Sunday, August 30, 2009

Subprime loan goes to India, a new bubble in microfinance

From WSJ:

A Global Surge in Tiny Loans Spurs Credit Bubble in a Slum

RAMANAGARAM, India -- A credit crisis is brewing in "microfinance," the business of making the tiniest loans in the world.

Microlending fights poverty by helping poor people finance small businesses -- snack stalls, fruit trees, milk-producing buffaloes -- in slums and other places where it's tough to get a normal loan. But what began as a social experiment to aid the world's poorest has also shown it can turn a profit.

That has attracted private-equity funds and other foreign investors, who've poured billions of dollars over the past few years into microfinance world-wide.

The result: Today in India, some poor neighborhoods are being "carpet-bombed" with loans, says Rajalaxmi Kamath, a researcher at the Indian Institute of Management Bangalore who studies the issue. In India, microloans outstanding grew 72% in the year ended March 31, 2008, totaling $1.24 billion, according to Sa-Dhan, an industry association in New Delhi.

"We fear a bubble," says Jacques Grivel of the Luxembourg-based Finethic, a $100 million investment fund that focuses on Latin America, Eastern Europe and Asia, though it has no exposure to India. "Too much money is chasing too few good candidates."

Here in Ramanagaram, a silk-making city in southern India, Zahreen Taj noticed the change. Suddenly, in the shantytown where she lives, lots of people wanted to loan her money. She borrowed $125 to invest in her husband's vegetable cart. Then she borrowed more.

"I took from one bank to pay the previous one. And I did it again," says Ms. Taj, 46 years old. In four years, she took a total of four loans from two microlenders in progressively larger amounts -- two for $209, another for $293, and then $356.

At the height of her borrowing binge, she says, she bought a television set. The arrival of microfinance "increased our desires for things we didn't have," Ms. Taj says. "We all have dreams."

Today her house is bare except for a floor mat and a pile of kitchen utensils. By selling her TV, appliances and jewelry, she cut her debt to $94. That's equal to about a fourth of her annual income.

Around Ramanagaram, the silk-making city where Ms. Taj lives, the debt overload is stirring up social tension. Many borrowers complain that the loans' effective interest rates -- which can vary from 24% to 39% annually -- fuel a cycle of indebtedness.

In July, town authorities asked India's central bank to either cap those rates or revoke lenders' licenses. "Otherwise, the present situation may lead to a law-and-order problem in the district," wrote K.G. Jagdeesh, deputy commissioner for the city of Ramanagaram, in a letter to the central bank.

Alpana Killawala, a spokeswoman for the Reserve Bank of India, said in an email that the central bank doesn't as a practice cap interest rates for microlenders but does press them not to charge "excessive" rates.

Meanwhile, local mosque leaders have started telling people in the predominantly Muslim community to stop paying their loans. Borrowers have complied en masse.

The mosque leaders are also demanding that lenders give them an accounting of their finances. The lenders say they're not about to comply with that.

The repayment revolt has spread to other communities, including the nearby city of Channapatna, and could reach further across India, observers say.

"We are very worried about this," says Vijayalakshmi Das of FWWB India, a company that connects microlenders with financing from mainstream banks. "Risk management is not a strong point for the majority" of local microfinance providers, she adds. "Microfinance needs to learn a lesson."

Nationwide, average Indian household debt from microfinance lenders almost quintupled between 2004 and 2009, to about $135 from $27 or so, according to a survey by Sa-Dhan, the industry association. These sums are obviously tiny by global standards. But in rural India, the poorest often subsist on just a few dollars a week.

Some observers blame a fundamental shift in the microfinance business for feeding the problem. Traditionally, microlenders were nonprofits focused on community service. In recent years, however, many of the larger microlending firms have registered with the Indian central bank as a type of for-profit finance company. That places them under greater regulatory scrutiny, but also gives them wider access to funding.

This change opened the door to more private-equity money. Of the 54 private-equity deals (totaling $1.19 billion) in India's banking and finance sector in the past 18 months, microfinance accounted for 16 deals worth at least $245 million, according to Venture Intelligence, a Chennai-based private-equity research service.

The influx of private-equity cash is the latest sign of the global rise of microfinance, pioneered by Bangladeshi economist Muhammad Yunus decades ago. On Wednesday, Mr. Yunus, a 2006 Nobel Peace Prize winner, was one of 16 people honored by President Barack Obama with the Medal of Freedom.

"We've seen a major mission drift in microfinance, from being a social agency first," says Arnab Mukherji, a researcher at the Indian Institute of Management in Bangalore, to being "primarily a lending agency that wants to maximize its profit."

Making loans in poorest India sounds inherently risky. But investors argue that the rural developing world has remained largely insulated from the global economic slump.

International private-equity funds started taking notice of Indian microfinance in March 2007. That's when Sequoia Capital, a venture-capital firm in Silicon Valley, participated in a $11.5 million share offering by SKS Microfinance Ltd. of Hyderabad, India, one of the world's largest microlenders.

"SKS showed the industry how to tap private equity to scale up," said Arun Natarajan of Venture Intelligence.

Numerous deals followed with investors including Boston-based Sandstone Capital, San Francisco-based Valiant Capital, and SVB India Capital Partners, an affiliate of Silicon Valley Bank.

As of last December, there were over 100 microfinance-investment funds globally with total estimated assets under management of $6.5 billion, according to the Consultative Group to Assist the Poor, or CGAP, a research institute hosted at the World Bank.

Over the past year, investors have poured more than $1 billion into the largest microfinance funds managed by companies, a 30% increase. The extra financing will allow the industry to loan out 20% more this year than last, much of it to countries such as the Ukraine, Cambodia and Bosnia, CGAP says.

Here in Ramanagaram, Lalitha Sharma recalls when the first microfinance firm arrived seven years ago. Those were heady times for her fellow slum-dwellers: Money flowed freely. Field agents offered loans to people earning as little as $9 a month.

They came to Ms. Sharma's door, too. She borrowed $126. Under the loan's terms, she said she would use it to finance a small business -- a snack stand she runs with her husband. Many microfinance providers require loans to be used to fund a business.

But Ms. Sharma, a 29-year-old mother of three, acknowledges she lied. "You have to mention a business to get a loan," she says. "There was no other way to get the money." She used it to pay overdue bills and to buy food for her family. Ms. Sharma earns $8 a week, on average, in a factory where she extracts silk thread from cocoons.

Over the next four years, she took nine more loans from three different lenders, in progressively larger sums of $209, $272, $335 and $390, according to lending records reviewed by The Wall Street Journal. A spokesman for BSS Microfinance Private Ltd. of Bangalore, another of her lenders, declined to comment on her borrowing history, citing central-bank privacy rules.

This year, she took another $314 loan to pay for her brother-in-law's wedding, again saying the money would be used for business purposes. She also juggled loans from two other microlenders -- $115, $167 and $251 from the Bangalore lender Ujjivan, and $230 from Asmitha Microfin Ltd.

Ujjivan confirmed it issued three loans. An Asmitha official said he had a record of a loan to a Ramanagaram resident named Lalitha, but at a different address.

"I understand that it is credit, that you have to pay interest, and your debt grows," Ms. Sharma says. "But sometimes the problems we have seem like they can only be solved by taking another loan. One problem solved, another created."

Many of the problems in Indian microlending might sound familiar to students of the U.S. mortgage crisis, which was worsened by so-called "no-documentation" loans and by commission-paid brokers. Similarly in India, microlenders' field officers are often paid on commission, giving them financial incentive to issue more loans, according to Ms. Kamath.

