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Sunday, 28 September 2008

Looking Past the Crisis

ByDavid Sterman, Interim Portfolio Manager

If you take a quick snapshot of key economic indicators, you'll see that there is obviously plenty of reason for concern. But a more liquid banking system, falling energy prices and the sheer resilience of the U.S. consumer could set the stage for the next upturn to begin in 2009.

It's an old investing axiom that the market looks six to nine months ahead, so the timing of an economic bottom and eventual turnaround is likely to dominate market discussions in coming weeks and months. Let's take a closer look at the current headwinds and possible eventual tailwinds.

* Technology/semiconductors: Book-to-bill for semiconductors fell to just 0.83 in August 2008, down 37% from August 2007. Flat-panel TVs, GPS devices and iPods were key demand drivers for tech and chips in recent weeks. Those segments have matured, and it's hard to spot the next hot trend. Consumer PC technology is no longer making radical leaps, and consumers are upgrading only when their current systems wear out.

Silver lining: The weak book-to-bill figure could set the stage for lower inventories and firmer prices. And the weak demand environment is fueling rising losses for the smaller niche players; that should finally lead to industry consolidation and also keep the door closed to new tech IPOs.

That creates a little running room for the larger, better-capitalized tech names. Still-strong balance sheets will likely lead to more share buybacks. Valuations are also firmly in check: Tech bellwether Intel trades just above its five-year low.

* Small and medium-sized businesses are having an increasingly hard time securing loans while banks are stressed. These firms are typically the backbone of new job creation, and their cautious stance is likely to keep their employees (who are also consumers) fearful and tight-fisted as well.

Moreover, any small and medium-sized firms that saw a boost in exports due to the plunging dollar could see reduced foreign demand now that the dollar is strengthening. That could explain why capacity utilization figures appear to be softening.

Silver lining: These companies have stayed lean, with a tight lid on head count and inventories, so massive further retrenchment is unlikely, and signs of an upturn could fuel an inventory rebuild in 2009.

* Retail:The upcoming holiday season is likely to be disappointing. Trouble is, many retailers make almost all of their profits in the fourth quarter, so full-year losses appear likely for a growing number of players. Analysts have yet to write off the fourth quarter, and downward estimate revisions appear increasingly likely. Retailer distress could have an ancillary negative impact on mall-based REITs.

Silver lining: The Darwinian nature of retail can provide a solid boost for the survivors. For example, Pier One is poised to eventually boost sales now that Bombay, a key rival, is out of business. In a similar vein, Bed Bath & Beyond is not heartbroken over the implosion of Linens 'n Things.

* Airlines and autos: Weakening business and consumer confidence implies continued sales weakness in the near term for these two industries. Airlines are entering into the seasonally weakest point of the year, so the demand trends are likely to remain uninspiring for the rest of the year, at least.

The domestic auto makers are scrambling to keep up with Toyota and Honda in terms of fuel efficiency. Whether GM and Ford Motor can turn a profit on smaller, fuel-efficient vehicles is also a challenge, especially in the context of high prices for raw materials such as steel.

Silver lining: Both industries have taken a huge amount of costs out of their operations and can now turn a profit at far lower levels of demand -- when that demand re-materializes. Also, $100 oil is a lot less painful than $140 oil, and the moribund global economy implies that we are unlikely to see another demand-driven spike any time soon.

As I've noted in the past, small-cap stocks are often the best way to play a resurgent economy. That may explain why the Russell 2000 has held its own in the recent turmoil.

Is it time to assume that the economy will be on the mend in 2009? No one can answer that. Serious hurdles remain. Interest rates are my biggest concern. Although inflation appears to now be in check, the rising budget deficits and persistently high trade deficits may make it hard to keep a lid on interest rates.

However, if interest rates stay at low current levels, then you should look past the near-term headwinds, as I suggested recently.

Friday, 26 September 2008

When's the Right Time to Invest?

It's not surprising that first-time investors often worry about the timing of their initial stock purchases. Getting started at the wrong point in the market's ups and downs can leave you staring at big losses right off the bat.

But take heart, Fools: Whenever you first invest, time is on your side. Over the long haul, the compounding returns of a well-chosen investment will add up nicely, whatever the market happens to be doing when you buy your first shares.

Don't Waste Time

Rather than fretting about when you should make that first stock purchase, think instead about how long you're planning to keep money in the market. Different investments offer varying degrees of risk and return, and each is best suited for a different investing time frame.

In general, bonds offer smaller, more dependable returns for investors with shorter time frames. According to Ibbotson, short-term U.S. Treasury bills yielded roughly 3.7% per year from 1926 to 2003. (We picked 2003 as an endpoint because it was right after the end of a bear market.) While this seems relatively meager, remember that inflation was nonexistent for most of this period, making a 3.7% average annual return fairly attractive until the 1960s.

Longer-term government bonds have provided slightly higher returns: an average of 5.4% annually from 1926 to 2003. Surprisingly, their gains have been relatively volatile. In the 1980s, for instance, they returned nearly 14% annually, but in the 1950s, bonds lost an average of nearly 4% per year.

Stocks have also been very good to investors. Overall, large-cap stocks have returned an average of 10.4% per year from 1926 to 2003 -- quite a bit higher than bonds. Surprisingly, the range of the returns for stocks is not that much larger than the range for bonds over the same period. Stocks suffered a slight decline in the 1930s, but enjoyed several particularly strong decades as well, including the 1950s (18% average annual return), the 1980s (16.6%), and the 1990s (17.3%).

When Will You Need the Money?

The longer you have to amass your cash, the greater risk you can accept, since you'll have more time to wait out periods of bad returns.

If you need the money within the next five years, you'll want to avoid individual stocks and stock-centric mutual funds. If you need the money within the next three years, you should also avoid bond mutual funds and real estate investment trusts (REITs), which can drop if interest rates increase.

With those options eliminated, you have a few choices left: buying individual bonds or certificates of deposit (CDs) with durations of less than three years, putting your money in a money market fund, or using a savings account. Each vehicle generates income while guaranteeing the return of your principal. The sooner you need the money, the less you can afford to lose, right?

On the other hand, stocks are a very attractive option for long-term goals like retirement. The higher returns are simply too good to pass up.

When to Sell

Once you've decided what to buy, and when to buy it, you'll next need to decide when to cash out. Since bonds essentially sell themselves when they mature, this question primarily applies to stocks or stock mutual funds.

Some investors believe they can "time" the market, accurately predicting when it will rise and fall. As a result, they counsel selling all your stocks when the market is about to fall, and buying them all back when the market prepares to rise. Unfortunately, if investing were that easy, these same folks would be sunning themselves on beaches in Acapulco, rather than trying to sell their timing methods to other investors.

Granted, when overall economic woes begin to hurt corporate earnings growth, and companies start to flounder, you might consider selling some of your overvalued, lower-quality companies. But beyond that very general scenario, an accurate system for timing the market remains an investor's pipe dream.

Many mutual fund investors are quick to withdraw their cash when returns turn sour. But several academic studies have proven that investors who jump from one fund to the next, chasing performance, tend to do vastly worse than those who stay put. Be prepared to stick with a fund through good times and bad -- with one exception.

In an actively managed fund, you've entrusted your cash to a professional money manager. If that manager abandons your fund to manage another, his or her replacement may not manage your money with equal skill, and you may want to consider selling. Otherwise, a few months of poor fund performance are no reason to jump ship.

Selling stocks can present a more complex set of questions. Two major warning signs may suggest that it's a good time to sell:

• The business's fundamentals change. Is a new competitor rendering its basic products obsolete? Is the company branching out into areas wildly unrelated to its core competencies, leaving you no longer able to understand the business?

• The stock becomes overvalued. Has the market bid the company's shares up to unsupportable heights? Is the stock likely to crash on the slightest bad news? Does the risk of such a tumble outweigh any tax hit you'd take by selling now?

While both those red flags can provide excellent reasons to sell, many of the other screaming sirens surrounding the market can be safely ignored.

Don't Listen to the Noise

The media pays meticulous attention to Wall Street -- but it tends to focus entirely on one particular index, assuming that it reflects the entire market. Index goes up? The market is bullish! Index goes down? Here comes the bear market! Index yo-yos back and forth? Now the market is "volatile!"

Some investors, particularly those keen on technical analysis, study the ups and downs of market graphs to gauge whether investors will take the market higher. For Foolish investors, this is an exercise in futility. Successful investing relies not on monitoring the market as a whole, but on analyzing the strengths and weaknesses of individual companies. Whatever the market's doing at the moment, a buy-and-hold approach to investing is the best way to earn reliable long-term returns.

Review, Review, Review

Of course, you can't just load your portfolio with a few stocks -- however well-chosen -- and forget all about them. Like houseplants, investments need regular care and attention to flourish. Unless you've parked your money in government bonds, with their guaranteed rates of return, you need to check on your investments regularly to make sure they're beating the market -- and doing so more substantially and less expensively than other, similar options.

Reviewing your investments, particularly when you may have made mistakes, also offers a crucial opportunity to learn from your mistakes. Everyone makes errors now and then, but most successful investors avoid making the same goofs twice. Set aside time to review your portfolio at least once every three months, if not every week. While you shouldn't be glued to the computer screen, tracking your investments minute-by-minute, don't forget them entirely, either.

Wednesday, 24 September 2008

Buy, Sell, or Stay Put? Advice from the Pros

By Amy Feldman

If you're feeling pummeled by market mayhem, you're not alone. With Lehman Brothers (leh.) filing for bankruptcy, Merrill Lynch (NYSE:MER - News) selling out, and AIG getting a government bailout, investors have been knocked for a loop. Financial advisers have been fielding phone calls from panicked clients, but the smarter ones called their clients first to put things in perspective. "My issue with my clients is: Are they getting to a place where they cannot sleep?" says David Diesslin, a financial planner in Fort Worth. BusinessWeek spoke with more than 15 of the country's top financial advisers to find out what's keeping their clients awake at night. Here's what they're telling them to do about it.

Should I pull my money out of the market?

