1. The Malaysian Government appears not to be perturbed by what is happening in the world.
2. It appears to be convinced that it can isolate and insulate itself from whatever is happening to the world.
3. It seems to be confident that it will be left untouched.
4. It merely reacts to situations as they arise one by one.
5. The mainstream media hardly ever mention the turmoil that the world is facing. Certainly no in-depth analysis has been made. Only Malaysian Business has asked whether we are prepared for the worldwide catastrophe that must bring chaos and problems to our economy, finance, politics and social life. The rest seemed blithely unconcerned. Certainly the people are not being prepared for the inevitable.
6. We are admittedly more fortunate than many other countries. When costs are rising and manufactured exports are shrinking, our commodities have come to our aid. Our export earnings from petroleum and gas, palm oil, rubber and tin have increased many times over.
7. The rise in the price of petrol and products has begun to affect our lives, our living standards and our complacency.
8. We produce about 650,000 barrels a day, consume 400,000 and export roughly 250,000 barrels. We used to earn 30 US Dollar per barrel; today we earn 140 US Dollar, almost all profit. Work out the revenue from 250,000 barrels per day for one year.
9. Besides, we produce 900,000 barrels equivalent of gas, mostly exported. There is no need to take notice of the petrol we produce in Sudan and elsewhere, all selling at 100 US Dollar plus.
10. But we also earn more, much more from palm oil. It used to cost us RM600 per ton to produce. It must be slightly more now. But one ton of palm oil used to sell for RM800 before. Now it sells for more than RM3,000. The palm oil plantation companies are laughing all the way to the bank.
11. But the prices of rubber and even tin have also increased tremendously.
12. For the Government it must mean a great increase in revenue. The profits from petroleum accrue 100% to the Government. I believe in 2006 when oil price was about 70 US Dollar Petronas made a profit before tax of 60 billion Ringgit.
13. Whereas the tax on corporate incomes of the manufacturing companies is minimal, corporate tax revenue from companies producing and exporting palm oil, rubber and tin is very high. If we care to look at the profits of companies today many make well over a billion a year, some more than three billion.
14. So the Government should be flushed with money. But companies not involved in the production of raw material cannot be doing so well. Their imported raw materials including oil and components have all increased in price. They have to increase their export and domestic prices but profits may be less.
15. The construction companies have few contracts to share among themselves. The big Government projects have not materialised. The sub-contractors and building material suppliers are not doing well either.
16. The big construction companies have gone abroad. Some are doing quite well but they cannot help Malaysian subcontractors as the local subcontractors are entitled to get the contracts.
17. Malaysian investors are also not investing in the country. They have a good choice for making money investing in such countries as China and Vietnam. They will pay taxes in these countries.
18. In the meantime the world is undergoing a traumatic economic and financial turmoil. It began with the devaluation of the US Dollar. I do not know how much US Dollar bonds are held by Malaysia. I remember telling the Governor of Bank Negara to reduce our dollar holdings before I stepped down. I hope she has done so. Otherwise we would lose 80 Malaysian sen for every US Dollar we hold. When we hold 30 or 40 billion US Dollar the loss can be considerable.
19. We may make some money from the other currencies which have appreciated against our Ringgit.
20. The US Dollar is going to go down further due to unwise playing around with money. Sub-prime lending was considered profitable before but now the market has collapsed. The loan papers had been readily bought by institutions but now the papers are worthless because no one wants to buy them. And the borrowers are not paying simply because they have no money.
21. The US which condemned us so righteously for bailing out companies now approves massive bailouts by Institutions and the Federal Reserve Bank. These are not small amounts. They are talking about US200 - US400 billion dollars.
22. Bear Stearns sale is a classic case but other banks are faring no better. They will have to sell at fire-sale prices like the banks of Southeast Asia had to do after currency traders bankrupted these banks. A taste of their own medicine should have a salutary effect on the arrogance of the big money people, and their countries.
23. The financial problems of the United States have spilled over to the European countries. They too had been involved in sub-prime lending, either directly or indirectly.
24. The US dollar is going to shrink further as countries unload their dollar holdings, refuse to buy US Dollar bonds, and use other currencies for trading. Oil producers may demand to be paid in their own currencies. The international financial regime will then collapse.
25. The US Dollar is not backed by anything. It sustains its value because it is used as a trading currency. When countries start using other currencies for trading and quickly dispose off the US Dollar in favour of Euro or Yen; when the US Dollar is no longer used for the reserves of the rich countries, then the US Dollar will not be worth the paper on which it is printed.
26. The United States already suffers from twin deficits. When the dollar becomes useless the United States will go into deep recession. Printing more money by the Federal Reserve Bank (which incidentally is not owned by the Government but by other banks) will only result in its devaluation and inflation in the United States.
27. The United States must surely go into severe recession (I am sure the United States will do something illegal in order to prevent this from happening). But whatever, United States recession will affect the whole world.
28. Unprecedentedly the world is experiencing food shortages, something which it had not seen for decades.
29. I will not say anything about the world as everyone knows and I know I am not an economist or a financial expert. But I will try and guess what would happen to Malaysia.
30. Twenty percent of our export goes to the United States. Obviously this market would not be able to absorb what we have to sell to them. We will not lose all but quite a substantial sum will be lost.
31. The economies of the developed countries will also suffer, maybe less than the United States. But our export to them would shrink also.
32. With the money form our petroleum export and revenue from other raw materials we had been able to subsidise for some time. But the prices of fuel and other goods will all increase far beyond the percentage of the increase in oil prices after the subsidy was withdrawn. This is aggravated by the actual increase in prices of foodstuff and food grains, building materials, and assorted imported goods. Even the items produced within the country will increase in price because of imported contents.
33. But the Government is still talking about 5%-7% inflation. This is quite meaningless to lower and middle-income people who must pay 40% more for petrol and 100% more for rice. Other necessities too have increased in price by well over 5%-7%. Stopping price control in the belief that the market will determine prices is imprudent.
34. One of the reasons why Malaysia's inflation rates had remained low compared to other developing countries and even some developed countries is the control over prices of essential goods. Without control there will always be profiteering. And profiteering will result in a high rate of inflation.
35. Today wage earners in particular are suffering. Wages have not increased to compensate for increased cost of living. While chasing prices with increases in wages can cause a wage/price spiral, but judicious increases to cushion off the rising costs would reduce the impact of inflation on the lower income people.
36. Malaysia must give up the idea of competing on the basis of low cost labour. Against China, Vietnam, Thailand, Indonesia we just cannot win. We must provide other elements attractive to investors.
37. Confidence in the consistency of Government policies and political stability would be among the factors attractive to business. There can be a lot of other things that can be provided to offset the rise in wages. After all we must remember that many developed countries have very high wages. Even if we double the salaries and wages paid in Malaysia we would still be far lower than wages in developed countries.
38. We had planned to go hi-tech in order to increase income. But there is not much moving in the implementation of this policy. Instead we want to be an agricultural country again. Planting food crops on the side tables of roads may increase food production but it will not help fight inflation on the scale needed for overcoming the turmoil in the world.
If the PAP cannot improve the lives of the middle class and the poor, it could face a crisis in the 2011 election.
When the republic celebrates its national day next month with its traditional stirring parade and patriotic songs, the mood of many of its citizens will be less than joyful.
On Aug 9 they will try to put aside an unusual combination of bad news – including crushing inflation and threat of a global recession – to wave flags and watch the fireworks.
But it will be with a heavy heart. To put it simply, Singapore’s 43rd birthday is coming at a bad time, possibly one of the worst in decades.
Ironically, the economy of the richest nation in South-East Asia had been firing on all cylinders in recent years.
A booming construction sector, record tourist arrivals and a fast-growing financial sector have contributed to a gross domestic product growth of nearly 8% last year.
The number of millionaires (in US dollar terms) increased to 77,000, making Singapore the seventh in the world in growth of people with high net worth.