Lenders are aware that applicants often lie on their paperwork, says Ujjivan's founder, Samit Ghosh. In fact, he says, Ujjivan's field staffers often know the real story. But his organization maintained a policy of "relying on the information from the customer, rather than our own market intelligence."

He says that policy will now change because of the trouble in Ramanagaram. The lender will "learn from the situation, so it won't happen again," he says.

It's tough to monitor how borrowers spend their money. Ujjivan used to perform regular "loan utilization checks," but stopped because it was so costly. Now it only checks in with people borrowing more than $310, Mr. Ghosh says.

BSS checks how loans are being spent a week after disbursing the money, and makes random house visits, according to S. Panchakshari, its operations manager. The company doesn't have the power to insist that borrowers not take loans from multiple lenders, he said in an email.

Lenders also tend to set up shop where others have already paved the way, causing saturation. There is a "follow-the-herd mentality," says Mr. Ghosh at Ujjivan. Microlenders "often go into towns where they see one or two others operating. That leaves vast chunks of India underserved, "and then a huge concentration of microfinance in a few areas."

[where credit is due]

In Ramanagaram district, seven microfinance lenders serve 22,500 women (most microloans go to women because lenders consider them less likely to default than men). Loans outstanding here total $4.4 million, according to the Association of Karnataka Microfinance Institutions, a group of lenders.

Lenders in Ramanagaram say the loan-repayment revolt was instigated in part by Muslim clerics who oppose the empowerment of women through microfinance. Most lenders are still servicing loans to Hindu borrowers, but have stopped issuing fresh loans to Muslims. "We can't do business with Muslims there right now," says Mr. Ghosh. "Nobody wants to take that kind of risk."

The irony is that, for years, Indian microlenders have touted themselves as bankers to the nation's impoverished minority Muslim community, which has long been excluded from the formal banking sector.

A 2006 report commissioned by India's prime minister found that while Muslims represented 13% of India's population, they accounted for only 4.6% of total loans outstanding from public-sector banks.

Islam prohibits the paying of interest, but mosque officials don't cite that as the reason for the loan-payment strike. They stressed the overindebtedness of the community, and the strains it's putting on family life.

Ramanagaram's period of wild borrowing irks some residents, both Hindu and Muslim. Alamelamma, a 28-year-old vegetable seller, says that she has benefited from microfinancing and that the profligate borrowers "have ruined it for the rest of us."

One gully away, Ms. Sharma, the heavy debtor, has a different view: She would like to see the microlenders kicked out of the community entirely. "Not just for now, but forever," she says.

Will China suffer double-dip too?

Worries that China will suffer double-dip in economic growth once the effect of government's stimulus wanes, from WSJ:

Ten months after China unleashed a massive economic-stimulus program, worries are building about what happens to the world's third-biggest economy when the government money runs out.

China's stock markets have plunged this month on concerns Beijing might tighten the reins on lending and abruptly end the party. Even if the speculation is overblown, the economy still looks unready to motor on after the four trillion yuan ($585 billion) in stimulus starts to fade later this year.

The authorities haven't weaned the economy from its dependence on exports, so with demand for Chinese goods in key markets like the U.S. likely to remain weak, the letup in public spending and loans later this year could leave China in a bind.

While the country might shift benignly to stable levels of economic growth, it faces the risk of a renewed slowdown -- or worse -- next year, asset bubbles, overcapacity in basic industries or a burst of inflation from all the money the authorities have injected into the economy.

"China is not changing its growth model," says prominent China-watcher Andy Xie. "It is pumping up demand in ad hoc ways."

Instead of steering the economy toward growth based on domestic demand, Beijing is using stimulus as a stopgap until exports rev up again, says the Shanghai-based economist. But if developed economies don't rebound as expected, "we will have a second dip by around the middle of next year and we will be talking about a second stimulus" in China, Mr. Xie said.

Worries like this partly explain why Chinese shares sank 15% from Aug. 4 through Friday after jumping about 90% since the start of the year. The Shanghai Composite Index closed 1.7% higher Friday at 2960.77.

China is likely to hit the government's official growth target of 8% if for no other reason than the authorities have the power to make that happen, at least for a time. Money supply is growing at its fastest in 13 years and fixed-asset investment is running at growth levels not seen since the height of the last inflationary cycle in 2004.

Economic growth picked up to 7.9% on year in the second quarter from 6.1% in the first as the stimulus kicked in and the global economy began to stabilize.

If China doesn't find a substitute for exports as the stimulus wanes, however, it will have to live with slower growth, although Subir Gokarn, chief Asia-Pacific economist for Standard & Poor's says that "may not be such a bad thing."

S&P forecasts China's growth will slow to 7.5%-8.0% this year from 9% last year, then edge up to 8.0%-8.5% next year. On the bullish end of the spectrum, Goldman Sachs expects China to zoom to 11.9% growth in 2010.

There is always an outside risk, though, that with the massive amounts of cash China has pumped into the economy and questions about the country's published data, things could take a turn for the worse, potentially spelling another rough period for global markets and even economies.

China opens up to private equity

China starts to allow foreign private equity firms to raise money in local currency, reports WSJ:

China is opening up to foreign private equity firms -- but the promised land is no paradise yet.

For the first time, foreign firms have the green light to raise yuan-denominated funds. It's a significant, but qualified, breakthrough for the likes of Blackstone Group, Carlyle Group, and the private equity arms of CLSA and Macquarie Group -- all of which have announced, or will soon announce, new funds.

Raising funds in yuan means being able to tap wealthy Chinese investors, as well as state-backed institutions like China's national pension fund.

And using local currency should mean the funds can more speedily take advantage of investment opportunities in China.


But this isn't going to be easy -- both when it comes to raising money and deploying it.

For starters, the foreign firms face competition in raising funds from China-based private equity groups that have a purely Chinese focus -- and better local knowledge.

It's unclear, also, whether the foreign firms will be allowed to bring their own money into China, convert it into yuan and take equity stakes in mainland companies, says William Liu, a partner at law firm Linklaters.

That's important if the firms are to follow the model of investing alongside their limited partners -- ensuring some of their own money is on the line too.

A regulatory uncertainty applies to investment opportunities as well -- whether or not the foreign firms setting up local currency funds will be treated as foreign or domestic investors. The difference being a heap of approval procedures for investments, as well as restrictions on sectors to invest in.

It's questionable, too, whether local governments and regulators will want to give foreign firms access to China's best investment opportunities. For now, with Chinese banks offering so much credit to companies, turning to private equity is anyway less of priority for China Inc.

In a smart move, foreigners setting up yuan funds are aligning their strategies with government priorities. Hong Kong-based First Eastern Investment Group will set up three funds, investing in small and medium sized enterprises, green companies and infrastructure firms respectively.

First Eastern is typical in that it's scaled back its ambitions: The three funds, worth $850 million together, will be smaller in total than initial plans for two funds raising $1.5 billion.

Keeping the funds small, for now, is reasonable. Plenty of uncertainty remains over private equity's freedom to maneuver in a country that is still some way from having capital allocation guided purely by market forces.

Tuesday, August 25, 2009

Lessons from 1937's double-dip

With economic recovery looking on track, what lessons can be learned from the 1937-stalled recovery --- the double-dip contraction? (source: WSJ). This is a followup to my previous post "The lessons of 1937".

WASHINGTON -- A few months ago, Obama administration officials were sounding the alarm about another 1929. These days, it's 1937 that has them in a sweat.