In short, no. With the Dow Jones industrial average down 4.4% on Sept. 15, and off 22.9% from its peak last October, investors are undoubtedly watching portfolios shrink. Right now, it's hard to see beyond the bad news. But the market has survived major upheavals in the past -- the savings and loan crisis, for example.

In fact, a number of advisers see a positive sign in the government's decision to allow Lehman to fail. "In the short term, there will be volatility and uncertainty, but the world didn't come to an end," says Coral Gables (Fla.) financial planner Harold Evensky, who was rebalancing clients' portfolios to make sure equities kept their weighting after the sell-off. "Investors who are properly invested own little pieces of companies around the world, and, for the most part, those companies are still fine and making money."

The smart strategy remains the tried-and-true one: Set your asset allocation and stick with it. Panic selling is more likely to harm your portfolio than doing nothing. "Selling at the bottom is not a good strategy, but I'm not a soothsayer," says Laurence Kotlikoff, an economics professor at Boston University and president of ESPLanner. "All I can say is, I'm staying in the market. The U.S. economy can get along quite nicely with fewer Wall Street investment companies, none of which seems able or willing to tell shareholders precisely what they are holding."

I have a life insurance policy or annuity with AIG. What will the Federal Reserve bailout mean for me?

It means you can take a deep breath. Even when there was a risk of bankruptcy, American International Group's insurance subsidiaries appeared healthy and policyholders weren't really at risk. There are numerous safeguards in place for policyholders. Now, with the government injecting $85 billion into the parent and the risk of bankruptcy gone, policyholders should be able to stop worrying.

What about my money market fund? Could it be affected by the market turmoil?

Sadly, yes. On Sept. 16, The Reserve Fund announced that hundreds of millions of dollars of debt securities issued by Lehman (leh.) and owned by its Primary Fund were worthless. That means The Primary Fund "broke the buck" -- net asset value fell from $1.00 per share to $0.97. At Evergreen Investments (AMEX:ERC - News), however, parent Wachovia (NYSE:WB - News) announced it would support the value of three money funds so they would not reflect the decline in value of Lehman debt. Several other money funds have followed suit.

What if I now realize my investment strategy is way off? Should I move my money?

If you were 100% in equities or overweight in your own company's stock, it's good to get out of denial about the risks. "This is a wake-up call for a lot of people," says Christine Fahlund, a financial adviser at T. Rowe Price Group (NasdaqGS:TROW - News). "People are finding out that their risk tolerance isn't what they thought it was or that they're not superstars when it comes to investing."

The big question is how quickly to act. "It's not a good time to sell anything, so it depends how bad it really is," says George Feiger, chief executive of Contango Capital Advisors in Berkeley, Calif. Investors not yet approaching retirement may be able to move portfolios toward a desired asset allocation slowly and wait for the market to settle down.

Will I still be able to retire?

The real reason to worry isn't market movements, no matter how nerve-wracking; it's whether you're saving enough. If you're in your 20s, 30s, or 40s, you've got lots of time on your side. "With a longer time horizon, say 10 to 20 years, even the crash of 1987 looks like a blip," says Michael Mauboussin, Legg Mason's (NYSE:LM - News) chief investment strategist.

For some people on the verge of retirement, there's a tougher reality that may mean working longer. Psychologically, being able to blame the market turmoil is helping investors cut through their denial about how long they're going to need to work to have a comfortable retirement. "It's the first time that people are saying publicly, 'In this market, I am not ready to retire,' " Fahlund says. "The reason is probably more than just their investments, but finally they can share these emotions with people and feel like they are in this together."

What if I'm already retired?

The big problem is the cash squeeze that can come from the double whammy of lower asset values and interest rates. With your portfolio throwing off less cash, you may be tempted to reach for yield. Or you may consider selling assets -- at what are now low valuations. Do either, and you could face trouble in the long term. "It's easy to tell a guy who's 35 and panicking that this is the wrong time to sell. But the consequences are worse if you're older, and it's harder to overcome the emotion and fear," Feiger says. Be sure to run the numbers, and don't assume you'll be short because of the plunge on Sept. 15.

Is this a buying opportunity?

That depends on your risk tolerance. "We may not have final markdowns yet, but if you have the stomach, some investments are looking cheaper," Diesslin says. Even so, he'd steer clear of financials.

Stephen Wetzel, a financial planner and adjunct professor of financial planning at New York University, is far less circumspect. "I'm buying like a crazy man: value stocks, financial services, value funds, muni bonds, some international small cap. You don't get opportunities like this very often."

Bondsellers may get lawsuits

HONG KONG - HONG Kong investors who bought complex financial products backed by collapsed US investment bank Lehman Brothers were considering suing the institutions who sold them, a lawmaker said on Tuesday.

Investors argued that the banks who sold the instruments guaranteed by the failed Wall Street titan did not fully explain the high risks associated with the products.

'The investors are considering mounting legal action against the banks for misrepresentation,' Albert Ho, chairman of the Democratic Party and a lawyer, told AFP.

Many of the investors, who paid a total of 12.7 billion HK dollars (S$2.30 billion US), had been sold mini-bonds which are based on derivatives linked to major firms' stocks but are worthless if the guarantor goes bankrupt.

'These products used to be sold by only investment banks to clients who had at least 1 million US dollars,' said Mr Ho.

'But a few years ago, commercial banks wanted to snatch a piece of the pie and started to convince their elderly customers to buy the mini-bonds without explaining to them the risks involved,' he said.

Mr Ho said investors will meet the city's Consumer Council on Thursday to see if they can get legal and financial assistance to try and recoup their losses.

Mr Ho said many of the bond holders were retired and had put all their savings into the investment because they trusted their banks.

A meeting held on Monday night with investors was attended by 800 people, Mr Ho said. Some of them held a protest on Sunday to urge the government to provide assistance.

The Hong Kong Monetary Authority said it would investigate if 21 sellers of the mini-bonds had mis-sold them, according to a report in the South China Morning Post.

The Consumer Council said it had received a handful of enquiries from the investors and would consider their application for its legal assistance fund if it thinks they have a case, a spokeswoman for the council said.

Lehman Brothers collapsed last week under the strain of the US subprime, or high-risk, mortgage crisis, sparking turmoil on financial markets across the world. -- AFP

US risks a recession

WASHINGTON - FEDERAL Reserve Chairman Ben Bernanke bluntly warned Congress on Tuesday the United States risks a recession, with higher unemployment and increased home foreclosures, if lawmakers fail to act on the Bush administration's plan to bail out the financial industry.

Mr Bernanke told the Senate Banking Committee that failure to act could leave ordinary businesses unable to borrow the money they need to expand and hire additional employees, while consumers could find themselves unable to finance big-ticket purchases such as cars and homes.

Mr Bernanke's remarks came in response to a question from Senator Chris Dodd, a Democrat and the committee's chairman, who seemed eager to hear a strong rationate for lawmakers to act swiftly on the administration's unprecedented request.

'The financial markets are in quite fragile condition and I think absent a plan they will get worse,' Bernanke said.

Ominously, he added, 'I believe if the credit markets are not functioning, that jobs will be lost, that our credit rate will rise, more houses will be foreclosed upon, GDP will contract, that the economy will just not be able to recover in a normal, healthy way.'

Gross domestic product is a measure of growth, and a decline correlates with a recession. Mr Bernanke and Treasury Secretary Henry Paulson urged Congress earlier on Tuesday to swiftly pass a US$700-billion (S$989 billion) Wall Street bailout, warning the entire US economy was at risk.

The warnings came as President George W. Bush vowed before world leaders at the United Nations that US lawmakers would approve the country's largest financial bailout since the Great Depression of the 1930s.

Mr Bernanke told lawmakers that despite the unprecedented steps already taken by the Republican administration to confront the crisis, global financial markets 'remain under extraordinary stress'.

Action was 'urgently required to stabilise the situation and avert what otherwise could be very serious consequences for our financial markets and for our economy,' he said in remarks prepared for delivery.

But the proposal to give the Treasury unprecedented authority to borrow US$700 billion to buy toxic mortgage-related assets from struggling financial institutions has met with stiff opposition from some lawmakers.

They have signaled they will not be hurried into approving such a massive US government financial intervention, and have called for proper oversight measures to be put in place to prevent future problems.

Nervous global markets were on Tuesday focused on the grilling that Mr Bernanke and Mr Paulson faced from the Senate Banking Committee, as the two men urged lawmakers to quickly approve the plan unveiled only days ago.

Democratic congressional leaders and some Republican colleagues have insisted the bailout include sweeping safeguards and oversight to protect American taxpayers.

Global equities markets sank amid growing doubts about the prospects for the US bailout's swift passage. US shares had plunged Monday but were trading modestly higher Tuesday morning as investors watched the skirmish in Congress.

Mr Bush assured worried world leaders that his administration was working to avert a financial meltdown.

'I can assure you that my administration and our Congress are working together,' he said in his farewell address to the UN General Assembly. 'I'm confident we will act in the urgent timeframe required.'

But lawmakers remain cautious.

'I'm prepared to act quickly but I'm not going to act irresponsibly. If it takes longer, so be it,' said Senator Chris Dodd, chairman of the Senate Banking Committee.

Mr Dodd said he was 'angry' about being faced with a crisis that was 'a preventable, avoidable situation' created by a political climate he described as 'basically an eight-year coffee break'.

'You had regulators sitting back as loans were being made with no documentation ... predatory lenders taking advantage of the situation - that's how this all unfolded. It's not a mystery,' Mr Dodd said.

Mr Dodd has proposed a number of amendments to the package, including a provision to allow the government to take a stake in the companies it bails out, limits on compensation for company bosses and severance packages of the rescued firms and additional help for American homeowners facing foreclosures.

Democratic Senator Hillary Clinton said she agreed with those ideas and was putting forth proposals of her own.

'I would like to make sure we have oversight and accountability in this immediate package,' she said in a separate CNN interview.

Mr Bernanke underscored the urgency of the swiftly escalating global credit squeeze.

