EU Revives Buyback Idea as Crisis Hits Italy

European finance ministers revived the prospect of bond buybacks to ease Greece’s plight and declined to rule out a temporary default, struggling to contain the debt crisis as investors pounded Italy, the continent’s third-largest economy.
Prodded by investors and the European Central Bank, the euro’s guardians said a bailout fund set up last year may be used to buy bonds in the secondary market or enable Greece to retire its debt at a discount. They offered another cut in rates on its emergency loans.
As exploding bond yields in Italy and Spain brought the crisis closer to the heart of the euro area, Europe’s search for answers took it back to proposals that were scuttled by Germany earlier this year. After a nine-hour meeting, the 17 euro ministers issued a six-paragraph statement pledging to flesh out details of a new strategy to end the 21-month-old crisis “shortly,” without setting a timeline.
“There are a variety of ways of enhancing the flexibility,” European Union Economic and Monetary Affairs Commissioner Olli Rehn told reporters late yesterday after the ministers met in Brussels. Buybacks are “one of those. I would at this stage not exclude any option. But instead we are exploring these possibilities.”
The decision to have another look at reinforcing the European Financial Stability Facility, the 440 billion-euro ($618 billion) bailout fund that was beefed up only last month, came after talks with bondholders over a “voluntary” rollover of Greek debt ran into a threat by credit-rating companies to put Greece in default.

Bonds Plunge

Financial markets growing impatient with the EU’s response punished its most debt-ridden states yesterday, with bonds plunging across the periphery, the euro sinking to a seven-week low and declines in banks and insurers depressing European stocks.
“The time for talking is over as Europe needs to take action fast,” said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. “It may already be too late as there is already contagion with the bond market vigilantes moving on from Greece to Italy and Spain.”
Finance ministers offered varying interpretations of the commitment to explore a wider range of options. For Dutch Finance Minister Jan Kees de Jager, who insists on getting bondholders to roll over Greek debt, the pledge includes the possibility of the “selective default” opposed by the ECB.

‘Explore’ Default

“I cannot say whether or not it will include selective default in the end result, but we can explore the options,” De Jager told Bloomberg Television.
The statement singled out the ECB as opposing a “credit event or selective default.” Luxembourg Prime Minister Jean- Claude Juncker, the meeting’s chairman, said this doesn’t mean that European governments “would do everything in order to provoke a credit event.”
Greece, the trigger of the debt shock, was the only country mentioned. Juncker said the reassurances are “offering adequate responses” to concerns about Spain and Italy as well.
Europe’s lunge back to basics came after Greek Prime Minister George Papandreou complained that a “cacophony” had sowed “panic” that overwhelmed the budget cuts that he pushed through his parliament amid street riots last month.
The uphill struggle for solvency in Athens was dramatized by data yesterday showing the central government’s deficit widened 28 percent in the first half of 2011, with spending surpassing targets and revenue falling short.

Greek Loan

Greece last week obtained European and International Monetary Fund assurances of a loan payout of 12 billion euros in July, part of the 110 billion-euro package it was awarded in May 2010.
A second package will also include lower interest rates and longer repayment times for official loans, the statement said. In a nod to demands by Finland and Slovakia, it said Greece might be required to put up collateral.
In a letter to Juncker, Papandreou also said a French bond- rollover proposal under discussion with banks was potentially “too expensive, too little and too dangerous” and might tip Greece into formal default.
With Greek 10-year debt fetching less than 55 cents on the euro, buybacks were forced back onto the table by the Institute of International Finance, a group representing more than 400 banks and insurers that has tried to broker an accord on the French proposal.

Buybacks

Rejected by Germany earlier this year, the buybacks would pare Greece’s debt burden of 142.8 percent of gross domestic product by enabling it to retire bonds at a discount.
In discussions that wrapped up last month, Germany blocked proposals to add buybacks to the bailout fund’s toolkit, opposing the use of taxpayer money to help countries like Greece wriggle out of their debt.
German Finance Minister Wolfgang Schaeuble came to yesterday’s meeting opposed to a further reinforcement of the fund, saying there is “no discussion whatsoever” of another boost to its firepower. He wasn’t asked about buybacks. He is slated to speak to reporters after the meeting ends later today.
Italy, a focus of German concern in the 1990s runup to the euro with debt over 100 percent of GDP, returned to the forefront as investors dumped Italian bonds and stocks. Italy now has Europe’s second-highest debt load, at 119.0 percent of GDP in 2010.