The Great Depression was W-shaped. The stock-market collapse led to a steep economic decline. But by 1933, the economy had rebounded. Then a series of monetary and fiscal blunders drove the country back into a deep recession at the end of 1937.

[history lessons]

That episode is at the heart of the debate over how quickly the government and the U.S. Federal Reserve should unwind the emergency measures they have taken to fend off a Depression-like contraction.

For the administration, the answer is clear: Err on the side of continued expansionary policies. "What you learned from that episode in 1937 is that it's not enough to be recovering," says Christina Romer, chairman of the president's Council of Economic Advisers and an expert on the Great Depression. "You don't want to do anything when you start recovering that nips it off too soon."

For fiscal conservatives, the answer is equally clear: Start cutting the federal deficit and slowing the growth in the money supply now, before the binge generates a burst of inflation.

Ms. Romer is "sending the absolutely wrong message -- that we can't do anything to worry about inflation until the recovery is locked in because of concern for unemployment," says Allan H. Meltzer, a political economist at Carnegie Mellon University. "The reason economists and central bankers have two eyes is so they can do two things at once."

The economy was recovering briskly during Franklin D. Roosevelt's first term in the White House. The jobless rate, which had peaked at 25% in 1933, fell to 14% in 1937 -- not exactly cause for celebration but a relief nonetheless.

The comeback stalled in 1937. Banks, nervous about the fragile recovery, were holding huge amounts of cash in reserve at the Fed. Fearing an inflationary surge should the banks decide to lend that money out to businesses and individuals, the Fed -- which had made the mistake of tightening monetary policy soon after the 1929 stock-market crash -- miscalculated again. The Fed ratcheted up banks' reserve requirements three times, starting in 1936. The banks reacted by cutting lending even further.

"There's no doubt that [Fed Chairman Ben] Bernanke is heavily influenced by these two mistakes of the Fed during the Depression and is absolutely intent on not repeating them," says Alex J. Pollock of the American Enterprise Institute, a free-market think tank in Washington.

Compounding the Fed's errors, the federal government tightened fiscal policy. Congress approved a big bonus for World War I veterans in 1936, providing a spark of consumer spending. But lawmakers allowed the subsidy to lapse in 1937. At the same time, the government began collecting the first Social Security taxes, on top of income and capital-gains tax increases that Mr. Roosevelt approved in 1934-35.

Tightening the monetary and fiscal screws sent the economy into free fall again -- the second trough of the W. Unemployment shot up to 19%, prolonging the nation's suffering.

Fast-forward to 2009. Most economists surveyed by The Wall Street Journal this month believe that the recession is over. On average, they expect to see a 2.4% increase in output in the third quarter, at a seasonally adjusted annual rate. Construction of new single-family homes has started to climb. Auto sales are up.

But administration officials and their allies fear a second dip if the government pulls back the $787 billion stimulus or if the Fed clamps down too soon.

"I think it's a fringe view to say we should get rid of the stimulus," says Ms. Romer. Economists who say the economy is on the upswing do so because they assume a continued fiscal boost through 2010, she says.

"Even though the Fed is talking about and obviously doing internal planning for the exit strategy, nobody should think it's imminent," says Princeton University economist Alan Blinder, a former Fed vice chairman and economic adviser to the Clinton White House. "And it shouldn't be imminent; the Fed has got to have its pedal to the metal for some time yet."

Mr. Meltzer says the risk lies not in pulling back too soon but dithering too long. And he would scrap the stimulus program immediately and replace it with cuts in marginal tax rates for individuals and businesses. "It's certainly not a bad idea to get rid of a policy that isn't working," he says. "It takes courage, but that's what we pay these people to do." And, he says, the Fed should now slow the growth of the money supply.

Conservative voices in Congress are sending the same message. Last week, Sen. Jon Kyl, an Arizona Republican, reiterated his view that the rebounding economy renders further stimulus spending superfluous.

This week the Obama administration and Congressional Budget Office are to release new federal deficit forecasts. The White House projection is expected to be a record $1.58 trillion for the year ending Sept. 30, and the congressional forecast could be even larger. Expect the news to prompt an outcry from those who believe that the inflation of the 1970s is now a bigger risk than the deflation of the 1930s.

Saturday, August 22, 2009

The danger of data mining

Data mining and stock predictions. Some wise words.

Reports from Jackson Hole, WY

Series of interviews at Jackson Hole, WY, where the Fed's annual summer policy conference takes place. Fed watchers should not miss.

Fred Mishkin interview:

Ken Rogoff interview:

Glen Hubbard interview:

Time to rethink investment model in US college endowment?

Traditional view is that college endowment investment should focus on long term; short term ups and downs should not be major concern. But with most big college endowments down over 25% last year, question arises as to how to reconcile the long-term investment goal with short term liquidity problem: pay for student's tuition, for example. (source: WSJ, 08/21/2009)

College endowments, reeling from their worst annual performance in decades, are questioning their faith in investments that fueled huge returns before backfiring last year.

The crisis of confidence has been playing out at the University of Chicago, in a previously unreported battle that divided the overseers of the nation's 10th-largest university endowment, a committee that included hedge-fund managers Sanford "Sandy" Grossman and Cliff Asness. Amid last fall's market turmoil, the committee argued over whether their portfolio's assets, $6.6 billion in June 2008 but falling fast, were too risky and volatile.

[The University of Chicago, shown this week, had a $6.6 billion fund.]

The endowment's managers staged a $600 million share selloff to buy safer instruments, an unusually abrupt no-confidence vote in its portfolio model. In a late October email to committee members, Kathryn Gould, a venture capitalist who heads the college's endowment committee, and Chief Investment Officer Peter Stein, wrote: "We will no doubt look like heroes AND idiots in the next couple of months."

More such judgments will be passed beginning later this month, when colleges begin disclosing how their portfolios fared over the fiscal year that ended June 30. Northern Trust Corp. estimates that, over the period, the average U.S. college endowment has a 20% decline.

Harvard University has predicted the asset value of its endowment, the nation's largest, would drop as much as 30%. Yale University and Princeton University have projected declines of about 25% each. The University of Chicago has predicted a 25% decline in its portfolio value for the fiscal year.

Though loath to discuss their money-management strategies, many universities appear to have considered moving to more conservative investments. Harvard tried last year to sell a chunk of its private-equity portfolio but didn't receive an acceptable offer; it has been cashing out some of its hedge-fund investments, say people with knowledge of the situation.

Most college endowments used to favor stocks and bonds. David Swensen, hired in 1985 as Yale chief investment officer, argued that endowments -- long-term investors that were unconcerned about redemptions or short-term market fluctuations -- were ideal for the likes of real estate, leveraged buyouts and distressed debt. Yale beat markets by a wide margin.

But the stock market's nosedive last year showed what some see as flaws in the model. "The endowment model contained a colossal intellectual error in thinking -- that long-term investors don't need short-term liquidity," says Robert Jaeger of BNY Mellon Asset Management, a unit of Bank of New York Mellon, who advises endowments on how to structure their portfolios.

Some endowments maintain that, despite steep losses, they aren't second-guessing themselves. "That would require moving away from equity-oriented investments that have served institutions with long time-horizons well," Mr. Swensen said in an interview earlier this year.

In 2005, the University of Chicago hired Mr. Stein from Princeton, where he had worked under a protégé of Mr. Swensen. In June 2008, the university's endowment had 77% of assets in "equity-like investments" -- foreign and domestic stocks, private equity and hedge funds -- according to the 2008 annual report.

That September, around the time that Lehman Brothers collapsed, members of the investment committee took a hard look at their mix.