That was the recent past. The present is less cheery. A Newsweek correspondent who visited here in 2007 asked: “If the island’s economy is booming, why are so many citizens worse off than they were 10 years ago?”
Even as the country prospered, the lives of lower middle class and the poor have become tougher over the past decade. It has in fact become bleak for the elderly and unskilled, who work as cleaners and labourers, admits the Ministry of Manpower.
Their wages have remained stagnant for 10 years, unlike other groups such as managers, professionals, sales and service workers, as well as plant and machine operators.
Last year, managers – the best-paid group – earned 4.86 times more than cleaners and labourers. The gap has widened in 10 years. It was 4.13 times in 1997.
A government committee on low-income earners says 300,000 workers, or 20% of the population earn S$1,200 (RM2,760) or less a month – half of them S$900 or less.
“Income gaps are widening,” said Finance Minister Tharman Shanmugaratnam, while Minister Mentor Lee Kuan Yew admitted that a narrowing was not likely any time soon because of cheap labour from China and India.
Inflation, the worst in 26 years, has further aggravated the problem since it is affecting the poorer class more than others.
The wage gap has become a particularly acute problem among older and lower-skilled workers, who are among the most disenchanted population in Singapore.
Commentators believe that the political fortunes of the ruling People’s Action Party (PAP) are tied to its ability to tackle this dilemma at a time when Lee's influential presence enters its sunset years.
If inflation worsens further or if the PAP cannot improve the lives of the middle class and the poor, it could face a crisis in the 2011 election.
An unusually frank write-up in the government-controlled Channel News Asia last year said that middle class stagnation could lead to social instability.
“Anecdotally, it seems to me that our society is already beginning to fray at the edges. There is an increasing coarseness to life,” the writer said.
“People have no more time to be considerate to others; even scavengers have to become pushy for fear of losing out to competitors.”
On a possible scenario if poverty spreads, he sounded a warning to the contended rich: “Even if you close your eyes to vagrants around us, you can’t avoid breathing the air that you share with them.
“Even if you drive around in a sealed BMW or Lexus, one day, homeless kids will catch up with you at traffic junctions offering to clean your windshield.
“Or you find yourself taking the long walk to your parked car, because the shorter route takes you past suspicious-looking men who might be desperate enough to snatch your bag.
“I wonder if the decay has begun to set in, even as we continue to boast of high GDP growth rates.”
The island state has become a rich oasis with pockets of rising poverty, where the homeless sleep at void decks or beaches.
Workers in their 60s or 70s clean toilets and sweep floors, instead of enjoying their retirement with grandchildren as is befitting the world’s seventh richest nation (in per capita GDP).
To say the government is not worried is understating the fact. It has set up a special body to study measures to improve the earnings of these 300,000 people.
Ideologically, Lee has always rejected subsidies or welfare schemes for the needy. The younger ministers, led by his son Prime Minister Lee Hsien Loong, have, however, been tweaking the no-welfare system by dishing out more cash and topping up savings of the lower-income workers.
Called Workfare, it provides hundreds to thousands of dollars to poorer families. Much of it has, however, been eaten up by the higher cost of living.
Some economists have called for a new social safety net to meet Singapore’s modern needs. Yeoh Lam Keong suggests identifying a basket of goods and services that is necessary for individuals and families to enjoy a minimum standard of living.
Based on this index, the government should formulate new policies to help low-income earners counter the effects of globalisation.
“We are in a strong fiscal position and if any country in the world can afford to find a better solution to deal with this growing income divide, it is Singapore,” Yeoh said.
UBS confirmed on Friday that it faced more heavy writedowns on its US credits, meaning that it would break even or make a loss in the second quarter.
Europe’s biggest casualty of the US subprime crisis did not quantify the writedowns, which analysts have estimated at up to $7.5bn.
The bank said it had continued to make money in wealth and asset management but suffered renewed losses in investment banking. UBS has written off about $38bn since the start of the subprime crisis.
The bank stressed that it had no need to raise funds, saying its latest losses would leave the bank’s Tier 1 capital ratio at about 11.5 per cent as of June 30.
UBS has raised more than SFr30bn ($29.2bn) this year, mainly through a rights issue and sale of shares to strategic investors.
Bank shares, which have fallen heavily in recent weeks, initially recovered on the news, jumping more than 8 per cent. But by the close of trading, the stock was down 2.57 per cent at SFr20.48, well below the SFr21 a price of its recent SFr16bn rights issue.
Citigroup said, in a note to investors: “While [Friday’s] statement rules out an immediate capital increase, we believe that the Swiss regulator’s increased focus on the leverage ratio suggests harsher capital requirements ahead.”
UBS gave an indirect indication of its latest markdowns by noting that its second-quarter results would benefit from a tax credit of about SFr3bn in connection with its losses to date. Working backwards, and assuming roughly normal profitability of up to SFr2bn in wealth and asset management combined, that implies a loss of at least SFr5bn in investment banking to produce break-even.
UBS said its latest writedowns stemmed from the effect of “further market deterioration” on previously disclosed positions, particularly adjustments to the value of its exposures to monoline insurers.
At the time of its first-quarter results, UBS disclosed that it had exposures of $6.3bn to monolines – a position viewed as ominous by many analysts given the concerns and subsequent ratings downgrades of many bond insurers.
The bank also confirmed fears that its problems with subprime, and broader reputational damage, had eroded its blue chip-private banking franchise, which until recently had escaped fallout. UBS said group net new money had been negative in the second quarter, though it did not distinguish between wealth and asset management.
The bank added that outflows were most severe in April but said matters improved in May and June, especially in wealth management. Full results for the second quarter will be revealed on August 12.
UBS on Friday failed in an attempt to move a lawsuit with HSH Nordbank over UBS’s alleged mismanagement of a $500m portfolio of collateralised debt obligations to London. The case, which is set to be heard in New York, was among the first to be filed over subprime mortgage losses in the wake of the credit crunch. UBS said it would seek to take the case to the Court of Appeal, given its possible impact on similar disputes.
Spain, Ireland `Thrown to the Wolves' After ECB Move
By Ben Sills and Fergal O'Brien
July 4 (Bloomberg) -- Jose Mauricio Rodriguez Montalvo rents a room from his sister to help her afford her basement flat in Madrid as mortgage costs soar.
``She's crying over the Euribor,'' the 12-month money- market rate used to set Spanish mortgages, Montalvo, 28, said in an interview. ``We're just praying it won't keep going up.''
For homeowners in Spain and in Ireland, struggling to stay afloat amid the wreckage of a decade-long real-estate boom, those prayers are going unanswered. The European Central Bank yesterday increased its benchmark rate to 4.25 percent to fight inflation, pushing both economies a step closer to recession.
The two countries are particularly vulnerable to higher lending costs because their housing industries account for about 10 percent of their economies, twice the EU average. Montalvo's family has seen its monthly mortgage payment leap 50 percent to 2,080 euros since the ECB began raising rates in December 2005.
``They have been thrown to the wolves,'' said Stuart Thomson, who helps manage $46 billion in bonds at Resolution Investment Management Ltd. in Glasgow, Scotland. `It's much easier to bring inflation lower if you're willing to have a recession in economies like Spain, Italy and Ireland.''
The Irish economy contracted for the first time in more than a decade in the first quarter. Growth in Spain was the slowest in 13 years in the period, and economists surveyed by Bloomberg News see a 45 percent probability of a recession, or two consecutive quarterly contractions, within the next year.
Balancing Act
The ECB has more than doubled its key rate in less than two years under its mandate to control prices. Euro-region inflation accelerated to 4 percent last month, the fastest in 16 years, on soaring food and oil costs, even with growth slowing.
Trichet yesterday signaled further rate increases weren't imminent as he strikes a balance between taming inflation and not choking economic growth. Still, while he acknowledged some countries will be harder hit than others by the rate increase, he said the bank must serve the entire euro region just as the Federal Reserve sets policy for all 50 U.S. states.