'At this juncture, in light of the fast-moving developments in financial markets, it is essential to deal with the crisis at hand,' Mr Bernanke pleaded.

Mr Paulson echoed the central bank chief's comments, warning that if Congress did not act quickly, a credit crisis could threaten 'all parts of our economy'.

Mr Paulson warned against losing the 'bipartisan consensus' on the urgency of the bailout with attempts to lard the bill with add-ons.

'We need to build upon this spirit to enact this bill quickly and cleanly, and avoid slowing it down with other provisions that are unrelated or don't have broad support,' he said.

Mr Bernanke said the plan to buy up illiquid assets would create liquidity in the market and reduce uncertainty.

And he added it would also 'help to restore confidence in our financial markets and enable banks and other institutions to raise capital and to expand credit to support economic growth'. -- AFP, AP

Tuesday, 23 September 2008

Short-selling ban stuns hedge funds

Many lose a fortune and could fold up in the coming months

Published September 22, 2008
By NEIL BEHRMANN
IN LONDON

HEDGE fund short sellers, caught in Friday's bear squeeze, are believed to have lost fortunes. Many of them are expected to close down in coming months, analysts say.

Although a minority of hedge funds and traders made fortunes when Wall Street, London and other global markets soared, bears were caught unawares by the dual action of the US Securities and Exchange Commission (SEC) and the UK's Financial Services Authority (FSA). Both regulators, followed by Ireland and other European countries, clamped down on short selling.

Hedge funds, investment proprietary traders and other speculators had borrowed shares and sold them, aiming to profit from further price declines. Futures, options and other derivatives were also used to profit from a further market slide.

Instead, the short-selling ban caused an acute bear squeeze, forcing hedge funds and other bears to buy back shares.

Prices opened sharply higher as selling dried up and the bears scrambled to cover their short positions. Banks, insurance companies and other financial shares rose between 30 per cent and 60 per cent at one point, before falling back when the market began to settle down.

The bear squeeze and exceedingly volatile markets in recent weeks have now placed a question mark on the viability of some hedge fund businesses.

George Ball, chairman of Sanders Morris Harris Group, a large American asset manager, is predicting that 1,000 hedge funds will fail in the coming 12 months. This follows 350 failures in the first half of the year. The regulatory restrictions will crimp the flexibility of hedge fund managers, he says.

Hedge funds are likely to be under severe pressure for several reasons:

First, performance has been poor. In the year to Sept 18, before the huge rally on Friday, Hedge Fund Research's HFRX daily global hedge fund index was already down 9.7 per cent.

Relative value hedge fund strategies had fallen by 17 per cent while the HFRX long short hedge funds had declined by 11.6 per cent. Macro hedge funds, that trade all the markets, were still up by 4.6 per cent because of a good first half.

Second, withdrawals are accelerating and risk-averse investors have reportedly given hedge funds notice that they intend redeeming their investments by the end of the year.

Third, short-selling restrictions, tighter regulation and deleveraging are limiting hedge fund manager flexibility and trading.

Fourth, banks and prime brokers are expected to reduce loans to hedge funds. The borrowing and consequent leverage helped them profit in dull markets.

The regulatory moves to curb short selling received praise from companies and the expected criticism from AIMA, the hedge fund industry body. The regulators were accused of creating false markets in banking shares, but they countered that in the current crisis something had to be done to underpin faltering banks.

'The Commission is committed to using every weapon in its arsenal to combat market manipulation that threatens investors and capital markets,' said SEC chairman Christopher Cox.

The SEC said it had banned short selling in 799 financial companies until Oct 2, while Britain's FSA has placed 33 companies on its banned list.

Ireland also outlawed short selling of its biggest banks but said the ban would be kept under 'continuous review'.

The Committee of European Securities Regulators warned further short-selling restrictions could be imposed across its 27 member states.

Recession may hit S'pore

SINGAPORE may slide into a recession as slowing global economic growth undermines demand for the city-state's exports, the finance minister said.

A recession - typically two consecutive quarters of economic contraction - 'cannot be ruled out,' Finance Minister Tharman Shanmugaratnam said through a spokesman in an emailed response to an Associated Press inquiry.

'We had to expect slower growth than previously expected, given the downward adjustments in the US, Europe and even parts of Asia compared to expectations just 3 months ago,' Mr Shanmugaratnam said.

Singapore's economy grew 2.1 per cent in the second quarter compared to the same quarter a year earlier, down from 6.9 percent growth in the first quarter.

Last month it lowered its growth forecast for this year to between 4 per cent and 5 per cent.

Mr Shanmugaratnam said it was too early to revise the forecast again 'given the extreme fluidity of developments in the US currently.'

Earlier on Monday, Singapore's trade minister Lim Hng Kiang also painted a gloomy picture on Singapore's economiy, saying that economic growth may dip below 4 per cent this year, even as global financial markets try to turn the corner.

'The financial difficulties in the US has led to de-leveraging and credit contractions, therefore slowing global growth,' said the Minister, who was speaking to the media on the sidelines of the Latin Asia Business Forum 2008.

'That means more difficult export markets for Singapore companies and for our economy...later this year and going into next year.'

Mr Lim added that he expects economic growth to be 'closer to 4 per cent, maybe even a bit below 4 per cent, depending on how the financial crisis pans out over the next few weeks and months'.

Singapore's non-oil exports, which account for about 70 per cent of gross domestic product, have been hit hard by the recent economic slowdown in developed countries. Non-oil exports, led by electronic goods and pharmaceuticals, tumbled 14 per cent in August from the same month a year earlier and 5.8 per cent in July. -- AP

5 Lessons for the Next Financial Mania

By Rick Newman

Why do we keep relearning the simplest rules in the world?

Buyer beware. Cut your losses. What goes up must come down. If it seems too good to be true, it probably is. No matter how complex the market meltdown of 2008 might seem, all of these simple aphorisms--clich├ęs, really--directly apply.

Of course, in every financial free-for-all--whether it's the S&L crisis, the dot-com bust, the Enron fraud, or today's housing-related meltdown--the chicanery takes a different form. On Wall Street, they call that "innovation." But right now, innovations like credit-default swaps and mortgage-backed securities look more like old-fashioned pyramid schemes: I'll take your money, you take somebody else's, and eventually some guy neither of us knows (or the government) will get stuck holding the bag.

Here's a guarantee: Wall Street will "innovate" again. A lot of guys in expensive suits will make a lot of money for a while. You'll want in, even if you don't completely understand what's going on. The suckers will be the ones who forget what happened in 2008. Smart investors will remember the following lessons:

The fine print matters. One of the most startling developments of the whole debacle has been the vulnerability of money market funds, which most investors consider virtually as safe as a government-insured savings account. Turns out they're not. When a couple of institutional money market funds "broke the buck" and essentially fell below the value of the principal invested in them, the government rushed to set up an insurance fund to back such funds. That's because confidence in the market is rooted in the safety of such basic accounts, where many investors park cash they might need over the short term--assuming the principal is safe.

But money-market accounts generally aren't insured by anybody, as the fine print in the prospectus no doubt points out. That illustrates a problem repeated over and over in the current crisis: A failure to understand the risks of an investment. During the housing boom, everybody focused on how much money they might make--and precious few focused on what could go wrong. Wall Street investors underestimated how risky mortgage-backed securities would be if housing prices fell. A lot of home buyers failed to do the math on their interest-rate resets, assuming it would all work out. Yeah, it's tedious to scour the fine print in such an overlawyered society. But if you don't even know what the worst-case scenario is, you'll be paralyzed if it actually happens.

Don't trust CEOs. Not because they're all liars, necessarily. But because they get paid, among other things, to be energetic cheerleaders no matter how bad their team is losing. The CEOs of Bear Stearns, Lehman Brothers, and Merrill Lynch all assured investors and the public that things were getting better for their firms, when the exact opposite was happening. Shareholders who believed them, and held on to their shares, lost a lot of money as bad investments and losses piled up. Skeptics who doubted the CEOs, and sold, cut their losses--or even made money, if they shorted the stock while the companies were on the way down.

Lehman CEO Richard Fuld wasn't just deceiving shareholders; he may even have been deceiving himself: In retrospect, it appears that Fuld had an unrealistic view of his firm's value, turning down buyout offers he deemed too low while waiting for a better offer--or government bailout--that never materialized. CEOs have an obligation to shareholders, but in reality that's second to their own self-interest--or self-delusion.

Don't trust geniuses. Wall Street is home to some of the brightest minds in the world, math and computer and finance geniuses with advanced degrees from all the best universities. If only they worked for you and me.

What they really do is find ways to make money for themselves and their firms. What they don't do is make sure their schemes serve the public interest. So a new kind of double-secret derivative might look really smart when it taps a new way to boost returns for the Bank of Brilliant People. If it works, everybody else will copy it, perhaps adding their own twists. But odds are, nobody in the system has bothered to run computer models showing what will happen if everybody starts issuing double-secret derivatives--and something goes wrong.

Theoretically, that's what government regulators are supposed to do. But the government is usually way behind the fast-thinking, overconfident gamblers on Wall Street. New regulations will attempt to change that. But the geniuses always find ways to outsmart the government and its flat-footed beat cops.

Don't trust yourself. It might have seemed like a great time to buy a house early in 2006. Interest rates were low and home values had been skyrocketing. Friends and neighbors seemed to be getting rich on real-estate deals and financing Lexuses and swimming pools with home equity. There was no reason to think the party would stop anytime soon.

But if you made your move then, you bought at the peak of the market, and chances are your big investment has lost 10 or maybe 20 percent of its value in less than three years. Yet lots of people who considered their money to be smart bought homes at precisely the wrong time. Now, the soaring foreclosure rate on many of those homes is one of the biggest underlying causes of the entire financial crisis.

People who bought at the peak of the market are generally OK if they bought a house because they needed a place to live--and plan to stay there. But millions who bought to join the craze, make easy money, or live like royalty--natural human impulses--now live in a nightmare, not a dream. And there's no government regulation that will curb greedy me-tooism.

