial institutions with taxpayers’ dollars. Apart from being a direct beneficiary, (Mr. Paulson own an estimated $700 million worth of shares in Goldman Sachs Inc), the plan also call for unquestionable decisions to be made by the Treasury Secretary. There is no provision for any oversight committee to see through the execution of the bailout plan.

We in Australia also face the same complacency as shown by the Australian Securities and Investment Commission (ASIC) with regards to the Fincorp fiasco. When questioned for its lack of regulatory activities, the ASIC claimed that it was not responsible for approving prospectus but rather that task lies with the issuer and the advisors of the issuer. This had brought little comfort to the 8000 retail investors who had lost A$300 million. After Fincorp, came the WestPoint, whom the financial planners touted as a safe investment. The irony was that all the financial planners were licensed by the ASIC.

Successful investors like Warren Buffett and George Soros do not face this sort of situation because they adopt their own approaches towards investing. While everyone was herding towards the credit default swaps market, Warren Buffett warned that these instruments were “financial weapons of mass destructions” as early as five years ago. George Soros made his billions when everyone else was losing money. The main reason George Soros emerged a winner in the currencies market was that he adopted a system of investment called statistical arbitrages during trading. By using mathemical principles, the arbitrages trading system allows an investor to hedge his investment regardless of the market outcome. (To find out more read, Sports-Arbitrage – How To Place Riskless Bets & Create Tax-Free Investments). Initially pioneered by Morgan Stanley Equity Desk Operations during the 1980s, the system today have advanced tremendously to using softwares like the ArbAlarm to allow investors to locate situation for arbitrages within mere seconds throughout the entire world.

The fact of the matter is that despite what the financial experts or government regulatory bodies claims, no investments is totally safe when control goes out of your hand. Before, bricks and mortars were considered “fail safe” investment as you have the physical asset to rely on. But with the subprime lending crisis that is happening around us today, we can see that everything is very much dependent upon external factors beyond our control. Superannuation returns and share prices are dependent on the global financial market. Property prices now are also affected by global economic conditions which are dictated by the very people who had caused the credit crunch crisis in this world.

Compared to a year ago, the corporate bankruptcy rates in the US have raised by 42%.
(Source: BankruptcyData.com).

Firms are also finding it extremely difficult get credit to starve off bankruptcy due to the credit crunch crisis. A notable example is the auto parts maker Delphi Corp now fighting for survival from corporate insolvency. In addition, job losses, foreclosures, and stock market depreciations are engulfing the US economy. Never in the history of modern economics, have we ever seen bankruptcy the size of that of the Lehman Brothers case. The scale of government bailouts like the case of Fannie Mae and Freddie Mac are rewriting the rules of corporate survival as we plough through “uncharted waters”. No sector of the US economy is being spared as the financial market continues its deleveraging process. The domino effect of the crisis have spill over to the Retail sector, Home builders, Financial firms , Airlines and the Energy sector.

As the US economy is reeling in aftershocks, the FBI has launched investigations into firms which had triggered the US government involvement into bailouts for Wall Street. Some of the firms that have been under the inquiries of the FBI for possibilities of fraud are IndyMac Bancorp Inc, Countrywide Financial Corp, Fannie Mae, Freddie Mac, Lehman Brothers, and AIG. The Federal Reserve and the US Treasury department both agreed that the only way to resolve this crisis and bring stability to the financial market is to rid the books of these financials companies of their “Toxic Assets”. The bailout plan proposed by Treasury Secretary Paulson, requires a $700 billion injection into the market to soak up all the toxic assets. This is in order to unlock the credit squeeze the market is currently facing.

Even as the members of Congress debate over the bailout plan proposed by the Bush administration, leaders from developed countries are urging the US to quickly enacted the plan in order to stabilise the global financial market. The Canadian Prime Minister, Stephen Harper, have expressed worries about the fundamentals of the US economy. He acknowledges that the US economy had impacted Canada’s growth. At the United Nation meeting in New York, France and Australia joined in the chorus to call on the US government to quickly find a solution to the crisis. Australian Prime Minister Kevin Rudd said that it is time for the US government to act decisively to restore order in the chaotic financial market. Although the bailout plan may help to give the financial market a dose of confidence and help unlock the credit squeeze, no one had answered the question of what to do with the surplus homes in the real estate market. Furthermore, the positions of those mortgage holders on “Main Street” who are in a precarious situation have also not been addressed.