``If you concentrate on California or Florida, it is not at all like Massachusetts or Alaska,'' he said in an interview with Ireland's RTE radio. ``It is the same in our case and we have to make a judgment what is good for the full body of the 320 million people'' in the euro area.
Fraction of Germany
Spain and Ireland make up less than 15 percent of the region's economy and their economies together are about half the size of Germany's. Growth in Europe's biggest economy accelerated in the first quarter to the fastest pace in 12 years and manufacturing was still expanding in June. Spanish industry contracted by the most on record.
Spanish Prime Minister Jose Luis Rodriguez Zapatero has called on the ECB to be ``flexible'' in setting monetary policy.
The Euribor has risen almost 30 basis points since June 5 when Trichet first signaled higher rates. That made new mortgages more expensive and will make existing ones costlier as 98 percent of Spanish home loans are on a variable rate. The jump in costs has sapped demand for housing.
Home starts in Spain plunged 70 percent in March from a year ago and dropped around 60 percent in Ireland. The slowdown prompted Dublin-based realtor Lisney to lower salaries by 10 percent for its 170 workers. The Irish unit of CB Richard Ellis plans to cut around a 10th of its workforce.
``Transactions have dried up,'' said Guy Hollis, managing director of CBRE in Ireland. ``It's not going to last forever, but we have to be prudent.''
Job Creation
The building boom going bust is tarnishing a decade of gains. Ireland's economy has grown the most in the euro area since monetary union in 1999, while Spain created more than a third of new jobs in the region.
After years of ``inappropriately low'' interest rates, Spain and Ireland are now feeling the ``hangover,'' said Alan Ahearne, a lecturer at Ireland's National University and a former economist at the Fed.
Irish banks including Allied Irish Banks Plc had their 2008 earnings estimates cut by Merrion Stockbrokers yesterday because of expectations for deteriorating credit quality.
The decade-long expansion does leave Spain and Ireland with resources to ease the pain of the slowdown. Zapatero's government will use a budget surplus of 2.2 percent of gross domestic product to finance 18 billion euros of measures to prevent defaults and aid unemployed construction workers.
Ireland, with the second-lowest government debt in the euro area after Luxembourg, will maintain a 184 billion-euro infrastructure investment plan.
That may not be enough to buffer the hard landing. The Spanish downturn destroyed 75,000 jobs in the first quarter when the unemployment rate jumped the most in three years to almost 10 percent. Ireland's jobless rate has risen to a nine-year high of 5.4 percent.
``Central banks are paid to cause a recession now and then,'' said Fortis Investments Chief Investment Officer William De Vijlder. ``Maybe it's a shock to put it like that, but that's reality.''
The story of the Hunt brothers, who cornered the market on silver in the 1970s, shows why speculators aren't driving up oil prices.
By Jon Birger July 5, 2008
NEW YORK (Fortune) -- Atlanta hedge fund manager Michael Masters has been a star witness in two recent Congressional hearings on how speculators are supposedly driving up oil prices. Masters and I don't see eye-to-eye on this issue, so I was surprised to get a call from him after my "Don't Blame The Oil Speculators" column went up on Fortune.com last week.
Masters contends that without speculators, the price of oil would be $65 or $70 a barrel. He points out that the amount invested in commodities index products has risen from $13 billion to $260 billion in five years, a fact he thinks is key to understanding oil prices.
"When a trader sends a buy order to the exchange floor or presses the 'buy' key on their trading terminal, if he or she is attempting to buy more contracts than are currently offered for sale at the market price, then the market price will rise," Masters told a House subcommittee in June.
My own view is that speculators can't materially impact prices if all they're doing is making bets on the direction of oil prices by trading futures and not taking delivery of actual oil - hoarding stuff that would otherwise go to consumers.
People don't fill up their tanks with futures contracts, and there's no evidence investors are putting more oil into storage as a bet on higher future prices.
In the end, Masters and I simply agreed to disagree. But there was one thing he said that really piqued my interest. "What do you think would happen," Masters asked, "if the market went into liquidation-only mode [i.e. if speculators started unloading their futures contracts], like we saw with the Hunt brothers in 1980?"
The lesson in silver Nelson Bunker Hunt and William Herbert Hunt were famous for cornering the silver market in the 1970s, eventually driving silver prices from $2 to $50 an ounce. When the Hunts liquidated their portfolio, silver crashed to $10. So the question Masters was asking seemed relevant: Would the oil market go into a silver-esque tailspin if oil-futures traders turned bearish?
I told him it was my understanding that investors in silver and gold frequently take delivery of the physical asset. In other words, investments in precious metals affect supply and demand in ways investments in oil futures do not. What I didn't know - and neither did Masters - was whether the Hunt brothers acquired actual silver or only silver futures. I figured the answer might help make my point.
Well, it turns out that the Hunt brothers did take delivery of silver - a massive amount in fact. In 1973 and 1974, the Hunts inventoried 55 million ounces of silver - about 10% of global supply, according to "Kingdom: The Story of the Hunt Family of Texas" by Jerome Tuccille.
The Hunts arranged to have most of their stash flown to Switzerland, where the silver was stored in the vaults of Credit Suisse, UBS and other Swiss banks. (An author of several best-selling business books, Tuccille is a vice president at T. Rowe Price.)
The point is that the Hunts were not merely flipping futures contracts. As I wrote last week, pension funds, index funds, hedge funds and other so-called oil speculators aren't actually buying oil. They're buying futures. The typical investment fund will buy, say, the August oil future and then sell it days before it comes due - typically rolling over the proceeds into the next month's contract.
If a hedge fund manager correctly bets that oil prices will keep rising, his investment profit comes out of the hide of the investor on the other side of the trade - not the consumer. Unless the hedge fund manager takes oil off the physical market, his trading will have little bearing on the price.
A lot to hide Circling back to Masters' question - what would happen if speculators turned negative on oil futures, the way the Hunts eventually did on silver - my answer is almost nothing. Futures market speculators did turn massively negative on oil November 2005 when crude was $57 a barrel. What happened? Oil was $61 by year-end. "It's a different ballgame with oil than it was with silver," Tuccille told me in an interview. "As you said, they're not taking delivery."
The story of the Hunts cornering the silver market confirms what most academics have been saying all along about oil.
Severin Borenstein, a Berkeley economist and the director of the University of California Energy Institute, contends that in order to push oil prices 30% above fair market value, speculators would have to hoard the equivalent of 2.5 million barrels a day.
"At that rate," Borenstein writes in a new paper, "in less than a year this secret market manipulator would have built an inventory larger than the entire U.S. Strategic Petroleum Reserve."
This manipulator would have had to escape the attention of the U.S. Department of Energy and the International Energy Agency, both of which report that oil inventories are declining, not rising. "That much oil," Borenstein concludes, "would be very difficult to hide."
I sent Masters an e-mail with my findings on the Hunts but have yet to hear back. The question I now have for him - or for anyone else who believes speculators are responsible for $140 oil - is simple:
Where are the Hunt brothers of today stashing all their oil?
Twenty years ago, Ted Forstmann contributed a scathing – and prescient – op-ed to this newspaper warning that the junk-bond craze was about to end badly: "Today's financial age has become a period of unbridled excess with accepted risk soaring out of proportion to possible reward," he wrote in October 1988. "Every week, with ever-increasing levels of irresponsibility, many billions of dollars in American assets are being saddled with debt that has virtually no chance of being repaid."
Within a year, the junk-bond market had collapsed, and within 18 months Drexel Burnham Lambert, the leading firm of the junk-bond world, was bankrupt. Mr. Forstmann sees even worse trouble coming today.
For a curmudgeon, he is a cheerful man. When we met for lunch recently in a tony midtown restaurant, he was wearing a well-tailored suit, a blue shirt and a yellow tie. He spoke with the calm self-assurance of someone who has something to say but nothing left to prove.
"We are in a credit crisis the likes of which I've never seen in my lifetime," Mr. Forstmann warns. He adds: "The credit problems in this country are considerably worse than people have said or know. I didn't even know subprime mortgages existed and I was worried about the credit crisis."