Don't count on a bailout. It might seem like the government's writing a check to everybody with an overdue bill or two. There's federal relief for people behind on their mortgages. New insurance for investment accounts. And, of course, billion-dollar loans for troubled conglomerates.

But there's heavy political pressure to make sure taxpayers get something back, and besides, anybody who qualifies for a government bailout is already in a lot of pain. Mortgage relief, for example, goes only to homeowners who are in such dire shape that a regular bank won't help them out--and you might have to give the feds some of the cash if you sell your home for a profit. The federal loan to AIG is at such a high interest rate that the company's shareholders want to pay off the debt as early as possible. And the government could always say no, just like it did to Lehman Brothers. Whatever you consider the worst-case scenario can always get just a bit worse.

Banks gave poor advice

ASIAN retail investors who bought structured products linked to the collapsed USinvestment bank Lehman Brothers are complaining about poor advice from banks and have urged authorities to save them from losses.

Investors in Hong Kong, Singapore and Indonesia have over the past week been outraged that the bond-like products they purchased were actually complex derivatives and they stood to lose most or all of what they had invested.

The products include Lehman-linked minibonds sold in Hong Kong and Singapore, many of which offered modest returns of between 4 and 6 per cent, and DBS Group's High Notes 5 series, which offered around 5 per cent and were linked to eight securities including Lehman bonds.

After staging a protest on Sunday, dozens of aggrieved retail investors turned up at the headquarters of the Hong Kong Monetary Authority on Monday morning to seek help from authorities, complaining that banks and financial advisers did not do enough to warn them of the risks.

Mr Tan Kin Lian, the retired chief executive of Singapore insurance firm NTUC Income, who advises investors through his blog, said many investors bought such products believing these instruments were relatively safe.

'People who would not take the risk of buying shares have been asked to buy these structured products,' he said.

He also said authorities should examine the design of such products, which were often 'grossly unfair' to investors in terms the risks and rewards.

'The odds are not balanced. You have a chance of losing $1 million, but you won't win $1 million. The structure would take away most of the profits and give you very little,' said Mr Tan.

COMPENSATION

Singapore investor Archie Ong, who stands to lose the bulk of his investment in DBS' High Notes, hopes authorities would force banks to compensate investors who thought they had bought low-risk products that paid steady dividends.

'They had been marketed as a low-risk alternative to equities which are much higher risk,' he said.

A Singapore blogger, who called himself Falcon, said 'why would one take such a high risk for the potential of earning 5 per cent? Such high risks of losing everything should give a potential return of more than 100 per cent.'

DBS spokeswoman Karen Ngui said, however, that investors in its structured notes had been adequately advised of the risks. 'It's stated clearly in the prospectus and application forms and the pricing statement as well.'

DBS needed about 30 days to unwind its structured notes before it could determine the actual losses suffered by investors, she added.

Lehman declined to comment.

The failed investments in structured products linked to Lehman has also affected investors in Indonesia who had bought such instruments from Citigroup, according to a report in the Jakarta Post on Monday.

Citigroup did not respond when asked to comment on the report.

The Monetary Authority of Singapore did not immediately respond to queries from Reuters, while Hong Kong officials met with angry investors but did not pledge specific action.

'We hope that through such talks we can better understand the situation and try to find a resolution,' Financial Secretary John Tsang told reporters. -- REUTERS

Turmoil to worsen: Wen

BEIJING - CHINESE Premier Wen Jiabao has warned the global economic slowdown and financial turmoil may get worse, pledging more flexible policies to maintain the country's growth, state media said on Monday.

'The international financial turmoil and the slowdown in the world's economy could worsen, and we cannot underestimate the impact of these changes on the national economy,' Mr Wen said, according to the Shanghai Securities News.

'We should improve the effectiveness, focus and flexibility of macro-control measures... to maintain the stability of the economy, the financial market and the securities market.'

It is particularly important to 'find the balance between maintaining steady and fast economic growth and curbing inflation", he told a meeting on Saturday with provincial and ministerial leaders.

China's economy expanded by 11.9 per cent last year, and cooling efforts have already seen growth slow to 10.1 per cent in the second quarter of this year.

The consumer price index dropped to 4.9 per cent in August, the fourth consecutive month of slowing inflation and well below the peak of 8.7 per cent in February, giving policy makers more room to focus on growth creating.

Both the central bank and the banking regulator issued statements earlier this month calling for more loans to boost the national economy, after Beijing in August raised this year's quota of new local-currency loans by five percent.

The finance ministry also unveiled 10 days ago a package of subsidies worth 3.51 billion yuan (S$730 million) to help small and medium-sized firms. -- AFP

The end of an era

NEW YORK - GOLDMAN Sachs and Morgan Stanley brought down the curtain on a Wall Street era on Sunday, agreeing to a radical revamp that completes the biggest overhaul in high finance since the Great Depression.

The last two major independent investment banks in the United States will become holding companies, a rescue move which accepts the kind of government regulation that Wall Street's top high-rollers long fought bitterly against.

Even as the United States announced a US$700 billion (S$999 billion) bailout to save financial institutions, the firms themselves asked for the change as one after the other of their rivals were swallowed up in the global financial crisis.

The move submits both firms to significantly more regulation and will limit the massive profits that spawned a culture of high-risk finance and made them, along with other investment banks, the envy of Wall Street.

As holding companies, both firms will have easier access to credit to survive the current crisis - unlike former rivals Lehman Brothers, which collapsed, and Bear Stearns and Merrill Lynch, which were taken over.

But it will also halt much of the massive risk-taking, often funded with huge debt, that created the swaggering investment-banking culture of Wall Street legend - a winner-take-all mentality often caricatured as naked greed.

Both firms will have to radically cut back the amount of money they borrow relative to the capital they have, a restriction that will curb profits dramatically.

'We believe that Goldman Sachs, under Federal Reserve supervision, will be regarded as an even more secure institution with an exceptionally clean balance sheet,' said Goldman chairman Lloyd Blankfein.

He said the decision had been 'accelerated by market sentiment' - an acknowledgement of the global financial turmoil that has transformed the face of Wall Street virtually overnight.

As the world financial crisis deepened last week, the US government took over troubled insurer AIG, Lehman Brothers collapsed and Merrill Lynch was bought out. Morgan Stanley was already in talks on a possible merger.

'This new bank holding structure will ensure that Morgan Stanley is in the strongest possible position,' chairman John Mack said.

Looking to shore up confidence and draw a line under the crisis, the US government put together a US$700 billion dollar bailout proposal.

The plan, now urgently awaiting approval by US lawmakers, would give the US Treasury almost free rein to buy up bad mortgage-related debts which sparked the current crisis.

US Treasury Secretary Henry Paulson said at the weekend that the US Congress now needed to take action fast.

'We need this to be clean and quick and we need to get it in place,' he said.

The US bailout plan brought cheer to markets. Asian bourses were largely up on Monday, and the Dow Jones surged 3.3 per cent on Friday.

But Europe's main markets dipped in early trade on Monday amid real uncertainty about the massive plan, the biggest bank rescue ever.

US financial authorities have meanwhile been working with their counterparts in Europe and Asia over the past fortnight to prevent a collapse of the global financial system.

Australia and Taiwan became the latest markets to announce restrictions on short-selling - a stock bet that share prices will go down, and which often helps them do so. -- AFP

Sunday, 21 September 2008

Why Wall Street Hates Gold and Silver??

(Excerpted from Chapter 12 of How to Prosper During the Coming Bad Years in the 21st Century.)

Wall Street ignored gold and silver during most of the 1970’s hyper-profitable bull market. They were either outright hostile, or acted as though the metals didn’t even exist. I got no respect, even though the first edition of my book sold 2.6-million copies and was near or at the top of The New York Times best-seller list in both hard and soft cover for two years, and I was all over the media; Wall street Week, Oprah twice, Regis and Kathy Lee three times, etc, etc. They were usually hostile also. Wall Street paid little attention to gold until it reached about $650, far too late for them to have much of a chance for their clients to make money.

Why the hostility? Partly because they believed their own rhetoric! Historically, because rising gold always means falling stocks or a troubled world, and they made most of their commissions in the stock market, they had to remain bullish on stocks, and bearish on gold. Their bullish stock-market recommendation was necessary because investors wouldn’t buy stocks if their advisors were dubious about the market’s future. They sneered at the inflation fears of us gold and silver fans, and derisively called gold investors “gold bugs.” Most of the young whippersnappers who now control Wall Street were in diapers 25 to 30 years ago during the last gold bull market so they haven’t experienced rising gold and inflation. Consequently, another gold bull market is inconceivable to them.

Studying Psycho-ceramics

One of the funniest things that ever happened to me illustrates the skepticism of mainstream media types regarding gold and silver. In 1978 I was on a national promotion tour for the first edition of my book when I found myself in Detroit, rushing to a TV station for a scheduled interview on a big morning show. I barely got there in time when the host turned to the camera and said, “Today we’re going to study psycho-ceramics, and with us today is a crackpot from California.” And the interview went downhill from there; with his biggest argument being that silver was an impractical investment for most people, unless you were very rich.

One year later I found myself in the same studio, same host, promoting the mass paperback of my book. But this time, when the light went on, he said, “Today we have with us one of America’s most brilliant financial advisors,” and the interview was terrific from then.

After the show, I reminded him of what he had said before, and asked him what had changed his mind. He very sheepishly said, “I read your book and bought silver from a local coin dealer, and tripled my money since you were here last.” So the media is not always infallible, even though they are usually wrong.

Inside Wall Street

Wall Street is a culture, as well as a financial institution.

Most of the young brokers who are the big producers on Wall Street are human beings, subject to all the errors of habit and behavior and peer pressure that plague all of us. They are surrounded by “group-think.” They make tons of money on the status quo. I have visited firms on Wall Street with big trading rooms full of twenty-something men and women whose annual income is measured in the millions – all on commissions on stock sales.