Spread Widens

Italy’s 10-year bond spread over Germany surged to 301 basis points, a euro-era high. The extra yield, a sign of investors’ skepticism about Italy’s fiscal health, has more than doubled from a 2011 low of 122 basis points on April 12.
Italian assets were upended by doubts whether Prime Minister Silvio Berlusconi, plumbing record-low approval ratings with two years left in office, will muster the strength to push through 40 billion euros in planned deficit-cuts.
The bond rout engulfed Spain, the fourth-largest euro user. Spanish 10-year yields climbed 36 basis points to 6.04 percent, stretching the spread over German debt as wide as 336 basis points, also a euro-era record.
Finance ministers also signed a treaty to establish the European Stability Mechanism, which will replace the temporary fund in mid-2013 and include provisions for a private-sector role.
Euro-area governments will put 700 billion euros of cash and callable capital into the ESM, giving it the capacity to lend 500 billion euros. It requires unanimous government ratification to go into operation.
To contact the reporters on this story: James G. Neuger in Brussels at jneuger@bloomberg.net; Jonathan Stearns in Brussels at jstearns2@bloomberg.net
To contact the editor responsible for this story: James Hertling at jhertling@bloomberg.net

Italy races to forefront of Europe debt crisis

Italy moved with alarming speed from the fringe of the European Union’s financial crisis to its very centre as efforts to prevent the debt contagion from spreading beyond Greece, Ireland and Portugal failed, even threatening to engulf the United States.
Plunging prices for trading in Italian debt presented Brussels with a nightmare scenario: The potential bailout of the third-largest economy in the euro zone could be unaffordable and could result in the destruction of the common currency.