"We had underestimated the value of liquidity and overestimated our degree of diversification," said Andrew Alper, chairman of the university's board of trustees and a committee member. He says the committee hoped to change the portfolio's long-term exposure to risk and volatility, and would have preferred to unload its stakes in private-equity firms.

But with the market in these illiquid assets essentially frozen and hedge-fund redemptions coming slowly, they began to talk about selling stock.

In early October, the Dow tumbled 18% in one week. In an Oct. 28 email viewed by The Wall Street Journal, Ms. Gould and Mr. Stein told committee members they were considering "an outright sale" of $500 million in stocks -- "virtually all the immediately saleable equities."

By early November, according to people familiar with the matter, Ms. Gould had instructed Mr. Stein to sell $200 million of equities.

James Crown, a trustee and a general partner at Henry Crown & Co., a Chicago investment firm, expressed confusion. "Where are we going with the endowment and why?" he wrote to committee members in a Nov. 2 email viewed by the Journal.

A force behind the sales push was Mr. Grossman, a Greenwich, Conn., hedge-fund manager and economist, say those familiar with the situation. On Nov. 6, during a three-hour committee meeting at university's business school, Mr. Grossman sketched out formulas on an easel to explain the portfolio's relationship to market risk. Other times he referred to the 2008 returns at his own hedge fund, QFS Asset Management -- some were ahead double-digits that year -- to make a case for selling, these people say.

They say some of Mr. Grossman's points were challenged by Martin Leibowitz, a managing director at Morgan Stanley, and by top trustee Mr. Alper.

Mr. Grossman says he advocated reducing risk and volatility but doesn't remember whether he pushed to sell stocks.

The night of the committee meeting, Ms. Gould wrote several members that Mr. Stein was preparing to sell $300 million in stocks. A sale of another $100 million followed. Some proceeds went into fixed-income funds.

Mr. Asness, co-founder of Greenwich, Conn., hedge-fund firm AQR Capital Management, expressed dismay at the response to Mr. Grossman's presentation. "Was Sandy that convincing?" he wrote in an email the next day. "I felt a consensus was building not to be so short-term."

University of Chicago officials won't say when they sold their stock, so it is impossible to calculate returns. Mr. Alper says the proceeds weren't invested into other stocks but that the endowment continues to hold equities.

Fallout continues. "We cannot time the market to this degree and should not be trying," Mr. Asness wrote in a January email to members of the committee.

Last year, the university changed its policy so only trustees could serve on its investment committee. That led three nontrustee members, including Messrs. Asness and Leibowitz, to step down in June.

Endowment CIO Mr. Stein announced his resignation in January. Mr. Stein said in a statement at the time that he left for family reasons.

Friday, August 21, 2009

Will Ben Bernnanke be reappointed? Part 3

Did Ben save the world?

Thursday, August 20, 2009

Will Ben Bernanke be reappointed? Part 2

Following my last piece on the chance of reappointing Bernanke as Fed Chairman, here is an analysis from David Rosenberg (former Chief Economist at Merrill):

Despite the fact that the Fed Chairman has a legion of fans within the economics community given his vast academic credentials, this is still a tough call. The White House and Congress do not seem to be big fans and what investors should realize is that (i) Bernanke was Bush's man and is a card-carrying Republican; (ii) this is a political appointment, do not make any mistake about that, and (iii) claims that Mr. Bernanke saved the world is a bit misleading because it was his actions (or inactions) while at the Fed as governor 7-8 years ago that contributed to the bubble. Bernanke was a giant cheerleader for the leverage-induced economy during his time as the chief economist at the White House and while he was aggressive (and likely broke every rule in the book of central banking) in getting the credit market and economy back on track, he failed at the outset to realize the severity of the credit collapse and treated it as a liquidity event only for months.

The Fed's economic forecast that was published just over a year ago for late 2008 and 2009 is an embarrassment, to say the least. Valuable time was lost under his watch and the question is (i) does the Administration look at his entire record as opposed to his period as a White Knight, and (ii) will Mr. B end up being a scapegoat once the economy relapses in the fourth quarter and the unemployment rate makes new post-WWII highs along the way. See the front page of the NYT for more — Bernanke, a Hero to his Own, Still Faces Fire in Washington. The search committee is already out, by the way, and the likes of Blinder, Yellen, Ferguson and Summers are on it.

Psychology game in housing

Another Robert Shiller interview:

Wednesday, August 19, 2009

China's commodity appetite

China signed a huge $41 billion liquefied gas deal with Australia:

Tension, what tension?

Australia and China have just signed their largest ever trade deal -- a 20-year agreement worth $41.1 billion for Petrochina to import liquefied natural gas from Exxon Mobil's share of the Gorgon gas field down under.

Cue warm words from Australia's energy minister about the health of the trade and investment relationship between the two countries.

The reality is this deal merely papers over the cracks.

The bare bones of the contract between Exxon and Petrochina were hammered out earlier this year, before a marked rise in bad feeling between Australia and China emerged.

So it predates Chinese anger over Chinalco's failed bid to take a major stake in Rio Tinto, for example, and Australian jitters over the arrest of Rio employees in China this summer -- including Stern Hu, an Australian citizen.

And because this deal doesn't involve any actual Chinese ownership of Australian assets or companies, it's palatable for the Canberra government.

Long-term contracts involving Australian resource supplies to China are fine. A much sterner test of the two countries' relationship will come when Australia's foreign investment authorities settle down to consider Yanzhou Coal's takeover bid for coal miner Felix Resources.

A rejection or moderation of that deal would reveal how delicate Sino-Australian relations remain. Opposition leader Malcolm Turnbull yesterday said they were at their lowest ebb for many years.

Me. Turnbull, of course, has political motives. He knows that the reputation of Australian prime minister Kevin Rudd -- a fluent Mandarin speaker -- rests to some extent on his ability to handle relations with China.

Mr. Rudd, an old China hand, will in turn know business with China in future won't be as smooth as this gas deal makes it seem.

Tuesday, August 18, 2009

"September Effect" in stock market

We have heard about "January Effect". How about "September Effect"? Will we have another one this fall? (source: WSJ)

September is fewer than three weeks away. Feeling nervous? Maybe you should be. For investors, the period between Labor Day and Halloween is proving an annual fright show. And no one knows why.

It was, of course, in September last year that Lehman collapsed and everything fell apart. But then it was also September-October 2002 that the last bear market plunged to its lows.

The 1998 financial crisis? It began late August, and rolled on for two months.
The famous crash of 1987 came in October. But most people have forgotten that the market actually started sliding downhill in late August.

That's almost exactly what happened in 1929 too. The big crash came in October, but the market peaked just after Labor Day. Prices began falling through September, then tumbled further still.

The worst month of the Depression? September, 1931, when the Dow fell about 30 percent. It was also in September, 2000, that the bear market really got going.
The 9/11 crisis, of course, came in September. That was hardly caused by investors. But what is forgotten is that the stock market was already looking wobbly. In the two weeks before the terrorist attacks, the Standard & Poor's 500-stock index fell 7 percent.

The great panic of 1907? October. The great crash of 1873? September.

So is there really a September, or a Halloween, effect?

Since 1926, investors have lost nearly one percent on average during September, according to market data tracked by finance professor Kenneth French at Dartmouth's Tuck School of Business. It's the only month with a negative average return.. For each of the other 11 months, investors gained nearly one percent on average.

Other research takes the idea of an autumn dip even further. Georgia Tech doctoral student Hyung-Suk Choi studied the so-called "September effect" as part of his recent Ph.D. thesis. (Read the research here) He looked at data for 18 developed stock markets around the world spanning up to 200 years, and found that in 15 of those markets, September brought red ink for investors.