Mr. Forstmann denies being an expert in the capital markets. But he does have some experience with them. He was present at the creation of the private-equity business. The firm he co-founded, Forstmann Little, rode the original private-equity boom in the 1980s while skirting the excesses of the junk-bond craze in the later years. It was for a time the most successful private-equity firm in the world, renowned for both its outsize returns and its caution. For two years after Mr. Forstmann wrote his 1988 op-ed, Forstmann Little sat on $2 billion in uninvested funds, waiting for the right opportunities. Savvy investments in Dr. Pepper and Gulfstream, among others over the years, helped make Mr. Forstmann a billionaire.
These days, he devotes most of his professional attention to IMG, the sports and entertainment agency. But the economy has him worried.
Mr. Forstmann's argument about the present crisis starts with the money supply. After Sept. 11, 2001, the Federal Reserve pumped so much money into the financial system that it distorted the incentives and the decision making of everyone in finance. He illustrates this with what he calls his "little children's story": Once upon a time, when credit conditions and the costs of borrowing money were normal, the bank opened at 9:00 a.m. and closed at 5:00 p.m. For eight hours a day, bankers made loans and took deposits, and then they went home.
But after 9/11, the Fed opened the spigot. Short-term interest rates went to zero in real terms and then into negative territory. When real interest rates are negative, borrowing money is effectively free – the debt loses value faster than the interest adds up. This led to a series of distortions in the financial sector that are only now coming to light. The children's story continues: "Now they [the banks] have all this excess money. And they open at nine, and from nine to noon or so, they're doing all the same kind of basically legitimate things with it that they did before."
So far, so good. "But at noon, they have tons of money left. They have all this supply, and the, what I would call 'legitimate' demand – it's probably not a good word – but where risk and reward are still in balance, has been satisfied. But they're still open until five. And around 3:30 in the afternoon they get to such things as subprime mortgages, OK? And what you guys haven't seen yet is what happened between noon and 3:30."
Straightforward economics tells us that when you print too much money, it loses value and prices go up. That's been happening too. But Mr. Forstmann is most concerned with a different, more subtle effect of the oversupply of money. When it becomes too plentiful, bankers and other financial intermediaries end up taking on more and more risk for less return.
The incentive to be conservative under normal credit conditions is driven in part by what economists call opportunity cost – if you put money to use in one place, it leaves you with less money to invest or lend in another place. So you pick your spots carefully. But if you've got too much money, and that money is declining in value faster than you can earn interest on it, your incentives change. "Something that's free isn't worth much," as Mr. Forstmann puts it. So the normal rules of caution get attenuated.
"They could not find enough appropriate uses for the money," Mr. Forstmann says. "That's why my little bank story for the kids is a fun way to put it. The money just kept coming and coming and coming and coming. What are you going to do with it? IBM only needs so much. The guy who can really pay his mortgage only needs so much." So you start thinking about new ways to lend the money, which inevitably means riskier ways.
"I don't know when money was ever this inexpensive in the history of this country. But not in modern times, that's for sure."
Combine this with loan syndication and securitization, and the result is a nasty brew. Securitization and syndication allow the banks to take the loans off their books and replenish their capital. They then use this capital to make new loans, which they securitize or syndicate and sell to the hedge funds, which buy them with the money they borrowed from the banks. For a time, everyone makes money.
In fact, for six years, a lot of people made a lot of money in this environment. So much money that, as Mr. Forstmann notes, the price of admission to the Forbes 400 list of the richest Americans has gone from $500 million 10 years ago to over $1 billion today. (Mr. Forstmann was bumped from the list two years ago, his reported 10-figure net worth no longer enough to keep pace.)
At the same time, both the size and the number of hedge funds and private-equity funds have ballooned. "I used to have one of the biggest private-equity funds in the world," he says matter-of-factly. "It was, I don't know, $500 million or a billion dollars. If you don't have a $20 billion fund now, you're kind of a [nobody]," Mr. Forstmann says. (The term he used to describe those of us without $20 billion PE funds was both more colorful and less printable than "nobody.") "And so what does that tell you?"
Mr. Forstmann hasn't raised a new fund in four years. But he doesn't blame the hedge funds or the private-equity funds – they are not the villains in his story. "Fundamentally, I don't see them as a cause," he says. "Obviously the proliferation of hedge funds and private-equity funds has created its own dynamic. But this proliferation is simply a result of the vast increase in the money supply."
Mr. Forstmann has been around a long time, so he's seen a lot. But is it possible that he's simply fallen behind the times? By his own description, he's a bit of a figure from another age – "a bit like Wyatt Earp in 1910."
But it would be a mistake to dismiss Mr. Forstmann's pessimism too quickly. After all, he knows something about both credit and crises.
"You've got [Treasury Secretary Henry] Paulson saying 'Oh, you see the good news is it's over.'" The problem, according to Mr. Forstmann, is that it's far from over. "I think we're in about the second inning of this." And of course, the credit crisis wasn't even supposed to last this long. "This all started in August [of 2007], and it was going to get cleared up by October. It hasn't gotten cleared up at all."
One reason is that the proliferation of new financial instruments has left the system more closely intertwined than ever, making a workout, or even a shakeout, much more difficult. Take what happened to Bear Stearns. "What should the health of one brokerage firm in America mean to the entire global financial system? To an ordinary person, probably not much. But in today's world, with all the interdependence, a great deal."
This circular creation of new credit, used to buy more newly created debt, all financed by ultracheap money and all betting with each other, has left the major firms hopelessly intertwined. "It's very interrelated," he says, locking his fingers together. "There's trillions and trillions of dollars that slosh around between all these places and if one fails . . ." He doesn't finish the thought.
Early in our conversation, Mr. Forstmann describes his conversational style as "Faulknerian." The word fits. He jumps between thoughts, examples and anecdotes in a pure stream of consciousness. One such aside is about Warren Buffett and the rule of the three "I"s.
"Buffett once told me there are three 'I's in every cycle. The 'innovator,' that's the first 'I.' After the innovator comes the 'imitator.' And after the imitator in the cycle comes the idiot. Which makes way for an innovator again." So when Mr. Forstmann says we're at the end of an era, it's another way of saying that he's afraid that the idiots have made their entrance.
"We're in the third 'I' for sure," he interjects an hour after first introducing the "rule." "And that always leads to something. Innovators don't just show up. Some disaster takes place because of the idiots, and then an innovator says, oh, look at this, I can do this, that or the other thing." That disaster is now.
In other words, "In order to fix what's going on in the United States there's going to have to be a certain amount of pain. The market's going to have to clear somehow. . . and it's hard for me to believe that it gets fixed without" upheaval in the financial system, the economy and the country as a whole. "Things are going to fail. Enterprises are going to fail. The economy is going to slow," he warns.
To be clear, although Mr. Forstmann talks about "fear and greed" getting out of whack, his is not a condemnation of "greedy speculators" or a "culture of greed" or any of the lamentations so popular among the populists in Washington. It is a diagnosis of the ways in which the financial sector responded to a government policy of printing money that was free, or nearly so. "The creation of much too much money caused all of this excess," he says. In other words, his is not an argument for draconian regulation, but for sound money.
Nor does he blame Alan Greenspan, even though he argues that this all started with the dot-com bubble and 9/11. "Greenspan," he allows, "had really tough decisions to make, so I don't think it's a black-and-white kind of thing at all." It was, and is, rather, "a case of first impression." Mr. Greenspan, he says, admits that he was "totally sure" that what he was doing was right. But he had "no idea what the consequences [were] going to be."
According to Mr. Forstmann, we are now living with those consequences. And the correction has only begun.