The spread to Italy is disturbing evidence that even the largest economies, none of which seemed to share any of the worst economic traits of Greece, are not immune from investors’ fears that debt loads are simply becoming too big to be paid off. Waning growth in the Western world is only intensifying the belief that debt defaults may be inevitable, a potentially catastrophic scenario that would slaughter the banks and cut off the credit required to keep companies functioning.
Markets fell around the world on Monday, hitting virtually every stock index and commodity. Oil lost 1 per cent, an indication that the markets think the debt crisis will crimp global growth. The euro took a beating, losing 1.5 per cent against the dollar. The failure among EU finance ministers to agree on new bailout terms for Greece added to the tension.
EU finance ministers, who met Monday to discuss Greece ahead of a regularly scheduled session, reiterated their vow to safeguard financial stability and said they are prepared to bolster “the scope and flexibility” of the existing bailout fund, known as the European Financial Stability Facility. The changes, they said in a statement released Monday night, would lengthen the bailout loan maturity dates and drop their interest rates. Greece has already been treated to lower bailout loan costs.
Whether new bailout terms will help Greece or other rescued countries avoid default remains an open question. Many economists believe nothing but a default, followed by debt reduction of 50 per cent or so, would allow Greece to support its debt.
The Italian bond selloff, coupled with rapidly sinking Italian bank share prices, sent European leaders into damage control mode on Monday. German Chancellor Angela Merkel, whose country is the single biggest contributor to the bailouts of Greece, Ireland and Portugal, urged Italy to take rapid action to contain the crisis. “Italy must send an important signal by agreeing on a budget that meets the need for frugality and consolidation,” she said at a press conference in Berlin.
Italy’s economy is as big as Britain’s and bigger than Canada’s. Most economists think it would be too big to bail out. Italy’s turmoil “adds a new ingredient to Eurostress,” Deutsche Bank economist Gilles Moec said.
A group of European banks that own the battered debt of Greece and other weak countries pleaded for the EU to buy back the debt. “It is essential that euro-area member states and the [International Monetary Fund] act in coming days to avoid market developments spinning out of control and risk contagion accelerating,” the banks said in a paper presented Monday to finance ministers of the euro zone, the 17 EU countries that share the euro.
Giulio Tremonti, Italy’s embattled finance minister, said he would “send the markets a strong signal,” promising that measures to reduce the budget deficit would be “armour-plated” and approved by parliament within a week, an extraordinarily quick pace by Italian standards.
The Italian cabinet recently approved €47-billion in spending reductions and tax hikes between now and 2015, but the bulk of the austerity program comes in the last two years, leading to speculation that Mr. Tremonti will be forced to accelerate the program to scare off the investors who are betting that the Italian debt markets have nowhere to go but down.
Italy was supposed to be contagion-proof and some economists think the plunging bond prices are unwarranted even if the Italian economy has stalled and the political landscape is unstable, thanks to Prime Minister Silvio Berlusconi’s never-ending sex and corruptions scandals.
They note, for instance, that Italy’s budget deficit – the difference between the amount it takes in and the amount it spends – is expected to be only 4 per cent of gross domestic product this year, down from 4.6 per cent in 2010. Italy’s 2011 figure is below the euro zone’s average expected deficit and well below Britain’s (7.6 per cent) and the United States’s (10.4 per cent), according to the latest Deutsche Bank forecasts.
But Italy’s many other problems have attracted the attention of the debt-ratings agencies and the investors who think they can make fortunes by betting against Italy’s bonds and banks. The problems range from open warfare between Mr. Berlusconi and Mr. Tremonti over the required severity of the austerity program – Mr. Berlusconi wants lower taxes – to an overall debt load second only to Greece’s, at 120 per cent of GDP. Italy’s market debt is €1.6-trillion.
Italy’s bond prices have been waning since Greece was bailed out 14 months ago, sending bond yields, or interest rates, ever higher (bond prices and yields move inversely), but never to the point of genuine crisis. The downward pace accelerated in mid-June, when the debt-ratings agency Moody’s put Italy’s bonds on debt alert, meaning it was likely to downgrade their creditworthiness. The bond prices went into virtual free fall last week.
According to economists and investors, the trigger events were the downgrading of Portugal’s debt to “junk” status last week; the slow pace of launching Greece’s second bailout as the first bailout, worth €110-billion, proves insufficient to prevent a default; Italy’s renewed flirtation with recession as growth dips; and a plainly uncompetitive economy that, like Portugal’s, has proved resistant to reform since the euro was born a dozen years ago.
The sense that the debt crisis is spreading beyond Europe and about to grip the United States, where budget talks are in stalemate as the government bumps into its borrowing limits, has only fuelled the debt-contagion fires.
Last week, the yields on Italian sovereign bonds hit their highest level since 2002 while Spanish bond yields came close to their recent record highs. Italian banks, which own almost a third of the country’s sovereign debt, took a beating on the stock market. UniCredit, one of Europe’s biggest banks, fell nearly 20 per cent last week and lost another 6 per cent on Monday, taking the one-week loss to an astounding 24 per cent. Mediobanca, Italy’s biggest investment bank, lost 3.7 per cent last week and dropped another 4 per cent on Monday.
Italian bond yields have climbed from 4.62 per cent to 5.55 per cent in just five weeks, a record pace. The last time Italian yields were above 5 per cent was in November, 2008, at the very height of the financial crisis. “What would keep me awake at night if I was a European finance minister is that we are only about 2 per cent away from a potential disaster scenario,” said Gary Jenkins, fixed-income analyst in London with Evolution Securities.
He was referring to the ominous 7-per-cent yield mark. The bailouts of Greece, Ireland and Portugal all happened after their bond yields surged to 7 per cent, a level that is considered unsustainable. In a note published Monday, RBC Capital Market strategist Peter Schaffrik. called Monday a “historic day for Italy” as its bond yields reached record highs, threatening the rest of Italy’s planned bond sales this year.
Mr. Schaffrik said that Italy is running short of options as the debt crisis it did not expect suddenly comes on strong. “We are not very optimistic that a grand solution can be presented that will put the Italian genie back in the bottle,” he said.
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Italy’s problem
€1.89-trillion - Italy’s national debt. ($257-trillion Canadian)
€176-billion - The amount of Italian bonds that mature by December.
€2-billion - The rise in annual interest payments for each one-percentage-point increase in Italy’s average debt yield
6.33% - Share of Italian bank assets that is the country’s government bonds, a higher figure than 5 per cent for Spanish banks. In the euro area Italy is second only to Greece, where banks holds government debt equal to 10 per cent of their assets.
47% - Share of government debt held abroad.
- Reuters