Fund manager Sven Bouman and finance professor Ben Jacobsen concluded that investors in most world markets have historically fared poorly from May through October each year. They made their money between November and April. (Read the research here.)

Hence the old British investors' saying, "sell in May and go away, don't come back till St Leger Day." (But since St. Leger Day is in the middle of September, even that date may be premature.)

Some of the September or Halloween effect is caused by a few really bad years. But that's not the whole story. To reduce the influence of outliers I looked instead at the median result since 1926 instead of the statistical mean. The performance gap between September and the other months shrank from 2 percent to 1.4 percent. That's smaller, but it's still a difference. The median September saw losses of just 0.07 percent. But the median month for the rest of the year gained 1.37 percent.
As for the causes of a possible September effect, most are stumped.
"There haven't been any good academic stories to explain it," admits Michael Cooper, finance professor at the University of Utah's David Eccles School of Business. "One credible explanation is just luck."

It's been suggested that mutual funds drive down the market by selling their losing stocks before their October 31 year end. Or that third quarter profit warnings come in early September, raising fears about full-year results. Or that these autumn crashes used to be related to the harvest, as Midwestern banks withdrew capital from New York.

(Still another theory cites seasonal affective disorder. Investors simply get more risk-averse, and more prone to sell, as the days get shorter. That's the case argued by York University finance professor Mark Kamstra and others. (Read the research here.))

So what, if anything, should you do?

In practical terms, maybe not that much. For most people, even a performance difference of one or two percentage points isn't going to cover the transaction costs of selling before the end of August and re-entering the market a month later. And stock market patterns aren't ironclad. The market may even jump in September, as it did in 2006 and 2007.

Perhaps the best you can do is brace for turmoil.

Glimpse of China's banking system

China's banking system and the current state of the economy through the eyes of Jing Ulrich, Chairman of China Equities, JP Morgan Chase.

Abby Cohen: market and economy outlook

Another Abby Cohen interview. She is Sr. investment strategist at Goldman Sachs. Her comments are always crystal clear.

Monday, August 17, 2009

Shape of recovery

Source: Joe Heller

Sunday, August 16, 2009

Should Ben Bernanke be reappointed?

Nouriel Roubini says Yes;

Anna Schwartz says No.

I say yay!

Woodstock at 40

Warning: This is not an economics/finance post.
Woodstock at 40-year anniversary.

On Point Special Issue

China got a problem in foreign reserves

One country accounts for over 30% of world's total foreign currency reserve (see the chart below). This is not normal.

This huge piles of money can't get back into China, because it will cause inflation. In one way or another, it needs to be "recycled".

The recycling previously took the form of buying US treasuries, partly contributing to the flood of global liquidity and housing bubble. Now after the bubble burst, and the yields on US treasuries almost give nothing in return, China faces a problem in finding its next "dollar recycling" channel.

US government offered to sell inflation-protected treasuries, but China still seems to be very worried about the prospect of the dollar.

There are not many options left on the table. Since when you got the money but you don't know where to spend?

Option 1: acquire foreign assets, especially foreign natural resources to secure the supply of China's high growth. This is what China has been doing, but I am sure it will stir some controversies. Nobody will feel comfortable in selling their natural resources to a country that is non-democratic and to firms largely controlled by the government. Well, you will hear "new colonism", that's for sure.

Option 2: use the dollar to purchase advanced manufacturing and research equipment that will increase China's productivity in the future. This seems to be a smarter way to spend the money, but China faces a lot of import restrictions, mainly from the US. The US policy makers still treat China as a potential rival, not ally. That's the problem.

Friday, August 14, 2009

Compare historical rallies

Summer is near its end; time to ponder where the market will be headed next. After almost 50% rally since March, the market has gone too far ahead of the real economy, in my opinion. Every recession is different, but with jobless rate sure to go higher and no real demand from the consumption, the history may repeat itself: this does not bode well for the market, especially after a big housing bubble.

(click on the graph to watch the video; source: FT)

Humility and economic forecasting

We didn't forecast "Great Depression"; We failed to forecast this "Great Recession".

Obama's economists painted a rosy picture for their stimulus plan, now it turned out to be deadly wrong; Should we trust the Fed to do the job then?

Watch the following video clips and have some humility in prediction and forecasting.

Thursday, August 13, 2009

The Sq-root recovery

An intelligent discussion on where the US economy and the market are headed next. You have heard about V-shaped recovery, W, U, L, but what is a square-root recovery?

Wednesday, August 12, 2009

Warren Buffett's Successor

Sunday, August 09, 2009

Hot money on China's plate

With China's stock market up 97% this year, hot money is pouring in, reports WSJ:

Hot money is again flowing into China, and that could put Beijing in a quandary. Should the torrent continue, it could complicate policy makers' efforts to battle inflation. Should it reverse, property and stock prices will be hit hard.

[china money]

There isn't an easy solution to this, nor does Beijing have much control over the situation. Hot money, or the speculative inflows that aren't explained by direct investment or trade, finds its way around China's tight grip on capital flows.

Its return became evident when Beijing reported last month that foreign-exchange reserves rose $178 billion, the most ever, in the second quarter. Analysts at UOB Group estimate that as much as $83 billion of this could be hot money, much of that flowing into stock and property markets and contributing to forming bubbles in both. The Shanghai Composite is up 97% so far this year.

[The further China moves away from economic crisis, the greater the anticipation that yuan revaluation will continue. ]

Gains in the value of the yuan could be substantial over the long term.

Two factors could keep the funds flowing in: expectations that Beijing will soon begin to raise interest rates, and a sense that, after being halted for a year, the revaluation of the yuan could resume. The yuan's revaluation has always been a motivation for hot-money investors.

Beijing could discourage the inflows by signaling that it won't live up to these expectations. A change in global sentiment would do the same: As investors retreated around the world in late 2008 and early 2009, some $173 billion of hot money flowed out of China, UOB estimates.

Alan Blinder comments on July employment report

Saturday, August 08, 2009

Abby Cohen on the market

Abby Cohen, sr. investment strategist at Goldman Sachs talks about her view on the market. She thinks the recovery will be led by inventory rebuilt, and the S&P 500 is likely to achieve 1050-1100 range by year end.

Thursday, August 06, 2009

China may be changing stand on climate talk

I am not a big fan of using emission cap to fight pollution. There are better ways to combat climate change, such as carbon-tax. And the US should do more to conserve energy; China also needs to realize achieving energy efficiency is in its own interest. Report from WSJ:

China signaled a slightly softer position on accepting a cap on the emissions that cause global warming, despite expressing frustration at the lack of a breakthrough on climate-change talks.

Disagreement over whether China and other developing countries should accept such emissions caps is a key impediment to negotiating a successor pact to the 1997 Kyoto Protocol on climate change in time for a planned December meeting in Copenhagen. China and the U.S. in recent months have made reaching a deal in time for Copenhagen a central element of their bilateral relationship.

Yu Qingtai, China's special envoy for the climate-change negotiations, emphasized the importance of reaching a deal. "The talks on climate change have been going on quite slowly. We only have a few months left before Copenhagen," said Mr. Yu, who welcomed efforts by the U.S. to pass a domestic climate bill. "The nature of the problem is such that we can't afford a failure."

Replacing the old pact, which expires in 2012, will be high on the agenda when U.S. President Barack Obama meets Chinese President Hu Jintao on the sidelines of a United Nations meeting in New York in September, and again when Mr. Obama visits China later in the year.