8 comments:
How to tell the truth about Bad Money part 1 of 2
How to tell the truth about Bad Money part 2 of 2
MALAYSIA AND A WORLD IN TURMOIL
Dr. Mahathir Mohamad
July 3, 2008
1. The Malaysian Government appears not to be perturbed by what is happening in the world.
2. It appears to be convinced that it can isolate and insulate itself from whatever is happening to the world.
3. It seems to be confident that it will be left untouched.
4. It merely reacts to situations as they arise one by one.
5. The mainstream media hardly ever mention the turmoil that the world is facing. Certainly no in-depth analysis has been made. Only Malaysian Business has asked whether we are prepared for the worldwide catastrophe that must bring chaos and problems to our economy, finance, politics and social life. The rest seemed blithely unconcerned. Certainly the people are not being prepared for the inevitable.
6. We are admittedly more fortunate than many other countries. When costs are rising and manufactured exports are shrinking, our commodities have come to our aid. Our export earnings from petroleum and gas, palm oil, rubber and tin have increased many times over.
7. The rise in the price of petrol and products has begun to affect our lives, our living standards and our complacency.
8. We produce about 650,000 barrels a day, consume 400,000 and export roughly 250,000 barrels. We used to earn 30 US Dollar per barrel; today we earn 140 US Dollar, almost all profit. Work out the revenue from 250,000 barrels per day for one year.
9. Besides, we produce 900,000 barrels equivalent of gas, mostly exported. There is no need to take notice of the petrol we produce in Sudan and elsewhere, all selling at 100 US Dollar plus.
10. But we also earn more, much more from palm oil. It used to cost us RM600 per ton to produce. It must be slightly more now. But one ton of palm oil used to sell for RM800 before. Now it sells for more than RM3,000. The palm oil plantation companies are laughing all the way to the bank.
11. But the prices of rubber and even tin have also increased tremendously.
12. For the Government it must mean a great increase in revenue. The profits from petroleum accrue 100% to the Government. I believe in 2006 when oil price was about 70 US Dollar Petronas made a profit before tax of 60 billion Ringgit.
13. Whereas the tax on corporate incomes of the manufacturing companies is minimal, corporate tax revenue from companies producing and exporting palm oil, rubber and tin is very high. If we care to look at the profits of companies today many make well over a billion a year, some more than three billion.
14. So the Government should be flushed with money. But companies not involved in the production of raw material cannot be doing so well. Their imported raw materials including oil and components have all increased in price. They have to increase their export and domestic prices but profits may be less.
15. The construction companies have few contracts to share among themselves. The big Government projects have not materialised. The sub-contractors and building material suppliers are not doing well either.
16. The big construction companies have gone abroad. Some are doing quite well but they cannot help Malaysian subcontractors as the local subcontractors are entitled to get the contracts.
17. Malaysian investors are also not investing in the country. They have a good choice for making money investing in such countries as China and Vietnam. They will pay taxes in these countries.
18. In the meantime the world is undergoing a traumatic economic and financial turmoil. It began with the devaluation of the US Dollar. I do not know how much US Dollar bonds are held by Malaysia. I remember telling the Governor of Bank Negara to reduce our dollar holdings before I stepped down. I hope she has done so. Otherwise we would lose 80 Malaysian sen for every US Dollar we hold. When we hold 30 or 40 billion US Dollar the loss can be considerable.
19. We may make some money from the other currencies which have appreciated against our Ringgit.
20. The US Dollar is going to go down further due to unwise playing around with money. Sub-prime lending was considered profitable before but now the market has collapsed. The loan papers had been readily bought by institutions but now the papers are worthless because no one wants to buy them. And the borrowers are not paying simply because they have no money.
21. The US which condemned us so righteously for bailing out companies now approves massive bailouts by Institutions and the Federal Reserve Bank. These are not small amounts. They are talking about US200 - US400 billion dollars.
22. Bear Stearns sale is a classic case but other banks are faring no better. They will have to sell at fire-sale prices like the banks of Southeast Asia had to do after currency traders bankrupted these banks. A taste of their own medicine should have a salutary effect on the arrogance of the big money people, and their countries.
23. The financial problems of the United States have spilled over to the European countries. They too had been involved in sub-prime lending, either directly or indirectly.
24. The US dollar is going to shrink further as countries unload their dollar holdings, refuse to buy US Dollar bonds, and use other currencies for trading. Oil producers may demand to be paid in their own currencies. The international financial regime will then collapse.
25. The US Dollar is not backed by anything. It sustains its value because it is used as a trading currency. When countries start using other currencies for trading and quickly dispose off the US Dollar in favour of Euro or Yen; when the US Dollar is no longer used for the reserves of the rich countries, then the US Dollar will not be worth the paper on which it is printed.
26. The United States already suffers from twin deficits. When the dollar becomes useless the United States will go into deep recession. Printing more money by the Federal Reserve Bank (which incidentally is not owned by the Government but by other banks) will only result in its devaluation and inflation in the United States.
27. The United States must surely go into severe recession (I am sure the United States will do something illegal in order to prevent this from happening). But whatever, United States recession will affect the whole world.
28. Unprecedentedly the world is experiencing food shortages, something which it had not seen for decades.
29. I will not say anything about the world as everyone knows and I know I am not an economist or a financial expert. But I will try and guess what would happen to Malaysia.
30. Twenty percent of our export goes to the United States. Obviously this market would not be able to absorb what we have to sell to them. We will not lose all but quite a substantial sum will be lost.
31. The economies of the developed countries will also suffer, maybe less than the United States. But our export to them would shrink also.
32. With the money form our petroleum export and revenue from other raw materials we had been able to subsidise for some time. But the prices of fuel and other goods will all increase far beyond the percentage of the increase in oil prices after the subsidy was withdrawn. This is aggravated by the actual increase in prices of foodstuff and food grains, building materials, and assorted imported goods. Even the items produced within the country will increase in price because of imported contents.
33. But the Government is still talking about 5%-7% inflation. This is quite meaningless to lower and middle-income people who must pay 40% more for petrol and 100% more for rice. Other necessities too have increased in price by well over 5%-7%. Stopping price control in the belief that the market will determine prices is imprudent.
34. One of the reasons why Malaysia's inflation rates had remained low compared to other developing countries and even some developed countries is the control over prices of essential goods. Without control there will always be profiteering. And profiteering will result in a high rate of inflation.
35. Today wage earners in particular are suffering. Wages have not increased to compensate for increased cost of living. While chasing prices with increases in wages can cause a wage/price spiral, but judicious increases to cushion off the rising costs would reduce the impact of inflation on the lower income people.
36. Malaysia must give up the idea of competing on the basis of low cost labour. Against China, Vietnam, Thailand, Indonesia we just cannot win. We must provide other elements attractive to investors.
37. Confidence in the consistency of Government policies and political stability would be among the factors attractive to business. There can be a lot of other things that can be provided to offset the rise in wages. After all we must remember that many developed countries have very high wages. Even if we double the salaries and wages paid in Malaysia we would still be far lower than wages in developed countries.
38. We had planned to go hi-tech in order to increase income. But there is not much moving in the implementation of this policy. Instead we want to be an agricultural country again. Planting food crops on the side tables of roads may increase food production but it will not help fight inflation on the scale needed for overcoming the turmoil in the world.
Poverty looms in Isle of Riches
INSIGHT DOWN SOUTH
BY SEAH CHIANG NEE
July 5, 2008
If the PAP cannot improve the lives of the middle class and the poor, it could face a crisis in the 2011 election.
When the republic celebrates its national day next month with its traditional stirring parade and patriotic songs, the mood of many of its citizens will be less than joyful.
On Aug 9 they will try to put aside an unusual combination of bad news – including crushing inflation and threat of a global recession – to wave flags and watch the fireworks.
But it will be with a heavy heart. To put it simply, Singapore’s 43rd birthday is coming at a bad time, possibly one of the worst in decades.
Ironically, the economy of the richest nation in South-East Asia had been firing on all cylinders in recent years.
A booming construction sector, record tourist arrivals and a fast-growing financial sector have contributed to a gross domestic product growth of nearly 8% last year.
The number of millionaires (in US dollar terms) increased to 77,000, making Singapore the seventh in the world in growth of people with high net worth.