Map of Europe's financial trouble

Courtesy of the Globe and Mail

Published Monday, Jul. 11, 2011 8:12PM EDT

Last updated Monday, Jul. 11, 2011 9:26PM EDT

In debt race, bond buyers wager on U.S.

The U.S. can do no wrong and the Europeans can do no right, at least in the eyes of bond investors.

Fearful investors are fleeing European bonds and other euro assets and pouring money into U.S. Treasuries, even though both face explosive debt problems.

The demand for Treasuries illustrates that investors expect U.S. policy makers to overcome their debt impasse long before the Europeans manage to come up with an enduring solution to their insolvency problems.

The failure of euro-zone leaders to devise a debt-restructuring plan for Greece that would not trigger bond defaults, and fresh worries that the crisis is spreading well beyond the confines of peripheral euro-zone nations to such key economies as Italy and Spain, is hammering the bonds of the more troubled countries.

On Monday, yields demanded by investors for the risk of owning Spanish or Italian debt jumped to the highest levels since the currency’s inception in 1999. Italy’s benchmark 10-year government bonds climbed 41 basis points to 5.68 per cent, a spread of more than 300 basis points above German bonds, regarded as the most secure in the euro zone. As recently as mid-April, the spread was only 112 points. Yields on 10-year Greek bonds are closing in on an astronomical 30 per cent.

The limping euro fell more than 1.5 per cent against the U.S. dollar and 1.8 per cent against the Swiss franc, as investors turned to what they regard as safer investments.

U.S. Treasuries remain firmly at the top of the must-own list, even in the face of a political logjam in Washington over the debt ceiling. As a result of the influx of capital, the greenback rose against 14 other currencies, including the Canadian dollar, while the yield on the benchmark 10-year U.S. Treasury bond plunged below 3 per cent for the first time in almost two weeks.

It was a remarkable display of confidence that U.S. policy makers will resolve their deep divisions over deficit cuts and lift the statutory borrowing cap, without which the government could face the first default in the country’s history. The U.S. Treasury has warned it will be out of funds by Aug. 2 if the $14.3-trillion (U.S.) debt limit is not raised by then.

After failing to broker a deal over the weekend between Republican and Democratic lawmakers on deficit reduction that would include raising the borrowing cap, U.S. President Barack Obama warned Monday that such a default could plunge the U.S. economy back into recession and inflict damage on global financial markets. But he ruled out any stopgap measure that would temporarily lift the borrowing cap. Republicans are adamant they will reject any deficit-reducing plan that includes tax increases. Most Democrats, including Mr. Obama, oppose cuts in spending on Medicare and other social benefits.

Yet as the clock ticks toward the Treasury deadline, global investors seem remarkably sanguine about the unfolding political drama.

In Europe, meanwhile, the markets have already concluded that a Greek default is inevitable. What worries investors is that delays in declaring the obvious are only making matters worse for other debt-ridden countries.

“Investors are extremely skeptical of everything the euro zone has done,” said Marko Papic, a senior analyst with Stratfor, a global intelligence company in Austin, Tex. “What we have seen so far is that every time the Europeans solve one issue, another one very quickly pops up.”

There seems to be no stomach for addressing the critical institutional problems at the heart of the current crisis. Investors regard the euro zone as broken, but politicians don’t seem to have the capacity or political capital to fix it.