Many are demanding answers as to how the situation could have gone so bad. The hardest hit in Australia will most probably be the retirees. After the dot com bubble burst, many have shifted their investment focus towards Real Estate Investment Trust (REIT). Today, the REITs are also vulnerable to the credit crunch crisis. Centro, one of the largest property groups in Australia had announced a loss of A$3 billion for the year 2007/2008. Over a period of a year, up to 40% in values have been wiped off the Australian REITs. Another casualty of the crisis is the Superannuation funds. AMP, reported earlier in the year a 22 % drop in profits for the first half of this year alone. Voluntary contributions have also fallen considerably by as much as 33% since last year. In fact many retirees are turning to the aged pension for survival as the superannuation returns slide further. This number had increased by 40% since the last financial year.

Financial planners have advised that when it comes to investment, we should diversify. Another common advice we hear is that bricks and mortars are a safe bet. Many of those who took these investments from so called “experts” have ended suffering when they see their life savings disappeared into thin air. As early as last year, Australians had lost an aggregate of a billion to dubious investment schemes. The collapse of WestPoint, Fincorp and the Australian Capital Reserve (ACR), are all stark reminders that we need to really rethink our investment strategy. Today, in a globalised economy, none of our investments are insulated from any fallout from any major crisis in the world.

Successful investors like Warren Buffett do not follow what the rest of the pack do when it comes to investing. As early as 2002, he had warned of a “time bomb” that was waiting to go off in the US financial market. He had viewed the credit default swaps market as “financial weapons of mass destructions”. And true to his words, today, we are now reeling from the effects of that “time bomb”. The thing is that if we wish to be successful like Warren Buffett or George Soros, we have to adopt their mindset. There is no way to get rich quick. Everyone needs a plan, patience, and an investment vehicle to start with. Things like risk level and tax liability need to be considered and not just the returns. George Soros, uses statistical arbitrage, to hedge his bets whenever he invested in any assets. This way, he reaps a positive return regardless of the direction the market is going. In layman term, this is called riskless investment and it’s not just restricted to financial markets. (To know more read, Sports-Arbitrage – How To Place Riskless Bets & Create Tax-Free Investments). This system of investing was developed by Morgan Stanley Equity trading division during the 1980s. Today, statistical arbitrages have progressed to encompass technological improvements. With the use of software like the ArbAlarm, it is possible for one to execute a trade within mere seconds from the desktop computer.

Apart from the risk level which we have to consider, there is another aspect most of us tend to overlook, that is the tax liability of the returns. Incomes derived from Real estate are subjected to Capital Gain Tax (CGT). Likewise too are the dividends we get from the superannuation funds. Until the superannuation has become your retirement pension, all the returns are subjected to 15 % CGT unlike capital gains made from statistical arbitrages which are tax free. (For more insight, see ATO Tax Ruling TR2004/D17). At the end of the day, we ourselves have to decide how we will live out our retirement years. Many seniors are finding it extremely difficult to survive on the aged pension as many do not have any savings. Even those who have a retirement nest tied in the stock market are finding their returns shrinking day by day as the credit crisis get worse.

One of the difficulties which lay ahead for US Treasury Secretary, Henry Paulson, is the problem of valuing the toxic assets of the ailing banking institutions. Many are concern that the Government could ended up paying in excess of what these assets are actually worth. With the uproar surrounding the Emergency Economic Stabilization Act of 2008, a move which the financial institutions are seen gaining at the taxpayer’s expense will no doubt have grave political implications. Although the bailout plan had been enacted into law, several provisions were tied to the Bill before the US Congress agreed to pass it into law. Some of the main provisions include:

(1)   Disbursement of the $700 billion funds in tranches with $250 billion being made available immediately to the Treasury Department.

(2)   A provision requiring the President of the United State to propose a bill requiring the financial institutions to reimburse the taxpayers for any losses after the 5 years of the plan running its course. In addition, the Treasury is allowed to take up equity in the participating financial institutions.

(3)   Provision for the curbing of excessive executive salaries of participating financial institutions.

(4)   The provision of two oversight committee to oversee the execution of the program.

From an initial 3 pages proposal, the final Bill had ballooned to 450 pages to covers for all these provisions thus providing Treasury Secretary Paulson with enough incentives to ensure a proper execution of the program. With thousand of mortgages tied to each piece of financial instrument and with delinquency rates spiking in the housing market, to unveil the actual underlying value of these assets can be daunting indeed. To compound the problem of finding a market price for these assets, the market for these instruments is not transparent.

Furthermore, the structures of these types of instruments are intricately complex. With variables like how many homeowners will become delinquent and the recuperation rates of the foreclosures tied to the value of these instruments, these assets will continue to decline in value as long as the housing market are in a downward spiral. As if these mortgage backed securities aren’t complex enough, Investment banks have taken these instruments one step further by rebundling them into even more complex instruments called collateralised debt obligations (CDO). The fact is none of these assets are in any way the same to each other.