That was the recent past. The present is less cheery. A Newsweek correspondent who visited here in 2007 asked: “If the island’s economy is booming, why are so many citizens worse off than they were 10 years ago?”
Even as the country prospered, the lives of lower middle class and the poor have become tougher over the past decade. It has in fact become bleak for the elderly and unskilled, who work as cleaners and labourers, admits the Ministry of Manpower.
Their wages have remained stagnant for 10 years, unlike other groups such as managers, professionals, sales and service workers, as well as plant and machine operators.
Last year, managers – the best-paid group – earned 4.86 times more than cleaners and labourers. The gap has widened in 10 years. It was 4.13 times in 1997.
A government committee on low-income earners says 300,000 workers, or 20% of the population earn S$1,200 (RM2,760) or less a month – half of them S$900 or less.
“Income gaps are widening,” said Finance Minister Tharman Shanmugaratnam, while Minister Mentor Lee Kuan Yew admitted that a narrowing was not likely any time soon because of cheap labour from China and India.
Inflation, the worst in 26 years, has further aggravated the problem since it is affecting the poorer class more than others.
The wage gap has become a particularly acute problem among older and lower-skilled workers, who are among the most disenchanted population in Singapore.
Commentators believe that the political fortunes of the ruling People’s Action Party (PAP) are tied to its ability to tackle this dilemma at a time when Lee's influential presence enters its sunset years.
If inflation worsens further or if the PAP cannot improve the lives of the middle class and the poor, it could face a crisis in the 2011 election.
An unusually frank write-up in the government-controlled Channel News Asia last year said that middle class stagnation could lead to social instability.
“Anecdotally, it seems to me that our society is already beginning to fray at the edges. There is an increasing coarseness to life,” the writer said.
“People have no more time to be considerate to others; even scavengers have to become pushy for fear of losing out to competitors.”
On a possible scenario if poverty spreads, he sounded a warning to the contended rich: “Even if you close your eyes to vagrants around us, you can’t avoid breathing the air that you share with them.
“Even if you drive around in a sealed BMW or Lexus, one day, homeless kids will catch up with you at traffic junctions offering to clean your windshield.
“Or you find yourself taking the long walk to your parked car, because the shorter route takes you past suspicious-looking men who might be desperate enough to snatch your bag.
“I wonder if the decay has begun to set in, even as we continue to boast of high GDP growth rates.”
The island state has become a rich oasis with pockets of rising poverty, where the homeless sleep at void decks or beaches.
Workers in their 60s or 70s clean toilets and sweep floors, instead of enjoying their retirement with grandchildren as is befitting the world’s seventh richest nation (in per capita GDP).
To say the government is not worried is understating the fact. It has set up a special body to study measures to improve the earnings of these 300,000 people.
Ideologically, Lee has always rejected subsidies or welfare schemes for the needy. The younger ministers, led by his son Prime Minister Lee Hsien Loong, have, however, been tweaking the no-welfare system by dishing out more cash and topping up savings of the lower-income workers.
Called Workfare, it provides hundreds to thousands of dollars to poorer families. Much of it has, however, been eaten up by the higher cost of living.
Some economists have called for a new social safety net to meet Singapore’s modern needs. Yeoh Lam Keong suggests identifying a basket of goods and services that is necessary for individuals and families to enjoy a minimum standard of living.
Based on this index, the government should formulate new policies to help low-income earners counter the effects of globalisation.
“We are in a strong fiscal position and if any country in the world can afford to find a better solution to deal with this growing income divide, it is Singapore,” Yeoh said.
UBS faces more US credit writedowns
By Haig Simonian in Zurich
July 4 2008
UBS confirmed on Friday that it faced more heavy writedowns on its US credits, meaning that it would break even or make a loss in the second quarter.
Europe’s biggest casualty of the US subprime crisis did not quantify the writedowns, which analysts have estimated at up to $7.5bn.
The bank said it had continued to make money in wealth and asset management but suffered renewed losses in investment banking. UBS has written off about $38bn since the start of the subprime crisis.
The bank stressed that it had no need to raise funds, saying its latest losses would leave the bank’s Tier 1 capital ratio at about 11.5 per cent as of June 30.
UBS has raised more than SFr30bn ($29.2bn) this year, mainly through a rights issue and sale of shares to strategic investors.
Bank shares, which have fallen heavily in recent weeks, initially recovered on the news, jumping more than 8 per cent. But by the close of trading, the stock was down 2.57 per cent at SFr20.48, well below the SFr21 a price of its recent SFr16bn rights issue.
Citigroup said, in a note to investors: “While [Friday’s] statement rules out an immediate capital increase, we believe that the Swiss regulator’s increased focus on the leverage ratio suggests harsher capital requirements ahead.”
UBS gave an indirect indication of its latest markdowns by noting that its second-quarter results would benefit from a tax credit of about SFr3bn in connection with its losses to date. Working backwards, and assuming roughly normal profitability of up to SFr2bn in wealth and asset management combined, that implies a loss of at least SFr5bn in investment banking to produce break-even.
UBS said its latest writedowns stemmed from the effect of “further market deterioration” on previously disclosed positions, particularly adjustments to the value of its exposures to monoline insurers.
At the time of its first-quarter results, UBS disclosed that it had exposures of $6.3bn to monolines – a position viewed as ominous by many analysts given the concerns and subsequent ratings downgrades of many bond insurers.
The bank also confirmed fears that its problems with subprime, and broader reputational damage, had eroded its blue chip-private banking franchise, which until recently had escaped fallout. UBS said group net new money had been negative in the second quarter, though it did not distinguish between wealth and asset management.
The bank added that outflows were most severe in April but said matters improved in May and June, especially in wealth management. Full results for the second quarter will be revealed on August 12.
UBS on Friday failed in an attempt to move a lawsuit with HSH Nordbank over UBS’s alleged mismanagement of a $500m portfolio of collateralised debt obligations to London. The case, which is set to be heard in New York, was among the first to be filed over subprime mortgage losses in the wake of the credit crunch. UBS said it would seek to take the case to the Court of Appeal, given its possible impact on similar disputes.
Spain, Ireland `Thrown to the Wolves' After ECB Move
By Ben Sills and Fergal O'Brien
July 4 (Bloomberg) -- Jose Mauricio Rodriguez Montalvo rents a room from his sister to help her afford her basement flat in Madrid as mortgage costs soar.
``She's crying over the Euribor,'' the 12-month money- market rate used to set Spanish mortgages, Montalvo, 28, said in an interview. ``We're just praying it won't keep going up.''
For homeowners in Spain and in Ireland, struggling to stay afloat amid the wreckage of a decade-long real-estate boom, those prayers are going unanswered. The European Central Bank yesterday increased its benchmark rate to 4.25 percent to fight inflation, pushing both economies a step closer to recession.
The two countries are particularly vulnerable to higher lending costs because their housing industries account for about 10 percent of their economies, twice the EU average. Montalvo's family has seen its monthly mortgage payment leap 50 percent to 2,080 euros since the ECB began raising rates in December 2005.
``They have been thrown to the wolves,'' said Stuart Thomson, who helps manage $46 billion in bonds at Resolution Investment Management Ltd. in Glasgow, Scotland. `It's much easier to bring inflation lower if you're willing to have a recession in economies like Spain, Italy and Ireland.''
The Irish economy contracted for the first time in more than a decade in the first quarter. Growth in Spain was the slowest in 13 years in the period, and economists surveyed by Bloomberg News see a 45 percent probability of a recession, or two consecutive quarterly contractions, within the next year.
Balancing Act
The ECB has more than doubled its key rate in less than two years under its mandate to control prices. Euro-region inflation accelerated to 4 percent last month, the fastest in 16 years, on soaring food and oil costs, even with growth slowing.
Trichet yesterday signaled further rate increases weren't imminent as he strikes a balance between taming inflation and not choking economic growth. Still, while he acknowledged some countries will be harder hit than others by the rate increase, he said the bank must serve the entire euro region just as the Federal Reserve sets policy for all 50 U.S. states.