“The markets started with the assumption the EU system would be able to fix a number of things, but it hasn’t been able to,” said Nicolas Véron, a senior fellow at Bruegel, a Brussels think tank. “The more [investors] see the EU institutions unable to fix situations – and the debate on private-sector involvement [in the Greek restructuring] has been quintessential in this respect – the more they take flight.”

The euro area has become the focus of the sovereign debt crisis, rather than the U.S., Britain or Japan – all of which have huge deficits of their own – because of the currency zone’s faulty design, said Edward Harrison, Washington-based founder of Credit Writedowns, a popular financial blog. While 17 countries share the common currency, there is no central fiscal authority or executive body capable of enforcing rules or addressing the vastly different levels of competitiveness within the region.

“The question in the U.S. is about political risk, not national solvency … That's why yields in Greece and Ireland are so much higher.”

Canadian malls growing in only one direction

frances bula

Special to Globe and Mail Update

Published Monday, Jun. 20, 2011 4:43PM EDT

Last updated Tuesday, Jul. 05, 2011 2:49PM EDT

When American and European retailers come to Canadian malls these days, they look around at the bustling crowds and see one thing: giant profits.

Our malls are hugely successful by international standards, with average sales of $680 a square foot per year. Some hot spots, such as the Yorkdale Mall in north Toronto, pull in more than $1,200 a square foot. The American average was $420 a square foot, according to 2009 figures. Only one mall beats Yorkdale: the Forum Shops at Caesars Palace in Las Vegas, with $1,400 a square foot, while others in Honolulu, New Jersey and Scottsdale range from $618 to $1,110.

Canadians have 39 per cent less mall space per capita than Americans, though those scarcer but more heavily used malls sell 45 per cent more product per square foot, according to participants at a recent Vancouver real-estate forum. This is not because of our climate, which is no more inhospitable than the northern states. Instead, Canadian cities have allowed fewer large regional shopping centres to be built since the mall heydays of the 1960s and 70s.

“Our malls are very strong. They enjoy so much retail sales because they are safeguarded against a lot of competition,” said Dianne Lemm, the principal broker for mall services with Northwest Atlantic Canada in Toronto.

That is why offshore retailers are pushing to come to Canada. Since the recession hit, that eagerness has only increased, as retailers noticed that Canadian consumers (and their banks) are in better financial shape than many others around the world.

The Minneapolis-based Target chain has found a way into Canadian malls by taking over Zellers sites. Accompanying Target in the push to get into Canada are two American companies that specialize in premium outlet malls. They’ve paired up with Canadian partners that are competing to build new malls across the country.

New Jersey-based Simon Property Group has formed a joint venture with developer Calloway REIT, and North Carolina-based Tanger has partnered with RioCan REIT. Both have announced they want to build in Halton Hills, a town 15 minutes west of Toronto with a large swath of rural land around it.

But any development is not going to happen as easily as it would in the United States, experts say. Due to the shortage of available land, the restrictions that many Canadian cities put on commercial space, and even the stringent demands of provincial highways ministries, mall developers are going to have to be creative and persistent.

“It will be difficult for them to get in. Especially in Vancouver; we haven’t built a mall in a long, long time,” said Scott Lee, a principal with Northwest Atlantic in Vancouver, where the last regional malls were built in 1979. “We’ve got much more stringent zoning.”

“The biggest issue we have in Canada is that if land is zoned for industrial or office, cities are adamant about preserving it,” says John Crombie, the national retail director at real estate brokers Cushman & Wakefield, who helped put together the Simon/Calloway partnership for Halton Hills.

Only two enclosed malls have been built in Canada since 1989 – Vaughan Mills in Toronto and CrossIron Mills in Calgary – because of that. Even places that have been mall-friendly in the past, such as Vancouver’s suburb to the east, Burnaby, no longer have room for them.

“The opportunities for development of new regional malls have substantially changed as urban communities have continued to grow and develop,” said Burnaby’s deputy planning director, Lou Pelletier. “Established communities like Burnaby have been increasingly focused on developing more urban, mixed-use town centres to support improved transit services, higher amenity urban living and more walkable, complete and compact communities.”

So how is expansion of retail space likely to happen?