So far, China has refused any limits on emissions, arguing they would be a form of economic discrimination against poorer countries. China also says that 20% of its carbon emissions comes from products made for export and that it shouldn't bear the burden.

But China appears to have shifted subtly recently, with some influential Chinese economists arguing that China might soon be rich enough to afford some of the changes necessary to combat global warming.

Mr. Yu also offered a sign that China is taking the first steps toward figuring out how much it could cap while still growing enough to reach its economic goals. He said Chinese scientists were looking at what would be China's peak emissions, or the level at which economic growth could continue and emissions could be cut back.

China and the U.S. are still miles apart. China, driven by a historically unprecedented wave of urbanization and industrialization, has recently surpassed the U.S. as the top emitter of greenhouse gasses. But Beijing insists that rich industrialized countries have a responsibility to clean up first.
Rich countries like the U.S. should cut their emissions at least 40% from their 1990 levels by 2020, China says -- a schedule much more aggressive than ones being considered in the U.S. or Europe. In addition, China wants money and technology for itself and other developing nations to smooth the adjustment to a low-carbon economy. "This isn't charity, but their responsibility," Mr. Yu said.

On the other side, countries like the U.S. say big countries like China and India are growing so fast that, unless they accept absolute limits on their greenhouse gasses, the extra pollution from all of their new factories obliterate gains made elsewhere, gutting the value of any deal.

Winning portfolio in the face of inflation-deflation uncertainty

How to build a portfolio that are both inflation and deflation proof (from WSJ):

Inflation or deflation?

Even the experts can't agree whether rising or falling prices lie in our future.

That leaves investors in a quandary: how to construct a portfolio at a time of great uncertainty. A wrong bet could be devastating. If your portfolio is built for deflation, for example, your assets will slump if the country instead experiences a bout of inflation.

The answer is to prepare for the economic scenario you think is most likely, and then build in some insurance in case you are wrong.

[Building a Portfolio]

"If you want to win the war," says Rich Rosso, a financial consultant at Charles Schwab, "you have to own both sides of the fight to some degree."

Such an approach necessarily means some investments will suffer no matter how the economy turns. That is OK: Buying insurance doesn't mean you actually want to use it.

Here are three portfolios, each with built-in insurance. The first will do best in an inflationary period but won't be crushed if deflation instead rules the day. The second is for investors who fear deflation, but want some protection against potential inflation -- even if it is down the road. And the third is aimed at investors who believe the economy will muddle through without severe inflation or deflation.


If you believe all the government spending in response to the financial crisis will ultimately beget inflation, you want a portfolio that thrives in a period of surging prices.


Commodities are the primary play, because everything from oil and corn to copper and pork bellies should gain. Plus, commodities -- particularly gold -- hedge against the dollar, offering a 2-for-1 benefit if a weak dollar accompanies inflation, as some expect.

Since commodities contracts can be a hassle for individual investors, consider a fund such as Pimco's CommodityRealReturn Strategy Fund, which offers exposure to a broad swath of industrial and agricultural commodities.

Though it seems counterintuitive, cash can do pretty well, too. The Federal Reserve would likely fight rising inflation by pushing up short-term interest rates, allowing investors with cash to capture the escalating rates through short-term certificates of deposit and money-market accounts.

Michele Gambera, chief economist at Ibbotson Associates, says his research shows that in the last five bouts of meaningful inflation, returns on cash essentially matched the inflation rate, meaning it isn't losing its purchasing power. Online banks and local credit unions tend to offer the highest rates.

Treasury inflation-protected securities, or TIPS, are an obvious investment since their principal adjusts upward along with inflation. TIPS exposure is available through mutual funds, such as the Vanguard Inflation-Protected Securities Fund, though Steven Fox, director of forecasting at Russell Investments, notes that holding individual bonds to maturity is more effective as an inflation hedge since "the majority of the inflation protection comes when the inflated principal is repaid." Individual TIPS are available through brokerage firms or

Sharp inflation is generally a negative for stocks, because rising interest rates potentially pinch corporate profits and undermine economic growth. But a few stocks will likely do fine. Start with energy and metals stocks because higher prices for their commodities will boost earnings, says Mark Kiesel, a managing director at Pacific Investment Management Co., or Pimco. Include as well U.S. firms with pricing power, such as regulated utilities, domestic pipeline companies and manufacturers of specialty materials. Examples of companies to consider: miners such as Freeport-McMoRan Copper & Gold and energy giant Exxon Mobil, or companies indirectly tied to commodity prices, such as driller Diamond Offshore Drilling, farm-equipment company Deere and seed supplier Monsanto.

Insurance Component: Long-term Treasury bonds and municipal bonds.

Both will likely soar in value amid deflation because their long period of fixed payments would be an attractive source of income as prices for goods and services broadly fall, and as paychecks shrink. And Treasurys, in particular, would likely become a haven for foreign investors, further pushing up their price.


Portfolio preparation is easier for deflationists: Put a chunk of money into long-term Treasury bonds and much of the rest into cash and some municipal bonds.

If broad-based deflation materializes, long-term Treasurys are likely to surge. The bonds' fixed-income stream, meanwhile, would be worth increasingly more relative to falling consumer prices.

Some investment-grade municipal bonds could serve a similar role while also providing tax advantages for high-income earners. But beware: Deflation would likely mean some taxing authorities struggle to service bonds reliant on a specific income stream, like user fees. Instead, stick to "investment-grade bonds tied to necessary services like water and sewage, power or necessary government offices like, say, a courthouse building," says Marilyn Cohen, president of bond-investment firm Envision Capital.

Round out your deflation portfolio with a big slug of cash. Though it won't generate much of a return in a low-rate, deflationary environment, cash in the bank will gain value as prices fall.

Insurance Component: Commodities react most drastically to surprise inflation, so they should be part of your insurance. Add in TIPS, too, and stocks geared "toward consumer-staple companies," says Ibbotson's Mr. Gambera. If inflation arises, companies such Coca-Cola, tobacco giant Altria, and toothpaste maker Colgate-Palmolive will have some pricing power.

Goldilocks Economy

[Goldilocks economy] 

Maybe, just maybe, world bankers will get this right, and the economy will experience neither severe inflation nor severe deflation.

"We think most likely the central banks of the world will get this close enough to right that we will settle in close" to a relatively benign inflation rate of between 1.5% and 2.5%, says Aaron Gurwitz, head of global investment strategy at Barclays Wealth.

In such a "Goldilocks" scenario -- where the economy is neither too hot nor too cold -- "risky assets would do best, so equities and bonds with some equity characteristics should receive the emphasis," says Scott Wolle, portfolio manager of the AIM Balanced-Risk Allocation Fund.

That means broad exposure to large-cap and small-cap U.S. stocks through funds such as the Vanguard 500 Index Fund or the Bridgeway Small-Cap Value fund; and exposure to developed and emerging markets through funds like the Vanguard Total International Stock Index Fund (mainly developed markets), and the T. Rowe Price Emerging Markets Stock Fund.

For the bond component, pick a fund such as the Fidelity Total Bond fund that largely owns high-grade, intermediate-term corporate bonds and mortgages, along with government and agency debt.

Insurance Component: Just in case the Goldilocks scenario is wrong, you will need insurance against either inflation or deflation. Pick up inflation protection through a commodity ETF, and deflation protection with long-term Treasurys. Cash also is OK in either situation.

Wednesday, August 05, 2009

Leveraged ETFs bring out-of-whack performance to investors

Here is a follow up on my previous post on leveraged ETFs. Case in example is financial 3x ETFs: no matter what direction you bet, you lose.