``If you concentrate on California or Florida, it is not at all like Massachusetts or Alaska,'' he said in an interview with Ireland's RTE radio. ``It is the same in our case and we have to make a judgment what is good for the full body of the 320 million people'' in the euro area.
Fraction of Germany
Spain and Ireland make up less than 15 percent of the region's economy and their economies together are about half the size of Germany's. Growth in Europe's biggest economy accelerated in the first quarter to the fastest pace in 12 years and manufacturing was still expanding in June. Spanish industry contracted by the most on record.
Spanish Prime Minister Jose Luis Rodriguez Zapatero has called on the ECB to be ``flexible'' in setting monetary policy.
The Euribor has risen almost 30 basis points since June 5 when Trichet first signaled higher rates. That made new mortgages more expensive and will make existing ones costlier as 98 percent of Spanish home loans are on a variable rate. The jump in costs has sapped demand for housing.
Home starts in Spain plunged 70 percent in March from a year ago and dropped around 60 percent in Ireland. The slowdown prompted Dublin-based realtor Lisney to lower salaries by 10 percent for its 170 workers. The Irish unit of CB Richard Ellis plans to cut around a 10th of its workforce.
``Transactions have dried up,'' said Guy Hollis, managing director of CBRE in Ireland. ``It's not going to last forever, but we have to be prudent.''
Job Creation
The building boom going bust is tarnishing a decade of gains. Ireland's economy has grown the most in the euro area since monetary union in 1999, while Spain created more than a third of new jobs in the region.
After years of ``inappropriately low'' interest rates, Spain and Ireland are now feeling the ``hangover,'' said Alan Ahearne, a lecturer at Ireland's National University and a former economist at the Fed.
Irish banks including Allied Irish Banks Plc had their 2008 earnings estimates cut by Merrion Stockbrokers yesterday because of expectations for deteriorating credit quality.
The decade-long expansion does leave Spain and Ireland with resources to ease the pain of the slowdown. Zapatero's government will use a budget surplus of 2.2 percent of gross domestic product to finance 18 billion euros of measures to prevent defaults and aid unemployed construction workers.
Ireland, with the second-lowest government debt in the euro area after Luxembourg, will maintain a 184 billion-euro infrastructure investment plan.
That may not be enough to buffer the hard landing. The Spanish downturn destroyed 75,000 jobs in the first quarter when the unemployment rate jumped the most in three years to almost 10 percent. Ireland's jobless rate has risen to a nine-year high of 5.4 percent.
``Central banks are paid to cause a recession now and then,'' said Fortis Investments Chief Investment Officer William De Vijlder. ``Maybe it's a shock to put it like that, but that's reality.''
Hunting for oil villains
The story of the Hunt brothers, who cornered the market on silver in the 1970s, shows why speculators aren't driving up oil prices.
By Jon Birger
July 5, 2008
NEW YORK (Fortune) -- Atlanta hedge fund manager Michael Masters has been a star witness in two recent Congressional hearings on how speculators are supposedly driving up oil prices. Masters and I don't see eye-to-eye on this issue, so I was surprised to get a call from him after my "Don't Blame The Oil Speculators" column went up on Fortune.com last week.
Masters contends that without speculators, the price of oil would be $65 or $70 a barrel. He points out that the amount invested in commodities index products has risen from $13 billion to $260 billion in five years, a fact he thinks is key to understanding oil prices.
"When a trader sends a buy order to the exchange floor or presses the 'buy' key on their trading terminal, if he or she is attempting to buy more contracts than are currently offered for sale at the market price, then the market price will rise," Masters told a House subcommittee in June.
My own view is that speculators can't materially impact prices if all they're doing is making bets on the direction of oil prices by trading futures and not taking delivery of actual oil - hoarding stuff that would otherwise go to consumers.
People don't fill up their tanks with futures contracts, and there's no evidence investors are putting more oil into storage as a bet on higher future prices.
In the end, Masters and I simply agreed to disagree. But there was one thing he said that really piqued my interest. "What do you think would happen," Masters asked, "if the market went into liquidation-only mode [i.e. if speculators started unloading their futures contracts], like we saw with the Hunt brothers in 1980?"
The lesson in silver
Nelson Bunker Hunt and William Herbert Hunt were famous for cornering the silver market in the 1970s, eventually driving silver prices from $2 to $50 an ounce. When the Hunts liquidated their portfolio, silver crashed to $10. So the question Masters was asking seemed relevant: Would the oil market go into a silver-esque tailspin if oil-futures traders turned bearish?
I told him it was my understanding that investors in silver and gold frequently take delivery of the physical asset. In other words, investments in precious metals affect supply and demand in ways investments in oil futures do not. What I didn't know - and neither did Masters - was whether the Hunt brothers acquired actual silver or only silver futures. I figured the answer might help make my point.
Well, it turns out that the Hunt brothers did take delivery of silver - a massive amount in fact. In 1973 and 1974, the Hunts inventoried 55 million ounces of silver - about 10% of global supply, according to "Kingdom: The Story of the Hunt Family of Texas" by Jerome Tuccille.
The Hunts arranged to have most of their stash flown to Switzerland, where the silver was stored in the vaults of Credit Suisse, UBS and other Swiss banks. (An author of several best-selling business books, Tuccille is a vice president at T. Rowe Price.)
The point is that the Hunts were not merely flipping futures contracts. As I wrote last week, pension funds, index funds, hedge funds and other so-called oil speculators aren't actually buying oil. They're buying futures. The typical investment fund will buy, say, the August oil future and then sell it days before it comes due - typically rolling over the proceeds into the next month's contract.
If a hedge fund manager correctly bets that oil prices will keep rising, his investment profit comes out of the hide of the investor on the other side of the trade - not the consumer. Unless the hedge fund manager takes oil off the physical market, his trading will have little bearing on the price.
A lot to hide
Circling back to Masters' question - what would happen if speculators turned negative on oil futures, the way the Hunts eventually did on silver - my answer is almost nothing. Futures market speculators did turn massively negative on oil November 2005 when crude was $57 a barrel. What happened? Oil was $61 by year-end. "It's a different ballgame with oil than it was with silver," Tuccille told me in an interview. "As you said, they're not taking delivery."
The story of the Hunts cornering the silver market confirms what most academics have been saying all along about oil.
Severin Borenstein, a Berkeley economist and the director of the University of California Energy Institute, contends that in order to push oil prices 30% above fair market value, speculators would have to hoard the equivalent of 2.5 million barrels a day.
"At that rate," Borenstein writes in a new paper, "in less than a year this secret market manipulator would have built an inventory larger than the entire U.S. Strategic Petroleum Reserve."
This manipulator would have had to escape the attention of the U.S. Department of Energy and the International Energy Agency, both of which report that oil inventories are declining, not rising. "That much oil," Borenstein concludes, "would be very difficult to hide."
I sent Masters an e-mail with my findings on the Hunts but have yet to hear back. The question I now have for him - or for anyone else who believes speculators are responsible for $140 oil - is simple:
Where are the Hunt brothers of today stashing all their oil?
COMMENTARY: THE WEEKEND INTERVIEW
Theodore J. Forstmann
The Credit Crisis Is Going to Get Worse
By BRIAN M. CARNEY
July 5, 2008
New York
Twenty years ago, Ted Forstmann contributed a scathing – and prescient – op-ed to this newspaper warning that the junk-bond craze was about to end badly: "Today's financial age has become a period of unbridled excess with accepted risk soaring out of proportion to possible reward," he wrote in October 1988. "Every week, with ever-increasing levels of irresponsibility, many billions of dollars in American assets are being saddled with debt that has virtually no chance of being repaid."
Within a year, the junk-bond market had collapsed, and within 18 months Drexel Burnham Lambert, the leading firm of the junk-bond world, was bankrupt. Mr. Forstmann sees even worse trouble coming today.