An additional difficulty which the Treasury Department will face is to strike a balance between maximising the taxpayer’s money as opposed to minimising the financial institutions losses. The depreciation of these assets has already left these banks financially weak and cash strapped. If the Treasury is to purchase these assets at discounted prices below book value, the bailout program may ultimately prove ineffectual in unlocking the credit squeeze. One way that the Treasury is considering to overcome these hurdles is to conduct reverse auctions to determine the market price for these assets. This way, the Treasury will let the financial institutions themselves decide the selling price.

Whatever method that the Treasury department will use to determine the market price doesn’t dull the fact that most Americans are angry at Wall Street. Many are still asking why the taxpayers, who are suffering at the hands of greedy and reckless financial institutions, are the ones who have to bail these banks out. Opposite the Globe in Australia, people are also asking the same questions as the bailout plan is not designed to help investors like Wingecarribee Shire and other local Australian local councils. The losses from these so called triple “A” investment will result in less monies for the local councils to spend on community development. The major American banks have their lobbyists to represent their interests but unfortunately tiny debt holders like the Wingecarribee Shire council will probably never see a cent of the Australian public money returned despite the bailout program.

This is one of the dire consequences of a globalised economy. Beside from the benefits of increasing trading opportunities, access to the world’s capital market, globalisation has also brought about intensification of risks even to areas which were traditionally regarded as safe. External factors, a few thousands miles away now has the abilities to influences and affect even what was considered the prime investment instruments, like the money market instruments, for many corporations, charities and even the conservative local councils to earn a reasonable yield on their surplus monies. However when greed takes precedence over prudence, the result is a proliferation of poisonous assets like the CDO’s and MBS’s which bears no relationship to the triple “A” ratings they carry in respect of their risks level. In the end, the victims are the investors who have no idea what they have brought.

Globalisation has also brought about changes in the ways of how share prices are being determined on the stock market as well. As increased competitions come about due to the integrations of markets, margins are being slashed. To make up for the loss of income, market traders are now resorting to market inefficiencies to generate additional revenues from declining trading margins. With technological advancements, computers are now programmed with algorithmic trading patterns to execute stock trades in a fraction of a second. In additions, trading systems like the TradElect on the London Stock Exchange can simultaneously process 3000 trade orders in a second. With these innovations and the use of quantitative analysis like statistical arbitrages, price differential as little as two decimal points allow market traders to reap billion of dollars in profits everyday. With the large volume of trades which passes through hedge funds, it is no wonder that hedge funds have the ability to move the prices of shares and create market sentiments.

Today stock prices are no longer valued based on their intrinsic values alone. The dividend yield of a share is no longer as important as the price differential which the market traders can isolate with their trading systems. It is for this main reason why hedge funds are the best performing managed funds in the financial markets. The downside however is that unless you have the financial capacity to develop and maintain such a system, this form of investing is off-limits to the ordinary investors who are bound to just follow market sentiments and like in the current credit crisis suffer the losses. Hedge funds, regardless of the direction of the market is heading, makes monies as their profits are based on mispricings of two complementary assets and not just one assets. Statistical arbitrages allow the market traders to almost reduce their risk levels to almost zero.

The upside is that as former London city stockbroker, Rajeev Shah pointed out, the arbitrage market is not the sole domain of the financial markets. Statistical arbitrage principles can also be applied to the world of sports betting. Using a software developed by him called the ArbAlarm, sports betting can no longer be regarded as gambling as one no longer places bets but “hedges bets” just like in financial markets with the risk level at zero level. (To learn more, read “Sports Arbitrage–How to place riskless bets & create Tax free investments”). In addition, capital gains from the world of sports betting are not subjected to capital gain tax according to the Australian Tax office. (See  Australian Tax ruling TR2004/DR17).

The traditional models of investing based on the three main assets class like Bonds, Stocks and Money Market Instruments are already outdated as demonstrated by the fact that today, superannuation returns are declining due to the credit crisis which the global economies are facing today. Ultimately, the ordinary investors are the one who are suffering due to the greed and recklessness of Wall Street. Even with the $700 billion bailout plan, not all investors will benefit from the rescue package. In time like these, we seriously ought to rethink how we can secure our retirement’s funds which are not subjected to the whims and fancies of a foreign nation problem. 

In Washington DC, while the debate about the $700 bailout plan rages on, Federal Reserve Chairman Ben Bernanke warned that, unemployment  in the US are rising and consumer spending have been sluggish despite easing oil prices. To compound the situation, August data shows that housing prices have been dropping at record level fueling worries that foreclosure rates will spike further.

The Head of Congressional Budget Office, Peter Orszag, also warned that unless Congress acts quickly, the US economy would face possible chaos with equaling severity to that of the Great Depression.