(click to enlarge; graph courtesy of BeSpoke Investments)

Tuesday, August 04, 2009

Bernanke's exit dilemma

Bernanke has the tools to drain liquidity out of the system, but does he have the will to do so? (source: WSJ)

Federal Reserve Chairman Ben Bernanke assured readers of this page ("The Fed's Exit Strategy," July 21) that he has the tools to prevent the huge reserves he's pumped into the banks from generating an inflation that would abort an economic recovery.

But does the Fed have the guts to use those tools? Will it risk censure from Congress and the Obama administration if it tightens money at the crucial juncture when inflationary omens accompany a reviving economy? Mr. Bernanke signaled the probable choice by writing that "economic conditions are not likely to warrant tighter monetary policy for an extended period."

The Fed's past record of judging when and how to use its tools for regulating the money supply is not impressive, particularly in times of economic distress. Its financing of large federal deficits in the mid-1970s sent inflation up to an annual rate approaching 15% before Jimmy Carter repented in October 1979 and installed Paul Volcker at the Fed with orders to kill the monster.

More recently, the Fed's continued easing of interest rates during the 2003 economic recovery created the credit bubble that collapsed last year with such devastation.

The Fed's difficulties in getting money policy right stretch back to its creation in 1913. In 1930 it starved the banks, creating a string of failures that worsened the effects of the 1929 stock market crash. In 1937, it starved them again, contributing to a prolongation of the Depression that had been manufactured in Washington by the clumsy taxation and interventionist policies of Herbert Hoover and FDR.

To be sure, the Fed has had its good years. It financed the 20-year period of low-inflation growth and prosperity that began in 1983 when the Reagan tax cuts became fully effective.

But because of its often self-contradictory double mandate to promote both monetary stability and full employment—plus the rap it has taken from economists like Mr. Bernanke for stinginess in the 1930s—it often overreacts to recessions with excessive generosity. With its federal-funds interest rate target at near zero, the spigots are now wide open. And as Mr. Bernanke promises, they will likely remain that way for an "extended period."

Quite apart from the question of the Fed's will, there is another large issue. Mr. Bernanke's assurances to the contrary, there can be doubts about whether his tools are really adequate to deal with the powerful inflationary pressures the politicians are in the midst of creating in the form of a mountainous and rising federal deficit.

Mr. Bernanke showed that he is well aware of that danger when, in his semiannual report to Congress on July 21, he pleaded with that body to bring the deficit under control. The federal budget deficit is projected at an incredible $1.8 trillion for the fiscal year ending Sept. 30, almost half of proposed federal spending. The Treasury's financing needs will be even higher than that when you count in the various "investments" the government has made in auto, housing and other dubious ventures.

But the day after he issued that plea, President Barack Obama was pleading with the American people to support his nationalized health plan. This plan would yet add hundreds of billions more to the deficit.

The Fed has been financing a significant part of the government's profligacy, and it is riding a runaway horse. Even if it has the means to cope with present financing needs, will it be able to do so when, and if, the economy actually recovers and it has to finance both a recovery and a spending-crazed government?

Martin Hutchinson, a former merchant banker who blogs as "Prudent Bear," wrote in May that the German Weimar Republic was monetizing 50% of government expenditure when in brought on the ruinous hyperinflation that destroyed the mark in the early 1920s. The Fed in May 2009 had monetized 15% of federal expenditures over the preceding six months—well short of the rate that destroyed the German economy, but not negligible.

The Treasury (and Congress) has been depending on the Fed's massive buying of Treasury bonds to keep the government's financing costs within reasonable bounds—as weakening international demand puts downward pressure on bond prices and upward pressure on the interest rate the Treasury must pay. The yield on the 10-year Treasury bond is below where it was a few weeks ago but well above early this year when investors world-wide were seeking the safety of U.S. Treasurys. Even massive Fed support hasn't been enough to prevent slippage in bond prices this year.

The Fed has more than doubled the size of its balance sheet in the last year to over $2 trillion. As of July 30, it held $695 billion in Treasurys, up $216 billion from a year earlier. In addition, it has added nearly half a trillion of mortgage-backed securities it purchased to keep Fannie Mae and Freddie Mac, now wards of the government, afloat.

Adjusted reserve balances of member banks exploded in late 2008, soaring to $950 billion from $100 billion in four months as the Fed has pumped liquidity into the banking system. They peaked at nearly $1 trillion in May. The reserves provide banks with a shield against runs but they also are high-octane fuel for bank lending, which means they can touch off another credit bubble, and the accompanying inflation, when credit demand picks up again.

In his Journal op-ed, Mr. Bernanke listed ways he can keep this monster in check. The Fed can pay interest on the bank reserves it holds. This would lessen the incentive of banks to find private borrowers and keep some reserves out of the credit stream, damping inflation potential. But the net effect would be to add still more liquidity to the system, which would run counter to the longer-term goal of mopping up liquidity.

He said that the Fed could also sell securities to the banks with an agreement to repurchase them, but these "reverse repos" would only mop up liquidity temporarily.

The standard way for the Fed to soak up liquidity, mentioned last on Mr. Bernanke's list, is to sell Treasurys to the banks. That would draw down bank reserves and reduce their inflationary potential. Under the Basel I international banking rules, Treasurys are zero-risk investments and don't have to be matched at 8% of their value with additional capital, as does private lending.

With the huge volume of Treasury financing coming down the road, the Fed will have plenty of bonds to sell (it already has, in fact). But the Fed buys Treasurys primarily by creating new money, or in other words by inflating the money supply. Will it have the nerve or even the capacity to "sterilize" inflation by reselling the bonds to soak up bank liquidity? Again, there are those political pressures. Will the Fed's admittedly bright money managers be able to strike a balance between warding off inflation and leaving the banks with sufficient liquidity to finance an economic recovery?

As to that huge volume of mortgage-backed securities the Fed is now holding, what is to be done with them? They are "toxic," which is why the Fed bought them as a means of keeping Fannie and Freddie solvent. They are "guaranteed" by Fannie and Freddie, which means they now are guaranteed by the U.S. Treasury. So they are yet another liability to add to all the other liabilities being piled on the Treasury. The Fed already has financed them once; will it have to finance them again when they come up for redemption?

In short, there are very good reasons to doubt that the Fed can cope with the political problems of avoiding inflation. The technical problems don't look very easy either.

Monday, August 03, 2009

Can country prosper without manufacturing?

It is still an open question whether a country can prosper without a strong manufacturing industry.  In this excellent analytic piece from The Wall Street Journal, Timothy Aeppel discusses the future of America's manufacturing industry and the competition it faces, especially from China. 

Contrary to common belief, the US still maintains a quite large manufacturing base: in fact, the sector generates more than 13% of the nation's GDP, making it bigger than retail trade, finance or the health-care industry.  But the recent estimate puts China ahead of the US in manufacturing by 2015.

So should the US just focus on its services industry, and let more and more factories move to China?  Or is there a better solution?

China's Gains in Manufacturing Stir Friction Across the Pacific

China is on its way to surpassing the U.S. as the world's largest manufacturer far sooner than expected. The question is, does that matter?

In terms of actual size, the answer is, no. But if size is a proxy for relative health of each nation's sector, the answer is yes.


Anyone who walks the aisles of a U.S. retailer might think China already is the world's largest manufacturer. But, in fact, the U.S. retains that distinction by a wide margin. In 2007, the latest year for which data are available, the U.S. accounted for 20% of global manufacturing; China was 12%.