For a curmudgeon, he is a cheerful man. When we met for lunch recently in a tony midtown restaurant, he was wearing a well-tailored suit, a blue shirt and a yellow tie. He spoke with the calm self-assurance of someone who has something to say but nothing left to prove.
"We are in a credit crisis the likes of which I've never seen in my lifetime," Mr. Forstmann warns. He adds: "The credit problems in this country are considerably worse than people have said or know. I didn't even know subprime mortgages existed and I was worried about the credit crisis."
Mr. Forstmann denies being an expert in the capital markets. But he does have some experience with them. He was present at the creation of the private-equity business. The firm he co-founded, Forstmann Little, rode the original private-equity boom in the 1980s while skirting the excesses of the junk-bond craze in the later years. It was for a time the most successful private-equity firm in the world, renowned for both its outsize returns and its caution. For two years after Mr. Forstmann wrote his 1988 op-ed, Forstmann Little sat on $2 billion in uninvested funds, waiting for the right opportunities. Savvy investments in Dr. Pepper and Gulfstream, among others over the years, helped make Mr. Forstmann a billionaire.
These days, he devotes most of his professional attention to IMG, the sports and entertainment agency. But the economy has him worried.
Mr. Forstmann's argument about the present crisis starts with the money supply. After Sept. 11, 2001, the Federal Reserve pumped so much money into the financial system that it distorted the incentives and the decision making of everyone in finance. He illustrates this with what he calls his "little children's story": Once upon a time, when credit conditions and the costs of borrowing money were normal, the bank opened at 9:00 a.m. and closed at 5:00 p.m. For eight hours a day, bankers made loans and took deposits, and then they went home.
But after 9/11, the Fed opened the spigot. Short-term interest rates went to zero in real terms and then into negative territory. When real interest rates are negative, borrowing money is effectively free – the debt loses value faster than the interest adds up. This led to a series of distortions in the financial sector that are only now coming to light. The children's story continues: "Now they [the banks] have all this excess money. And they open at nine, and from nine to noon or so, they're doing all the same kind of basically legitimate things with it that they did before."
So far, so good. "But at noon, they have tons of money left. They have all this supply, and the, what I would call 'legitimate' demand – it's probably not a good word – but where risk and reward are still in balance, has been satisfied. But they're still open until five. And around 3:30 in the afternoon they get to such things as subprime mortgages, OK? And what you guys haven't seen yet is what happened between noon and 3:30."
Straightforward economics tells us that when you print too much money, it loses value and prices go up. That's been happening too. But Mr. Forstmann is most concerned with a different, more subtle effect of the oversupply of money. When it becomes too plentiful, bankers and other financial intermediaries end up taking on more and more risk for less return.
The incentive to be conservative under normal credit conditions is driven in part by what economists call opportunity cost – if you put money to use in one place, it leaves you with less money to invest or lend in another place. So you pick your spots carefully. But if you've got too much money, and that money is declining in value faster than you can earn interest on it, your incentives change. "Something that's free isn't worth much," as Mr. Forstmann puts it. So the normal rules of caution get attenuated.
"They could not find enough appropriate uses for the money," Mr. Forstmann says. "That's why my little bank story for the kids is a fun way to put it. The money just kept coming and coming and coming and coming. What are you going to do with it? IBM only needs so much. The guy who can really pay his mortgage only needs so much." So you start thinking about new ways to lend the money, which inevitably means riskier ways.
"I don't know when money was ever this inexpensive in the history of this country. But not in modern times, that's for sure."
Combine this with loan syndication and securitization, and the result is a nasty brew. Securitization and syndication allow the banks to take the loans off their books and replenish their capital. They then use this capital to make new loans, which they securitize or syndicate and sell to the hedge funds, which buy them with the money they borrowed from the banks. For a time, everyone makes money.
In fact, for six years, a lot of people made a lot of money in this environment. So much money that, as Mr. Forstmann notes, the price of admission to the Forbes 400 list of the richest Americans has gone from $500 million 10 years ago to over $1 billion today. (Mr. Forstmann was bumped from the list two years ago, his reported 10-figure net worth no longer enough to keep pace.)
At the same time, both the size and the number of hedge funds and private-equity funds have ballooned. "I used to have one of the biggest private-equity funds in the world," he says matter-of-factly. "It was, I don't know, $500 million or a billion dollars. If you don't have a $20 billion fund now, you're kind of a [nobody]," Mr. Forstmann says. (The term he used to describe those of us without $20 billion PE funds was both more colorful and less printable than "nobody.") "And so what does that tell you?"
Mr. Forstmann hasn't raised a new fund in four years. But he doesn't blame the hedge funds or the private-equity funds – they are not the villains in his story. "Fundamentally, I don't see them as a cause," he says. "Obviously the proliferation of hedge funds and private-equity funds has created its own dynamic. But this proliferation is simply a result of the vast increase in the money supply."
Mr. Forstmann has been around a long time, so he's seen a lot. But is it possible that he's simply fallen behind the times? By his own description, he's a bit of a figure from another age – "a bit like Wyatt Earp in 1910."
But it would be a mistake to dismiss Mr. Forstmann's pessimism too quickly. After all, he knows something about both credit and crises.
"You've got [Treasury Secretary Henry] Paulson saying 'Oh, you see the good news is it's over.'" The problem, according to Mr. Forstmann, is that it's far from over. "I think we're in about the second inning of this." And of course, the credit crisis wasn't even supposed to last this long. "This all started in August [of 2007], and it was going to get cleared up by October. It hasn't gotten cleared up at all."
One reason is that the proliferation of new financial instruments has left the system more closely intertwined than ever, making a workout, or even a shakeout, much more difficult. Take what happened to Bear Stearns. "What should the health of one brokerage firm in America mean to the entire global financial system? To an ordinary person, probably not much. But in today's world, with all the interdependence, a great deal."
This circular creation of new credit, used to buy more newly created debt, all financed by ultracheap money and all betting with each other, has left the major firms hopelessly intertwined. "It's very interrelated," he says, locking his fingers together. "There's trillions and trillions of dollars that slosh around between all these places and if one fails . . ." He doesn't finish the thought.
Early in our conversation, Mr. Forstmann describes his conversational style as "Faulknerian." The word fits. He jumps between thoughts, examples and anecdotes in a pure stream of consciousness. One such aside is about Warren Buffett and the rule of the three "I"s.
"Buffett once told me there are three 'I's in every cycle. The 'innovator,' that's the first 'I.' After the innovator comes the 'imitator.' And after the imitator in the cycle comes the idiot. Which makes way for an innovator again." So when Mr. Forstmann says we're at the end of an era, it's another way of saying that he's afraid that the idiots have made their entrance.
"We're in the third 'I' for sure," he interjects an hour after first introducing the "rule." "And that always leads to something. Innovators don't just show up. Some disaster takes place because of the idiots, and then an innovator says, oh, look at this, I can do this, that or the other thing." That disaster is now.
In other words, "In order to fix what's going on in the United States there's going to have to be a certain amount of pain. The market's going to have to clear somehow. . . and it's hard for me to believe that it gets fixed without" upheaval in the financial system, the economy and the country as a whole. "Things are going to fail. Enterprises are going to fail. The economy is going to slow," he warns.
To be clear, although Mr. Forstmann talks about "fear and greed" getting out of whack, his is not a condemnation of "greedy speculators" or a "culture of greed" or any of the lamentations so popular among the populists in Washington. It is a diagnosis of the ways in which the financial sector responded to a government policy of printing money that was free, or nearly so. "The creation of much too much money caused all of this excess," he says. In other words, his is not an argument for draconian regulation, but for sound money.
Nor does he blame Alan Greenspan, even though he argues that this all started with the dot-com bubble and 9/11. "Greenspan," he allows, "had really tough decisions to make, so I don't think it's a black-and-white kind of thing at all." It was, and is, rather, "a case of first impression." Mr. Greenspan, he says, admits that he was "totally sure" that what he was doing was right. But he had "no idea what the consequences [were] going to be."
According to Mr. Forstmann, we are now living with those consequences. And the correction has only begun.
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