First, many of the country’s 300 existing malls will expand upward on the land they already own to accommodate the horde of American and European chains wanting in, including Nordstrom, Macy’s, Juicy Couture, J. Crew, Vero Moda, Jack & Jones and more.

“We will see the expansion of regional shopping centres everywhere,” said Rick Amantea, vice-president of the Park Royal Shopping Centre in West Vancouver. The list of malls that have recently undergone expansions, have expansions under way or are planning them is long – from Yorkdale, under construction, to Park Royal and Oakridge in Vancouver, planning expansions, to the Chinook Centre in Calgary, which just completed its expansion.

Some new Mills-type malls – they combine standard mall shops with outlet stores, big-box stores and entertainment – will open on the edge of a few cities, says Ms. Lemm, including Tsawwassen Mills, which is being planned for First Nations land near Vancouver.

Premium outlet malls, featuring Ralph Lauren, Coach, The Gap, Crate & Barrel and more, will fight for prime spots in smaller communities close to big population markets.

Those malls will get a warm welcome. Mayor Rick Bonnette of Halton Hills, where both Simon/Calloway and Tanger/RioCan are looking to build their first premium outlet centres, is unreservedly enthusiastic. “To get an outlet mall like this is very prestigious,” Mr. Bonnette said. “It could create 500 jobs.”

In Abbotsford and Chilliwack, B.C., planners and politicians say they’re not averse to the idea of a destination outlet mall. And developers will undoubtedly be scouting towns around Edmonton, says Darren Snider, a principal at Avison Young there.

But every one of those enthusiasts say there could be barriers and slowdowns. In Halton Hills, Mr. Bonnette says that although the future outlet sites won’t have to go through a difficult rezoning, they will have to deal with Ontario’s Ministry of Transportation (MTO) to get the needed highway exit. “MTO, they’ll have some issues,” he said.

In B.C., the communities that lie at an ideal outlet-mall distance from Vancouver are desperately short of available land because of the province’s agricultural land reserve.

“The malls we have now were built on agricultural land,” says Chilliwack mayor Sharon Gaetz. “We don’t want to replicate that.”

Special to The Globe and Mail

Morgan Stanley to Lose Highly Secretive, and Colorful, Trader

At Caffe Vivaldi in New York’s Greenwich Village, Peter Muller bangs out a repertoire full of Carole King riffs on the piano along with his own soft-rock compositions that draw on the likes of Van Morrison and Cat Stevens.
“It’s not the same anymore,” he croons. “I’m still looking for my home.”
In the audience, couples sip house cabernet and applaud politely. Some drop $10 tips into a metal bucket.
About 40 blocks uptown in a 42-story skyscraper overlooking Duffy Square, straw-haired Muller, 47, performs for a tougher crowd -- as the multimillionaire math whiz behind one of Wall Street’s most secretive trading machines, Bloomberg Markets magazine reports in its August issue.
Muller is the founder of Morgan Stanley (MS)’s Process Driven Trading group, or PDT, a 70-person band of Ph.D.s and computer jockeys. They use algorithm-rich programs to bet Morgan Stanley’s money on pricing discrepancies in global markets.
Muller, who has had no outside investors to please, has kept the strategies and performance of PDT under wraps, stoking the curiosity and envy of rivals.
“They say: ‘I know him. He made a boatload of money for Morgan Stanley,’” says Arjun Divecha, chairman of Boston-based GMO LLC, who manages about $18 billion using quantitative techniques. “They don’t know how he’s done it.”
Muller makes no apologies for his obsessive secrecy.

Unlikely Executive

“I want my competitors to know absolutely nothing about what we do,” Muller says in his corner office, which is decorated with pictures of his wife, Jillian, and their two children as well as a pair of battered snowboards he retired years ago.
A troubadour, yoga enthusiast and math geek, Muller makes an unlikely Morgan Stanley executive. The 5-foot-10-inch (1.78- meter), 160-pound (73-kilogram) manager wears a handmade silver amulet around his neck that incorporates Native American symbols for sun, water and mountains. He practices ashtanga yoga, a style that incorporates synchronized breathing. He’s also a champion Texas Hold ’em poker player and writes New York Times crossword puzzles several times a year, garnering a core group of online fans.
Since he started PDT in 1993, its investments have returned an estimated annual average of more than 20 percent through 2010, according to a person close to the group. As a proprietary-trading desk, PDT uses different accounting rules than hedge funds. Its return figure has been adjusted to approximate its performance as if it were a hedge fund.