Few big Wall Street firms sell bullion (right off hand I can’t think of any) so it is only money out of their pockets if hot-shot brokers tell their clients to sell some stock and put the money into bullion or coins. Maturity and client concern are scarce commodities on Wall Street.

They are congenitally bullish on stocks, because that’s where their bread is buttered.

Financial Shows

Many of you listen to or watch financial shows, populated with people who are typical examples of main-stream Wall Street financial thinking.

If your broker’s opinion is important to you, you may be uncomfortable here. If you aren’t a maverick, you had better become one, and be quiet about it. You will have to leave the herd, and for a while, Merrill Lynch’s herd is all on Wall Street.

Terrorism and Other Things

Let’s consider just a few possible scenarios.

Panama and the Dollar

When we negotiated away the Panama Canal to Torrijos, the Panamanian Dictator, our chief negotiator was Sol Linowitz, a member of the board of Chemical Bank in New York. He was appointed for one day less than six months, so his appointment would not be subject to Congressional approval, and sure enough, the giveaway deal was signed one day before Linowitz’s term was up.

One key part of Linowitz’s banker-inspired mission was that the Canal Zone would be a “Free-banking Zone,” not subject to regulations or oversight. Even before the deal was signed, bank buildings were going up all over the Zone. Every multi-national bank was there, and it appears that they moved many of their international money systems there, with no oversight or regulation. Who determines their safety or vulnerability? No one!

If terrorist hackers were to hack into those computers and infect them with a destructive virus, the entire dollar-based monetary system would disappear in a nanosecond. In that case, for all practical purposes, the only spendable money left would be gold or silver coins or barter.

And what if they were able to sneak a nuke onto a ship and detonate it in the canal? It’s already bad enough that the Chinese are in control of the ports on both ends of the canal. Imagine the chaos with the banks obliterated and commerce fatally crippled.

These and innumerable other scenarios may seem beyond the edges of credibility, but I dare you to say they are not possible.

This is not a forecast, only a speculation about a possible worst-case, we-hope-not scenario.

The Hyperinflation Scenario

What if monetary inflation rose as a result of soaring demands on government with the soaring deficits, and the subsequent inevitable consumer inflation broke out into a real hyperinflation, with the modern money machine running night and day, like Germany during the 1920s. This would make money increasingly worthless and the precious metals increasingly precious. History tells us that this has happened over and over again, and we are repeating most of the same deadly mistakes.

Let’s pretend we are transported into a future where America is devastated by hyperinflation, and see what it looks like

The world will be in terrible trouble, and the prosperity and comfort that now surround you will be in tatters. You will be surrounded by people struggling to survive, let alone to prosper, as in the 1930s. That’s what happened in Germany after the hyperinflation of the deutschmark, and the general suffering was the fertile ground which gave birth to Adolph Hitler, dictator. If you have prospered by holding gold and silver, you can buy a lot of safety and security.

These are only a few of the possibilities.

The Best Case

Even if we wipe out or neutralize al Qaeda and the currency system hangs together, monetary inflation has already been cooked into the economic cake by the Federal Reserve and industry, and so is the silver supply/demand situation. Even in this “best-case” situation, you will make a bundle on this monetary-inflation-sensitive investment, even in a still-orderly world.

If all else fails, you still can count on Social Security, Medicare and the prescription-drug program to trigger a flood of trillions of dollars of “money printing” and the subsequent monetary inflation, followed as night follows day with soaring price inflation. As it becomes obvious to the public that these programs are plummeting into insolvency, the consumer inflation rate and gold and silver will soar.

When the dire facts become obvious, Congress will start desperately searching for solutions, but which ones?

Will they raise taxes and watch FICA soar and taxpayers revolt? Very little, if any! Will they cut benefits or raise the Social Security retirement age? Maybe a little bit, but not much. Will they dig in their heels and memorialize the current dysfunctional system by simply printing money? You bet! This will lay the groundwork for more ruinous inflation, and soaring gold and silver.

In this best case (the most likely – I think, I hope?), we will at least see rising inflation and an inflationary recession (which is already written in cement), and gold and silver and the metals and their mining stocks will go up – perhaps five to ten times, perhaps a lot more.

There is no best-case – or worst-case – scenario in which I can conceive of gold and silver being losers. You can mortgage the kids and bet the farm!

By Howard Ruff
The Ruff Times

10 things you should know

Couldn't keep up with the twists and turns that took place in the financial world last week? Here's a primer
By Ann Williams

1 THE FALL OF LEHMAN BROTHERS

The week that broke Wall Street began with Lehman Brothers. On Sept12, news broke that the fourth- largest investment bank in the United States was on the brink of collapsing due to bad mortgage assets. Lehman was scrambling for a buyer as customers and trading partners fled.

No deal, however, was reached during that desperate weekend. Lehman's chief executive had waited too long to sell the firm, and everyone was now afraid to buy.

The US government, its last hope, kept to its word and refused to bail Lehman out.

Just after midnight last Sunday in New York, Lehman announced it would file for bankruptcy, the biggest in history.

It was around midday last Monday in Asia, and immediately the carnage on stock markets began as investors dumped bank shares.

Lehman's fall showed that the US government would not automatically prevent big banks from failing. It also showed how much worse the financial crisis had become even after the government had rescued mortgage finance giants Fannie Mae and Freddie Mac earlier this month and investment bank Bear Stearns six months ago.

2 SAVE AIG, SAVE THE WORLD... NOT

Two days after allowing Lehman to fail came bigger news that the US government would bail out American International Group (AIG), one of the world's biggest insurers. It would give the company an US$85 billion (S$122 billion) loan for an 80 per cent stake.

AIG was hit by a big shortage of cash triggered by US$18 billion of losses over three quarters, a sinking stock price and cuts in its credit ratings.

The insurer, with US$1.1 trillion of assets, however, was deemed too big to fail. The US government said unlike with Lehman, it had to rescue AIG because of the insurer's extensive ties to businesses and ordinary people throughout the world through a host of insurance products.

The bailout, though, failed to calm the markets. Instead, it led investors to wonder what other companies might suddenly plunge towards insolvency.

3 CRISIS HITS HOME

For ordinary people around the world, the credit crisis, which has been playing out for the last 15 months, may have really hit home only with the fall of AIG.

Newspapers in Singapore, Hong Kong and Taiwan splashed pictures and carried stories of hundreds of worried people queuing up to cash out on their insurance policies held with AIA, a unit of AIG.

For many ordinary investors in Asia, it was the first time their faith in American assets and the financial system was well and truly shaken.

Even after the US government stepped in to take over AIG and AIA put advertisements assuring policyholders that it could meet all claims, the queues continued.

4 THE BANK SALE WORTH WAITING FOR

Banks, meanwhile, were spooked by what was happening to Lehman. Merrill Lynch, the biggest brokerage in the US, wasted no time in finding a buyer.

It announced last Monday in New York that Bank of America would take it over for US$50 billion in a deal stitched together in just 48 hours.

And by last Wednesday, Britain's Barclays Bank, which had walked away earlier from buying up Lehman for the price its chief executive wanted, ended up with Lehman's core investment banking operations for just US$250 million.

With their shares plunging by the minute, other banks hung out 'For Sale' signs.

Lloyds of Britain rescued the country's biggest mortgage lender, HBOS, last Thursday in a US$22 billion takeover. At least five companies, including HSBC and Citigroup, were said to be looking at buying Washington Mutual.

Morgan Stanley bought time by exploring a possible merger with a smaller American bank, Wachovia, and more investment from a Chinese state-owned investment group.

With share prices bouncing back last Friday, banks like Morgan Stanley may no longer need a buyout or merger, so the Great Bank Sale may be over - for now.

5 CREDIT SQUEEZE TURNS INTO FREEZE

For 15 months, banks and other companies have suffered from a credit crunch as lending slowed. In the last week, however, as Lehman, then AIG and then Merrill went down, investors lost all confidence in the financial system.

The result was that all sorts of lending or credit froze, as the costs of short-term borrowing soared by as much as 30 per cent, hurting banks and other companies.

No corporate bonds were sold in the US in the last week - the first time that has happened since at least 1999 - while sales in Europe dropped 98 per cent.

Things reached crisis proportions when banks and investment firms simply stopped making loans to each other, as they hoarded cash to protect against any sudden need for it themselves.

6 CENTRAL BANKS RACE TO CALM THE STORM

With a global crisis on their hands, the top central banks from the US, Europe, Japan, Britain and Canada moved together last Thursday to pump an extra US$180 billion into money markets to keep credit flowing and interest rates down.

Many more billions were spent individually during the week.

The US Treasury also used US$50 billion to support money-market mutual funds and even lent more money directly to banks and other financial institutions, so they could buy certain assets from money-market funds.

With US$3.3 trillion in assets, money- market funds in the US are key in providing loans to companies so they can buy supplies and pay their employees.

With fund managers rushing to the safety of US Treasury bonds, corporations could not find buyers for their short-term loans. Making things worse, ordinary people who invest in these funds started pulling money out after one fund turned out to be not as super-safe as thought.

7 STOP THE LOOTING

They have been compared to looters after a hurricane, who are out to plunder. Short-sellers borrow stock to sell, then buy it back when the price drops, making a gain on the price difference.

Short-sellers, many of them huge hedge funds, have sought to profit from the financial crisis by betting against bank shares. In normal times, short-sellers add volume to share trading and help stocks find their true worth. When there is a crisis, on the other hand, unrestrained short-selling can make shares plunge even faster.

In response, the US and Britain slapped a temporary ban on the short-selling of financial stocks last Friday. Russia, whose stock markets plunged by more than 20 per cent last week, banned the shorting of all shares.

The ban on short-selling caused bank shares around the world, which had suffered big falls earlier in the week, to jump as much as 40 per cent last Friday.

8 THE MOTHER OF ALL BAILOUTS

After months of fighting each new emergency as it flared up, the US government announced last Friday a plan to once and for all deal with the bad mortgages and mortgage-linked assets at the root of the credit crisis by buying them all up from US banks.

The hope is that by helping banks get rid of bad mortgage debt, the government can avert a total meltdown of stock and credit markets around the world and free banks to make new loans to keep US businesses running and workers employed.