Congress has been unwilling to give its endorsement to the bailout plan in its original form due to the huge price tag attached to the plan. Another reason was the lack of oversight controls over the execution of the plan. The House Democratic Speaker Nancy Pelosi also said that Congress will not just hand over a “$700 billion blank cheque” without any safeguard. The anger felt by Congress is understandable as while the crisis is getting worse; CEOs of failing banks have been receiving “Golden parachute” payments to the tune of millions of dollars. To many, this amounted to rewarding them for failures. In fact, so great is the contention that the FBI is now investigating the two mortgage giants Fannie Mae, Freddie Mac, as well as Lehman and AIG for possibility of fraud.

Meanwhile the US dollar slide further when investors shifted their focus to bonds as unease about the bailout plan increases. Even Warren Buffett $5 billion investment into the Goldman Sach Group Inc failed to calm investors nerves. France, Spain, and Germany are also not spared the effects of the fallout from the US as surveys show investors’ confidence at an all time low. Talks of an European recession are now matters of concern with the Europeans markets. Meanwhile according to the South China Morning Post in Hong Kong, the Chinese government has already instructed all its banks to curtail their inter-bank leading to US banks with immediate effect to prevent any further losses. This is China first attempt in trying to defend its financial position from the fallout after its mainland banks have reported losses due to exposure to the financial crisis in the US.

The Chinese and the Europeans were not the only ones who are showing concerns about the situation in Washington DC. Australian Prime Minister, Kevin Rudd, at the United Nation meeting said that the world’s economy required the bailout plan to be put into effect quickly. He reiterated that the plan is a “good and strong” measure required to stabilise and to avoid a recession in the market. Speaking to reporters after his meeting with the World Bank President, Robert Zoelick, He called on members of the US Congress to work together to enact the plan as the world’s financial markets are under considerable stress.

The Australian Stock market in response to the situation in Washington, took a dive earlier this week as doubts whether the bailout plan will work affected investors confidence. The exceptions to the plunge in shares prices were those in the Oil and Gold sectors which gained ground amidst falling investors’ confidence. In addition, the International Monetary Fund forecasted that the Australian economy growth will slowed to 2.7% in 2008 down from 4.3% in 2007 whose growth had been fueled by raising commodity prices.

Analysts have warned that the situation is bound to get worse as the financial market starts to adjust itself to an equilibrium position. The process of deleveraging, that is the unwinding of bad debts, will cause additional downward spiral on an already distressed market. As bad as Australians wants to avoid the fallout from the crisis, the nightmare is not going to go away. As banks like the NAB write down their losses, multinational companies like Ford, Qantas, and Mitsubishi are retrenching workers to cut down overheads.

Many of us are questioning how did we ended up in a crisis of this magnitude. Some say it was the housing bubble burst, some say predatory leading practices was the cause while others said the credit default swaps market resulted in all this mess. The truth is that while we all hated to admit it, Greed played a major role in all the drivers for the credit crunch crisis. Everyone wants to get rich and as quickly as possible. Unfortunately there is no such thing as getting rich quickly. The truly wealthy like Warren Buffett and George Soros got to where they are now because they followed a definitive plan when it comes to investing their capital. Five years ago, Warren Buffett exited the credit default swaps market when everyone else was diving in neck deep. Today, everyone is talking about Warren Buffett “Time Bomb” going off already.

The reality is that if we want to be successful, we have to follow their footsteps in terms of mindset. George Soros, when it comes to investing, always hedges his bets in the currencies market. This way, no matter what direction the market turns, he is still able to reap a profit. In short, he practices what we call “riskless investment“. This form of investing capitalise on what we term as “Statistical Arbitrage”. (To gain more insight, read “Sports Arbitrage-How to place riskless bets & create Tax free investments“). Pioneered by Morgan Stanley Investment Bank during the 1980s, today statistical arbitrage have advanced to incorporate computers into everyday trading using softwares like the ArbAlarm to execute high frequency trading. With this technological development, trading situation takes mere seconds to execute. In addition to dealing with unorthodox investment vehicles, the successful investors also do not let go of control in respect of matters like capital gain tax. This path of thinking allows them to profit further without running afoul of the law. In fact, according to the Australian Tax Ruling (TR2004/D17), capital gains from this form of investment are not subjected to tax.

As the Governments of the developed countries meets and discuss at the United Nation about the financial crisis that the global economy is facing now, many  of us here at Main Street level, will have to start to rethink about our future and with whom we can leave it all too. While financial planners recommend us to invest in shares, we can see the stock market extremely volatile and having the ability to wipe out our “dreams” within days. The property market also leaves very little room for us to maneuver in the current economic climate. Whatever and however we decide, it will be us who will reap the fruits of our labour or bear the pain of our losses.