Top-Tier Quants

Hedge funds on average gained 10.4 percent annualized, net of fees, from July 1, 1993, through 2010, according to Chicago- based Hedge Fund Research Inc. The person says PDT notched that record with a Sharpe ratio of 3 to 4. The ratio measures risk- adjusted performance, and on this basis PDT generated 10 times the returns of the Standard & Poor’s 500 Index. The index gained about 8 percent annualized during that time.
“Wow,” says Daniel Celeghin, a partner at Casey, Quirk & Associates LLC, a consulting firm in Darien, Connecticut. “Those numbers would put them in the top echelons of quant managers.”
After almost two decades at Morgan Stanley, Muller is about to go out on his own, a move precipitated by the biggest regulatory overhaul of Wall Street since the Great Depression. Banks are jettisoning or closing groups like PDT as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which President Barack Obama signed into law in July 2010.
The law’s Volcker rule, named for former Federal Reserve Chairman Paul Volcker, bars banks from maintaining prop-trading operations and restricts the amount they can invest in hedge and private equity funds to 3 percent of their tier 1 capital. They can also own no more than 3 percent of such funds.

Spinning Off PDT

In its 2010 annual report, Goldman Sachs Group Inc. (GS) disclosed it had liquidated most of its long-short prop desk positions and was doing the same with its global macro group. Morgan Stanley in March completed the spinning off of FrontPoint Partners LLC, a hedge fund it acquired in 2006. Bank of America Corp. (BAC) disclosed in April a plan to sell its main private-equity business to management.
Now, it’s PDT’s turn. In January, Morgan Stanley said it would spin off the group at the end of 2012 as a separate firm -- retaining an option to buy a preferred stock position in the new company for undisclosed terms.
For decades, prop desks have played a crucial role in the transformation of investment banks such as Morgan Stanley from advisory and underwriting businesses to trading powerhouses that bet huge amounts of their own firms’ money. Once the closely held Wall Street partnerships began tapping the public markets for capital, prop desks could wager with shareholders’ money.

Vanishing Profit Centers

By the mid-2000s, prop traders were at the center of the exploding markets for collateralized debt obligations, or pools of bonds, and derivatives, which are instruments that derive their value from an underlying asset. These products were high- octane fuel for the credit bubble that ultimately blew up Bear Stearns Cos., Lehman Brothers Holdings Inc. (LEHMQ) and American International Group Inc. (AIG)
As the curtain falls on prop trading at banks, their profits may suffer. Morgan Stanley in 2008 began to pull back on risk partly by reducing leverage, and since then its fixed income trading revenue has been sluggish. Morgan Stanley’s net income fell 45 percent in the first quarter of 2011 from $1.78 billion a year earlier. While firms don’t generally disclose profits from prop trading, Goldman characterized it in 2010 as constituting about 10 percent of revenue in most years.

Statistical Arbitrage

The loss of this profit engine, along with other Dodd-Frank restrictions on products such as derivatives and debit cards, will hurt Wall Street banks’ returns in coming years, says Charles Peabody, an analyst at Portales Partners LLC in New York.
“It’s the cumulative effect of Dodd-Frank that will lower expected returns,” Peabody says. “Just about every business is facing some kind of crackdown.”
Mark Lake, a spokesman for Morgan Stanley, says the bank won’t comment on PDT.
Prop traders aren’t going away; they’re just changing addresses. Dodd-Frank only sought to end the practice in banks to reduce risk. Traders have been relocating to hedge funds and nonbank Wall Street firms such as KKR & Co.
PDT makes most of its money using statistical arbitrage, or stat-arb, former Morgan Stanley employees say. When PDT’s research suggests that a stock is temporarily overpriced based on its trading history, the group bets against it while piling into corresponding underpriced securities.