By taking on the actual mortgages and changing their terms, the government can also make it easier for home owners to pay back their home loans, thus helping the housing market to recover.

The cost: No official word has been given but estimates put it at US$500 billion to US$1 trillion.

There are no details yet on how the plan will work but the US government will likely buy the assets at a big discount and hold on to them until the US housing market recovers. Ideally, these loans could then be sold at a profit so US taxpayers, who are ultimately paying for the bailout, will get some money back.

The US Congress, which has to pass laws for the plan to be implemented, is looking at it now and will hold hearings this week. A deal must be hammered by the end of this week, when Congress adjourns because of the US presidential elections.

9 FLIGHT TO SAFETY AND BACK

Until last Thursday, panicked investors rushed to dump any asset seen as risky, especially stocks, as they piled into gold or US government bonds, seen as safe bets. Some just wanted plain cash.

But then the flight to safety reversed itself last Friday with news of the US government's sweeping plan to stem the crisis.

As investors poured their money back into stocks and investment funds, the price of gold fell by US$32 last Friday after soaring by US$116 in the previous two days.

The price of US Treasury bonds also tumbled. As a measure of how bad the fear was earlier in the week, investors piled into these bonds even though they were offering practically nothing in interest income.

Oil prices shot up by more than US$6 to over US$106 a barrel last Friday on hopes that the plan to resolve the bank crisis will spur economic growth, which is good for oil demand.

10 WHAT A RIDE

And so, investors all over the world went on the wildest ride of their lives last week.

To illustrate how volatile global markets had been, Russia suspended all stock market trading when shares plunged by 20 per cent to 25 per cent last Wednesday - and did so again when they rocketed up by 30 per cent last Friday.

The Irish stock exchange, with its biggest burst in history, jumped more than 25 per cent in the first hour of trading last Friday on news of the giant bailout.

Likewise in Asia and Europe, stock markets swung wildly up last Friday after plunging to dramatic lows earlier in the week.

In the US, the heart of the crisis, big plans to purge banks of bad assets and curb short-selling sent the Dow Jones Industrial Average, a key market index, soaring by 780 points in two days.

Because the Dow had plunged by about the same amount earlier in the week, however, the index actually ended the week where it started - pretty much like a real roller coaster.

Good comment by CNA forumer: Sessam

The worse may not be over because the details and reactions of global markets to the latest Paulson initiative are still so uncertain. What the Americans hope is that taking a more definite stand on a "final solution" and the restriction on short sales for a time will confer some stability on world markets. Their first objective is to prevent further deterioration of assets held by their financial institutions so that they can restructure themselves by selling of assets at reasonable prices to recapitalisation or by M&As.

We really don't know for sure what will be ahead, and one hope that the rises in world markets these 2 days after the announcement of the Paulson plan are returning confidence in the American ability to see through the crisis. But expect a lot of volatilities still...for it is still early days.

Costly intervention could narrow government's economic options later.

By Mark Landler

THE NEW YORK TIMES

Saturday, September 20, 2008

WASHINGTON — The rescue plan being created by the Bush administration is much like the financial crisis it is meant to end — complex, far-reaching and potentially rife with unpredictable consequences.

Among the dangers cited by economists Friday, as word of the plan began circulating, were an explosion in federal debt, higher financing costs, an escalating reliance on foreign capital, higher inflation and a further erosion of American economic sovereignty.

All of these dangers, these experts say, are hypothetical — except for the cost, which by some estimates could eventually exceed $1 trillion. Taking on that much additional debt could narrow the economic options available to the next presidential administration.

"The implications are that, at some point, you're going to have to see higher taxes, lower expenditures or a combination of both," said Carmen Reinhart, a University of Maryland economist.

Not all of the potential consequences of the plan are negative. Economist Nouriel Roubini, said the rescue, if properly executed, could lift the economy by reducing the burden on households, particularly those afflicted by troubled mortgages.

"If you reduce their debt payments, they will start spending again," said Roubini, a professor at New York University. "It's not going to help us avoid a recession, but it could make it shorter."

To finance the rescue effort, the United States will have to borrow even more from foreign investors. That hasn't been a problem in recent days, given the intense demand for Treasury bills, which are perceived as a safe haven by investors around the world.

But if the bailout doesn't quickly restore confidence in the U.S. financial system, foreign investment could slow, which would drive up the cost of financing that debt, said Kenneth Rogoff, a Harvard economics professor.

So far, the dollar has shown remarkable resilience in foreign markets, suggesting, he said, that foreigners still have faith in America's ability to get out of this crisis.

The concerns of foreign central banks over the fate of Fannie Mae and Freddie Mac played a role in the Treasury's rescue of the mortgage finance giants. That influence is likely to grow, along with the debt they hold.

"The people with leverage are the Japanese, the Chinese and the oil-producing countries, who will want assurances that the debt they hold is worth something," said Eugene Steuerle, a senior fellow at the Urban Institute who worked in the Treasury Department during the Reagan administration.

Steuerle said he hoped that the additional burden would force policymakers to confront the country's long-term budget imbalances.

The last time this happened, he said, was in the early 1990s, after a much more modest government rescue effort in the aftermath of the 1987 market crash.

But first the Treasury and the Federal Reserve must successfully carry out this plan. And the sheer scale and complexity of it left economists and other experts slack-jawed.

"It's like doing a quintuple jump in figure skating," said Edwin Truman, a senior fellow at the Peterson Institute for International Economics and a Treasury official in the Clinton administration. "It's impressive if they can do it. It's impressive even to try."

Among the potential sources of tension is the Treasury's ultimate decision on whether it will buy troubled mortgage-backed securities held by non-American banks. European banks, such as UBS, invested heavily in such securities.

"If (European bank) Paribas has bought a mortgage-backed security, why can't they present it to Treasury?" Truman said. "If the government is going to do it for the American banks, they should do it for everyone."

But that could provoke a strongly negative reaction from lawmakers, who already protested that other countries should chip in for the $85 billion rescue of the insurance giant American International Group, because it has operations in those countries or has insured their banks.

"Are the taxpayers in the United States going to bail out all the banks in the world?" said Allan Meltzer, a historian of the Federal Reserve. "I just don't know how this works out."

Meltzer said he thought the plan would be politically viable only if participation was voluntary and if the banks that received government aid were required to pay it back later. "We're protecting private industry, not the public interest," Meltzer said.

Perhaps the plan's longest-term consequence is a wholesale reordering of the financial landscape. Economists said the government will almost certainly impose a raft of new regulations on banks.

"It's hyperbole to say we're abandoning the free-market system," Rogoff said. "But we certainly seem to be entering a new uncharted territory of regulation."

Ban on Short-Selling Will Hurt Rather Than Help Brokerage

Courtesy of CNA forummer: Johnlaw

New measures to shore up the markets are coming so fast and furious that it is becoming hard to keep track of them. What most people do not realize is that they produced some not-very-pretty unintended consequences. As we discussed (courtesy reader Lune) at the time:

1) Congress raises conforming limits on Fannie/Freddie to help unfreeze the mortgage market. Result: agency spreads skyrocket, bringing down Bear and a host of hedge funds. Mortgage markets still remain frozen.

2) Fed opens TSLF to unfreeze mortgage market. Result: Carlyle goes bankrupt as people rapidly arbitrage the difference between holding MBS in firms that can and can't access the new credit facility. Mortgage markets remain frozen.


Note the spike in agency spreads and bankruptcy of Carlyle helped precipitate the run on Bear.

In fact, as Richard Bookstaber discussed at length in his book, Demon of Our Own Design, this sort of unintended consequence is precisely what you'd expect to see in a tightly coupled system, such are our financial system. Tight coupling occurs when processes move from step to step so rapidly that intervention is well-nigh impossible. Bear Stearns and Lehman are classic examples. A downgrade of their debt beyond a certain level meant that their counterparties could no longer trade with them, because that exposure would get them downgraded too. Thus a move (or threatened move) beyond a trigger point kicked off a sequence of unstoppable events.

One possible consequence is that hedge funds forced to exit positions by the SEC ban on short-selling might take losses big enough to lead to a run of the fund, forcing liquidation of positions. That rapid selling could produce distressed prices, and in a worst-case scenario, brokers could take losses if collateralized positions fell in value and hedge funds were unable to meet margin calls.

Note Morgan Stanley and Goldman are far and away the biggest prime brokers.

John Hempton sets forth another unintended consequence which is more certain to happen and broader in its impact and puts none to fine a point on it in his post title, "SEC Tries to Bankrupt Wall Street":

Last I looked when I was short a stock the broker borrowed the stock (yes, Virgina you do get a borrow) and sold it. They then had cash.

That cash was not available to me - it was pledged to whoever provided the stock to remove or reduce the risk that the stock won't be returned.

That means it is generally available to the broker (who will generally lend me the stock from their inventory or margin or prime broker clients).

Now there are a few hundred billion of short-sales out there. Probably more than normal - but a lot in almost all markets.

And those short sales produce cash balances of a few hundred billion, most of which are available to Wall Street brokers.

If you ban short-selling those balances will taken away from Wall Street brokers.

That would be rather unpleasant. Last I looked the debt market was skittish and was hardly going to replace that money.

So I conclude that the SEC in their "infinite wisdom" are going to stick the knife into Wall Street and bankrupt the lot of them. For political optics. So they can be seen to be doing something about short-selling.

The only reason the damage might not be as broad-scale as Hempton fears is that the "temporary" ban is on shorting financial stock. Oh wait, financial represented (until they started hitting the rocks) 40% of S&P earnings.

And there is something far simpler that the SEC could do. Just re-implement the uptick rule (it means you can short only when the last sale price was above the immediately prior sale). That rule comported itself well for over 50 years but for some unfathomable reason (no doubt at the behest of Wall Street) was eliminated b the SEC.