The gap, though, is closing rapidly. According to IHS/Global Insight, an economic-forecasting firm in Lexington, Mass., China will produce more in terms of real value-added by 2015. Using value-added as a measure avoids the problem of double-counting by tallying the value created at each step of an extended production process.

As recently as two years ago, Global Insight's estimate was that China would surpass the U.S. as the world's top manufacturer by 2020. Last year, it pulled the date forward to 2016 or 2017.

"The recent deep recession in U.S. manufacturing does mean that China's catch-up is occurring a few years earlier than would have been the case if there had been no recession," says Nariman Behravesh, the group's chief economist.

U.S. manufacturing is shrinking, shedding jobs and, in the wake of this deep recession, producing and exporting far fewer goods, while China's factories keep expanding. If manufacturers on both sides of the Pacific were thriving, there would be little reason to butt heads. But given the massive trade gap between the two nations and uncertainty in the U.S. over when and to what degree manufacturing will recover, China's ascent has become a point of growing friction.

Chinese manufacturing activity continued to tick up in July from the previous month, data from the China Federation of Logistics and Purchasing showed Saturday. The Purchasing Managers Index edged up to 53.3 in July, from 53.2 in June and 53.1 in May.

Many economists argue that the shrinking of U.S. manufacturing -- both in terms of jobs and share of gross domestic product -- is a normal economic evolution that started long before China emerged as a manufacturing powerhouse. From their point of view, the shrinking would happen regardless and is actually a sign of health that the sector doesn't need to be big to be productive and is shedding low-skill jobs and creating select higher-skill ones.

Global Insight's Mr. Behravesh is one of those who views China's rise as normal, even healthy. "In the natural course, countries go from agriculture to manufacturing to services," he says. "To subsidize manufacturing pushes [the U.S.] backwards down that curve."

But another school of thought -- one known by the somewhat backhanded label of "manufacturing fundamentalists" -- contends the U.S. decline isn't natural and must be reversed to retain America's economic power. From their perspective, that necessitates fighting Chinese policies that fuel low-cost exports, swamping a variety of industries from textiles to tires.

"The notion that we can be a nonmanufacturing society is folly," says Peter Morici, an economist at the University of Maryland. "It's pseudo-science that gives rise to the collapse of civilizations."

The Obama administration is stepping carefully through this minefield. At a two-day conference last week, the first meeting of a new forum designed to foster closer cooperation between the two countries, China's tightly managed currency policy was barely discussed even though it is a hot-button issue for many U.S.-based producers and organized labor. They argue that China undervalues its currency to gain a competitive advantage for its exports, which sell at a lower price in the U.S.

The U.S. Business and Industry Council, which represents U.S.-based manufacturers, accused the Obama administration of "panda-hugging." The administration earlier this year softened its stance on the issue when it declined to label China a currency manipulator.

John Engler, president of the National Association of Manufacturers, says he doesn't expect China to surpass the U.S. before 2020. "It may or may not continue to grow so rapidly," he says. "The importance of the China challenge to the U.S. depends on how we respond to it," such as implementing tax and investment policies that encourage domestic producers to expand.

Mr. Engler's group faces a delicate issue of its own regarding China: Many of its powerful members produce in China and are eager to avoid controversy on trade issues, while the group's large roster of smaller members are often outspoken critics of China.

Even in its weakened state, manufacturing remains a surprisingly large part of the U.S. economy. The sector generates more than 13% of the nation's GDP, making it a bigger contributor to the economy than retail trade, finance or the health-care industry. In China, manufacturing represents 34% of GDP.

Still, the concern remains that U.S. manufacturers now being hit by the economic downturn will never recover. J.B. Brown, president of Bremen Castings Inc., a family-owned foundry in Bremen, Ind., says the downturn has halted what had been a hopeful trend that emerged last year of work returning to the U.S. from China.

"I see a lot of people starting to look at going overseas again," he says, in part because costs are rising in the U.S. even in the depth of this recession. He notes, for instance, that Bremen's electricity rates jumped 17% this year -- and the company has been warned they could increase even more next year. Foundries like Bremen use large amounts of electricity to heat metal.

Sunday, August 02, 2009

Where is housing headed?

During this past week, we've had some really positive news on the housing market.

Sales of existing homes rose last month for the third consecutive time, while sales of new homes rose in June by the largest percentage in eight years. Better yet, the Case-Shiller housing price index rose 0.5%, the first month-over-month increase in the index in 34 months (dating all the way back to July 2006).

The increase of Case-Shiller price index is especially important, because it seemed to signal the housing price has turned the corner (see graph below). No wonder everybody is saying the housing has hit the bottom!


(graph courtesy of Bespoke Investment)

Or has it?

A closer look at the data makes me pause ---We may have seen the worst, but the housing market correction is far from over.

First, most mass media have chosen not to mention the price increase was largely due to seasonality. The folks at CaculatedRisk have done a great job demonstrating such seasonal effect.

As shown in the graph below (click to enlarge), house buying clearly exhibits a seasonal pattern: the spring season is the busiest, especially from March to May, then the buying activities gradually die down in the 2nd half the year.

Since Case-Shiller price index is a 3-month moving average, so the recent May price index is an average of previous 3 months, from March through May, which also happen to be the busiest months.

In the following graph, the price index is shown in terms of percentage change of month-over-month. The seasonal pattern again is very obvious. In the spring, we always see a peak of the price, then the trend sharply reverses. Watch, for example, how the trend had reversed in the second half of 2008.

What to take away is that even the recent price increase is the first since 2006, it won't be surprising if we find the price starts to decline again later in 2009. In fact, if you compare the May price with the price of the same month a year ago (in 2008), the index was actually down 17.1%.

Secondly, down to the micro level, the recent buying activities and the gradual warm-up of the price were the result of aggressive government interventions. The real correction may still come later. The Fed has been buying mortgage backed securities and ten-year treasuries, successfully pushing down mortgage rates to the historical low; And Obama government is sending out $8,000 checks to the first-time home buyers, providing them with great buying incentives.

However, most of the buying activities happened in the lower-end of the market and a lot of young buyers rushed into the market just to take the advantage of incentive measures, afraid of losing this "golden opportunity" in a lifetime, without considering their current income and affordability.

Some of these buyers are making the same mistakes that buyers had made before the housing bubble burst: they often leverage too much into the housing and continue to believe housing market will come back soon and expect to make a profit out of home value appreciation.

Finally, let me put the current housing bubble and correction into historical perspective, and explain why I think the housing correction is far from over.

The graph below shows how far speculators and frenzy buyers had pushed house prices since early 2000s: from level of 100 (normalized at year 2000) to over 225, then the bubble burst. The current level stands at 150, back to the mid 2003 level, but it is still way too high by historical standards: 50% above pre-bubble level in 2000, and almost doubles the average level of 75 over the preceding two decades.

History teaches us housing bubble often brings painful correction after it bursts, and the correction process is usually gradual and slow, taking many years to complete. Government intervention of the correction process only delays the inevitable; it won't solve the problem.

The following graphs, taken from David Rosenberg, former chief economist at Merrill Lynch, nicely capture the extraordinary nature of the current housing bubble, from different angles.

The first graph shows now it takes home builders almost 12 months to find buyers. The average length was only five months, before the housing bubble burst.

The second graph shows although housing inventory was down, it still remains at historical high level, both for existing homes and new homes.

And boy, there are still too many houses waiting to be sold:

The last graph shows American home-ownership is in a process of mean-reverting. Some people got lured into buying houses they never could afford, and now they are paying the price.