Reasons why the bailout might not work

Courtesy of CNA forummer: Johnlaw

The aim is two-fold. The government hopes that by buying these mortgages, enough debt will be removed from the balance sheets of banks to enable them to recapitalise and resume lending, something they have all but ceased doing since the subprime housing market collapsed. This, hopefully, will stem the precipitous drop in property prices, which has resulted in more and more homeowners defaulting on their mortgages. Secondly, the government hopes to sell these mortgages once the market recovers. If housing prices do cease falling and people resume buying homes, then the US stands to make a substantial profit from the mortgages it now holds.

But the US economy’s woes are not limited to merely falling home prices caused by a stagnant lending market. Nor will the removal of these bad debts guarantee that banks will become profitable again. Unless banks are able to return to their core business and resume lending, they will continue to fail, this bailout will be unsuccessful, and investors will resume their flight. Were that to happen the US economy will decline at an even swifter rate than we witnessed over the past week.

Asia casts nervous eye on US financial turmoil

By KELLY OLSEN,AP Business Writer

SEOUL, South Korea - Han Seung-woo is casting a wary eye on the financial crisis erupting halfway around the world on Wall Street.

From garment makers in southern China to real estate agents in India, businesses across Asia are worried that the turmoil will filter through to them.

"I'm watching nervously," said Han, the president of Sam-A Techno Solution, a technology services company in Seoul with 10 employees and annual sales of 3 billion won (US$2.7 million).

Even before the past week's dramatic events, the economic slowdowns in the U.S. and Europe were dragging on Asia's biggest economies in Japan, China and South Korea. Now, the worry is it could get worse.

The fears highlight the growing realization that Asian economies have not "decoupled" as much from their longtime dependence on the U.S. market as some had previously thought or hoped.

"Right now people somehow conclude that decoupling is a myth," said Citibank Korea economist Oh Suk-tae.

Lending has tightened around the world as Western banks stagger under the weight of billions of dollars in bad loans and mortgages that have accumulated from the wave of U.S. home foreclosures.

Those woes led to one of the most unforgettable weeks in financial history: major U.S. investment bank Lehman Brothers Holdings Inc. filed for bankruptcy, Bank of America bought Merrill Lynch & Co. and the Federal Reserve bailed out troubled insurer American International Group Inc. _ sending shock waves through global markets and fanning fears of a worldwide financial meltdown.

World markets rallied Friday on news of a U.S. government plan to rescue banks from billions of dollars in bad debt.

Han, the South Korean businessman, said if the bailout plan stabilizes the U.S. economy and exchange rates, that would obviously be positive.

But whether the worst is over remains to be seen, and the economic outlook is still plenty murky for businesses across Asia, especially smaller ones that lack the financial resources of larger corporations.

"We're OK until the end of the year, but I have no idea what 2009 will look like," said Christopher Fussner, president of Singapore-based electronic equipment distributor TransTechnology, which has 165 employees in nine Asian countries. "My clients are trying to digest what's going on."

Volatile markets also could undermine consumption and investment in Asia. Already, corporate borrowing costs are rising as investors demand a greater premium on corporate bonds, creating a drag on investment in the region.

"We have a perfect storm in the making," said Ifzal Ali, chief economist at the Asian Development Bank in Manila.

He predicts the Wall Street meltdown means U.S. economic weakness will last longer than thought, at least through 2009, seriously hurting exports from Asia, particularly China.

Shrinking demand for India's information technology companies and the withdrawal of global financial services companies from India will weaken property values and hit the outsourcing industry hard, predicts Anuj Puri, India country head of Jones Lang Lasalle, a real estate company.

"The IT sector is going to take a beating," he said, adding that he is going to shift his strategy to focusing more on domestic clients instead of foreign ones.

The pandemonium on Wall Street has added to anxiety for Chinese exporters that already have seen demand in key American markets decline.

"When we first heard the news, we were like, 'Oh, my! Why is the economy doing this again?' You know everyone is waiting for an opportunity to breathe, to recover," said Lu Lingru, trade manager for Tianji Leisure Products Ltd.

The 110-employee company in Zhejiang province in China's southeastern export belt sells gazebos, garden umbrellas and outdoor furniture and depends on the United States for all its sales.

"Certainly, this is going to affect our business," Lu said.

The company will be fortunate to equal last year's sales of 150 million yuan (US$22 million), Lu said, and is trying to persuade customers not to demand price cuts.

Likewise, in southern China's Guangdong province, garment exporter Zhongshan Maochang Garment Co. has already been under pressure from higher labor and material costs.

"Now, it's not easy to get orders from other countries because of the worldwide economic crisis," said Duan Zhihui, foreign trade sales manager. "On the other hand, when you do have orders, profits are shrinking," she said.

Not all think the situation for Asia is dire.

Subir Gokarn, chief economist for Standard & Poor's in New Delhi, says the region might not have decoupled but trends in recent years have insulated it from shocks in the U.S. economy.

"There will be an impact but there are forces within the region _ domestic demand in India and China and the ability of other countries to tap into that growth _ that will partially offset global developments," he said.

Exactly how Asia will ride out the current economic threat remains unclear, but some are bracing for a tough go.

"You have to stay flexible," said Kenneth Yu of Hong Kong. The 55-year-old businessman matches foreign investors with mainland companies looking for funding, an endeavor he says has become harder since the credit crunch began last year.

"I have to respond to different problems and crises ... otherwise you cannot survive," said Yu, who has engaged in various businesses in China. "But surviving is becoming more and more difficult than before."

__

Associated Press writers Jae-hyun Jeong in Seoul, Elaine Kurtenbach in Shanghai, Joe McDonald in Beijing, Alex Kennedy in Singapore, Erika Kinetz in Mumbai and Jeremiah Marquez in Hong Kong contributed to this report.

Credit Default Swaps: The Next Crisis?

As Bear Stearns careened toward its eventual fire sale to JPMorgan Chase last weekend, the cost of protecting its debt, through an instrument called a credit default swap, began to rise rapidly as investors feared that Bear would not be good for the money it promised on its bonds. Not familiar with credit default swaps? Well, we didn't know much about collateralized debt obligations (CDOs) either — until they began to undermine the economy. Credit default swaps, once an obscure financial instrument for banks and bondholders, could soon become the eye of the credit hurricane. Fun, huh?

The CDS market exploded over the past decade to more than $45 trillion in mid-2007, according to the International Swaps and Derivatives Association. This is roughly twice the size of the U.S. stock market (which is valued at about $22 trillion and falling) and far exceeds the $7.1 trillion mortgage market and $4.4 trillion U.S. treasuries market, notes Harvey Miller, senior partner at Weil, Gotshal & Manges. "It could be another — I hate to use the expression — nail in the coffin," said Miller, when referring to how this troubled CDS market could impact the country's credit crisis.

Credit default swaps are insurance-like contracts that promise to cover losses on certain securities in the event of a default. They typically apply to municipal bonds, corporate debt and mortgage securities and are sold by banks, hedge funds and others. The buyer of the credit default insurance pays premiums over a period of time in return for peace of mind, knowing that losses will be covered if a default happens. It's supposed to work similarly to someone taking out home insurance to protect against losses from fire and theft.

Except that it doesn't. Banks and insurance companies are regulated; the credit swaps market is not. As a result, contracts can be traded — or swapped — from investor to investor without anyone overseeing the trades to ensure the buyer has the resources to cover the losses if the security defaults. The instruments can be bought and sold from both ends — the insured and the insurer.

All of this makes it tough for banks to value the insurance contracts and the securities on their books. And it comes at a time when banks are already reeling from write-downs on mortgage-related securities. "These are the same institutions that themselves have either directly or through subsidiaries invested in the subprime market," said Andrea Pincus, partner at Reed Smith LLP. "They're suffering losses all over the place," and now they face potentially more losses from the CDS market.

Indeed, commercial banks are among the most active in this market, with the top 25 banks holding more than $13 trillion in credit default swaps — where they acted as either the insured or insurer — at the end of the third quarter of 2007, according to the Comptroller of the Currency, a federal banking regulator. JP Morgan Chase, Citibank, Bank of America and Wachovia were ranked among the top four most active, it said.

Credit default swaps were seen as easy money for banks when they were first launched more than a decade ago. Reason? The economy was booming and corporate defaults were few back then, making the swaps a low-risk way to collect premiums and earn extra cash. The swaps focused primarily on municipal bonds and corporate debt in the 1990s, not on structured finance securities. Investors flocked to the swaps in the belief that big corporations would seldom go bust in such flourishing economic times.

The CDS market then expanded into structured finance, such as CDOs, that contained pools of mortgages. It also exploded into the secondary market, where speculative investors, hedge funds and others would buy and sell CDS instruments from the sidelines without having any direct relationship with the underlying investment. "They're betting on whether the investments will succeed or fail," said Pincus. "It's like betting on a sports event. The game is being played and you're not playing in the game, but people all over the country are betting on the outcome."

But as the economy soured and the subprime credit crunch began expanding into other credit areas over the past year, CDS investors became jittery. They wondered if the parties holding the CDS insurance after multiple trades would have the financial wherewithal to pay up in the event of mass defaults. "In the past six to eight months, there's been a deterioration in market liquidity and the ability to get willing buyers for structured finance securities," causing the values of the securities to fall, said Glenn Arden, a partner at Jones Day who heads up the firm's worldwide securitization practice and New York derivative.

The situation is already taking a toll on insurers, who have been forced to write down the value of their CDS portfolios. American International Group, the world's largest insurer, recently reported the biggest loss in the company's history largely due to an $11 billion writedown on its CDS holdings. Even Swiss Reinsurance Co., the industry's largest reinsurer, took CDS writedowns in the fourth quarter and warned of more to come in the first quarter of 2008.

Monoline bond insurance companies, such as MBIA and Ambac Financial Group Inc., have been hit the hardest as they scramble to raise capital to cover possible defaults and to stave off a downgrade from the ratings agencies. It was this group's foray out of its traditional municipal bonds and into mortgage-backed securities that caused the turmoil. A rating downgrade of the monoline companies could be devastating for banks and others who bought insurance protection from them to cover their corporate bond exposure.

The situation is exacerbated by the heavy trading volume of the instruments, the secrecy surrounding the trades, and — most importantly — the lack of regulation in this insurance contract business. "An original CDS can go through 15 or 20 trades," said Miller. "So when a default occurs, the so-called insured party or hedged party doesn't know who's responsible for making up the default and if that end player has the resources to cure the default."

Prakash Shimpi, managing principal at Towers Perrin, downplays this risk, noting that contractual law requires both parties to inform and get approval from the other before selling the CDS policy to someone else. "These transactions don't take place on a handshake," he said. Still, being unregulated, there is no standard contract, no standard capital requirements, and no standard way of valuating securities in these transactions. As a result, Pincus said she wouldn't be surprised to see a surge in litigation as defaults start happening. "There's a lot of outcry right now for more regulation and more transparency," said Pincus.

A meltdown in the CDS market has potentially even wider ramifications nationwide than the subprime crisis. If bond insurance disappears or becomes too costly, lenders will become even more cautious about making loans, and this could impact everyone from mortgage-seekers to municipalities that need money to fix roads and build schools. "We're seeing players in all of those spaces being more circumspect about whose credit they're going to guarantee and what exactly the credit obligation is," said Ellen Marshall, partner at Manatt, Phelps & Phillips LLP.

Shimpi admits a meltdown or even a slowdown in the CDS market would affect the amount and cost of liquidity in the market. However, he dismisses concerns that municipalities and others seeking capital could be left in the dust. "Even if the U.S. takes a hit, there are other markets in the world that have different dynamics, and capital flows are international," he said.

Still, most agree the potential repercussions are far-reaching. "It's the ripple effects, the domino effects" that are worrisome, said Pincus. "I think it's [going to be] one of the next shoes to fall" in the credit crisis. Miller said the subprime debacle, rising unemployment, record-high oil prices, and now CDS market troubles "have all the makings of the perfect storm.... There are some economists who say this could be another 1929 — but I don't believe it," he said. "We have a lot of safeguards built into the system that did not exist in 1929 and 1930." None of them, though, are directly targeted at CDS. On Wall Street, innovators are always ahead of regulators. And that can sometimes have a very steep price.

Structured Products

"If you don't understand it, then don't buy it"

-- Investing legend, Warren Buffett


A BRIEF HISTORY



Structured products include structured investments, structured deposits, capital guaranteed funds and capital protected funds. The word "structured" is rarely used in the marketing and they are usually sold as unit trusts or ILPs (investment-linked products). Most are distributed mostly by banks although insurance companies have recently entered the picture.



In the 1990’s, they were a way for rich individuals and institutions to structure investments to get their preferred mix of risk, return, liquidity, income and capital gain. This was useful.



As issuers got good at structuring, they expanded to the mass market. But how to make a customised product for each and every small investor? It seemed impossible.



It didn’t take long to find a way to “customise for the masses”. The newly developed structured products appealed to the masses and had similarities to gambling. It works like this: A structured product might take 20 well-known stocks, for example, and let people place bets on which three would appreciate the most over 5 years.



The world’s best stock pickers and sports handicappers would be hard-pressed to guess the outcome. In addition, every structured product has an expiry date. These two features make it similar to a wager.



But like all games of chance it is exciting to try one’s luck. Plus it looks like the odds are structured in such a way to give you a big payout if you win.



Add to this a minimum return that is often “guaranteed” (as long as you fulfill other conditions like no early redemption). It appears to be an investment with no risks and good upside potential. Not surprisingly, it has sold very well.



ONE-TIME CHARGES



If you buy a structured product, it will almost certainly be from a bank who are the “distributors”. Their standard fee is 3 per cent of the amount invested. For example, a two-month marketing campaign that raises $100 million would produce $3 million in revenues for the bank.



This 3 per cent distribution charge is deducted from the net asset value (NAV) of the investment. It means if sold immediately after purchase, the investor would receive back 97 per cent of the investment.



The distribution cost does not seem to be excessive and is revealed in the fund’s prospectus (but not the brochures or advertisements). It is in line with initial sales commissions of unit trusts and ILPs (investment-linked products) which charge 2 to 5 per cent.



Distribution costs are one-time costs. If one holds the structured product for a number of years, the average annual distribution costs will be less than yearly fees.



The issuer will also include a charge in the price of the structured product. It is typically embedded in the instantaneous variance component.



ANNUAL CHARGES



Issuers charge annual management fees. They also charge performance fees which can be very high as I will explain.



Issuers are the architects who design the structured product. They also invest the money which the distributor (bank) collects and remits to them. Issuers are also called guarantors and underwriters.



Structured products usually sells in units and are classified as unit trusts. In this case, the must disclose the management fees.



When not sold in units, the issuer will subtract its fees directly from the fund's yield. In that case, there is no way to determine the cost the issuer charges.



The management fee may be higher than it appears, especially for guaranteed funds which invest about 90 per cent of the fund into bonds.



In these cases, the management fee may take a substantial portion from an already low return.



The issuer might take a fixed 1 per cent per year when total returns are between 1 and 5 per cent. It leaves only 0 to 4 per cent for the retail investor.



An example: When a guaranteed fund's return is 3 per cent, an issuer that takes a 1 per cent management fee is taking 1/3 = 33 per cent of the total return.



EARNINGS CAP



Let’s say the structured product is linked to stock returns and these perform well. Then the structured product will also do well. Returns could be quite high.



The high returns do not go to investors because returns are typically capped. It means they cannot go above a certain level.



An earnings cap is typically marketed as a benefit to investors and is called an “early buyout”. This is not correct. It is a drawback. The investor would have made more money if there were no earnings cap.



Usually, it is phrased something like this: “Should your investment do well, then at the end of year 2 you will receive an early buyout with a 5 per cent bonus.”



Scenario 1: Suppose the structured product does well enough to pay its promised maximum returns of 3 per cent in year one and 3 per cent in year two. At the end of year two, it pays the 5 per cent bonus. It means that over 2 years, you will have earned 11 per cent (3+3+5).



Scenario 2: Take a case where the product earns 8 per cent in both years 1 and 2. The total is 16 per cent. You will still receive the pre-determined 11 per cent and no more. The excess profits of 5 per cent (16 – 11) go to the issuer. It is not shared with investors.



Scenario 3: Suppose it was a great year and stocks shot up 26 per cent. The cap is the same and the issuer needs to pay investors only 11 per cent. In this case, the excess returns are even more. They are 26 – 11 = 15 per cent. As before, none of the excess returns go to investors. The entire 15 per cent goes to the issuer.



Nearly all structured products contain caps. It is an upper limit to returns. It guarantees that investors will not participate in high returns when markets are strong. Instead investors will receive a modest bonus in the form of a buyout. (Usually, it is 5 per cent.)



In a strong market, who gets the returns in excess of the cap? For some structured products, it may go to the issuer. For others, it may go to a counterparty to a hedge contract.



Regardless, the derivative portion of the structured product is a fair bet prior to charges. If one party wins, the other loses.



As second level of analysis, one must understand that it becomes a negative-sum investment. This happens when one considers fees of the issuer and distributor.



Those fees are found in (i) the issuing charge that is either (a) charged as a management fee or (b) embedded in the product itself, (ii) the issuer's profits from market-making, (iii) the front-end load charged by the distributor and various hidden fees deducted directly from the yield of the structured product -- such as foreign exchange conversion costs, gains or losses from foreign currency fluctuations, taxes deducted at source and brokerage commissions.



5 PROBLEMS OF STRUCTURED PRODUCTS



The first problem is that many structured products are not traded as unit trusts and do not show the management fee. Instead, issuers will embed their charges in the price of the product itself. As such, it is not possible to know how much you pay for it.



A second problem is the return caps. These limit returns when the product does well, such as in bull markets. It limits the profit potential. It may be fair if the cap is part of the structuring. One could think of it as the price one pays for benefits of the structured product. Typically, however, those benefits are emphasised while the return caps are downplayed.



A third problem is illiquidity. If the investor sells prior to the maturity date, usually 5 years, he must pay a penalty. This can result in getting back less than the initial investment, a loss. Even when the product is actively traded, the issuer will typically act as the market-maker. It is another source of profit for the distributor and another cost for the investor.



A fourth problem is the marketing. It is less than straight-forward and often suggests a higher payout than investors actually receive. For example, it may be promoted as giving a payout 5.5 per cent after 6 months. This works out to 11 per cent per year. That is good. (In fact, it is too good to be true.)



The prospectus always contains an admission (sometimes in hard-to-understand language) that such a high return requires a payout from capital. It means the payout is not a return on investment at all. The bank has simply given back a part of the investor’s own money and called it a “payout”.



Sometimes banks even send a letter congratulating you on receiving a high payout. The tactic seems to be effective and has spread. It has also been used to promote bank deposits and endowment insurance policies.



A fifth problem is the bank's marketing strategy. It advertises a range of returns. Bank staff then suggest to customers that the upper end of that range is likely.



In fact, there is no way to know since structured product returns are based on baskets of shares, bonds, stock indices or currencies. Forecasting the return to each component of the basket over a 5-year period is extremely difficult.



HOW TO RECOGNISE A STRUCTURED PRODUCT



Very often, structured products are marketed as familiar and safe investments: Either a unit trust or an investment-linked product (ILP). Typically, the word "structured" is never used. How to know if you are buying an ordinary unit trust or ILP -- or a structured product?



Usually, the only way to tell is if the return is linked to some other event -- like "no more than 3 stocks in a basket of 20 declining in price each year". Most structured products will also have a buy-out provision. It allows the fund to buy you out if it is moving in the right direction.



Most structured products also advertise high yields. But a part of the yield is often a return of your own investment.



Can structured products be sold under the CPF investment scheme (CPFIS), which permits you to use your CPF money to buy an investment?



The answer is "yes". If the product is sold as a unit trust or ILP, then it is possible that it could be sold under CPFIS. Keep in mind, therefore, that just because a fund is CPF-approved, doesn't mean it is not a structured product.

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