No Down Years

In a group of a dozen oil services stocks, six might be rising on a given day and six falling. At some point, the trend reverts: The gainers begin to fall and vice versa. For PDT, figuring out the precise time to place its bets is the tricky part.
PDT has lost money in only two quarters since its inception and never in a calendar year, according to two people familiar with the matter.
Muller skippered PDT through the August 2007 quant meltdown, when overleveraged hedge funds and other investors lost billions of dollars during a four-day period. PDT, along with other Morgan Stanley prop desks, lost $390 million in a single day, according to Morgan Stanley filings. Yet it powered back to finish the year in the black, people close to PDT say. The group also lost heavily in the fourth quarter of 2008 amid the global credit crash but still made money for the year.
“I think Peter is brilliant,” says Clifford Asness, co- founder of AQR Capital Management LLC, a $39 billion quantitative investment firm in Greenwich, Connecticut. “PDT will be a top-quality firm.”

Pandit’s Probe

The AQR Global Risk Premium fund ranked sixth in Bloomberg Markets’ February list of the top-performing large hedge funds, with a return of 27.3 percent for the first 10 months of 2010.
With PDT off to a strong start in the mid-1990s, Vikram Pandit, then Morgan Stanley’s head of institutional equity, wanted to know more about the secretive trading group, says Graham Giller, a researcher who worked with Muller. Giller says Pandit told him to find out details about PDT’s strategies.
“He felt it was the intellectual property of Morgan Stanley,” says Giller, who now runs Giller Investments (New Jersey) LLC in Holmdel. Giller says Pandit never set up a meeting at which Giller could inform him of what he had discovered. Pandit, Citigroup Inc. (C)’s CEO since 2007, declined to comment.

Wary of Quants

In going solo, Muller will have to drum up capital from investors who have grown wary of quants, whose returns have lagged behind those of other types of traditional managers for more than six years.
Equity managers using quantitative strategies generated a cumulative return of 37 percent from the start of 2005 through April 2011 compared with 49 percent for equity managers deploying traditional or combined approaches, according to EVestment Alliance LLC, an Atlanta research firm.
The assets of quant funds were down 10 percent as of December from their peak of $157.5 billion in 2007, as tracked by research firm Lipper Inc. And new fund launches in 2010 were less than half of the 2005 peak of 189.
“Quantitative managers have been losing market share, and it’s fairly significant,” says Mark Thurston, head of global equity research at Russell Investments in Seattle.
The underperformance may be due to cyclical forces, as beaten-down value stocks that many quant funds invest in have tended to lag behind their more-expensive growth counterparts in recent years. The decline may also stem from an abundance of quant-managed money pursuing similar strategies.

“Watership Down”

“Everything goes in cycles,” Muller says. “Success creates more competition.”
PDT keeps a low profile within Morgan Stanley’s headquarters. In the elevator vestibule at its ninth-floor offices, a plain, 7-inch-by-7-inch (18-centimeter-by-18- centimeter) plastic sign reads “Process Driven Trading.”
Muller has created a distinctive corporate culture at PDT, rejecting the eat-what-you-kill ethos practiced at some hedge funds. He cites a childhood book, “Watership Down,” as informing PDT’s environment.
The fantasy novel by Richard Adams tells the story of a nest of rabbits on an odyssey to find a safer home in the English countryside. Each of the principal rabbits -- with names such as Bigwig and Fiver -- excels in some area: intelligence, physical strength, intuition. After tribulations, they make it to their new abode.
Wanted Ph.D.s
What does this tale have to do with PDT? “It’s a community coming together with each individual contributing their unique skills,” Muller says. “It’s the whole that benefits.”
PDT has operated as a quasi-independent group within Morgan Stanley for almost 20 years, Muller says. Dede Welles, 41, is the legal head; Amy Wong, 43, serves as operating chief; and Eunice Baek, 41, runs human resources.
Baek canvasses schools such as Massachusetts Institute of Technology and California Institute of Technology for Ph.D.s in math-heavy fields with an interest in applying research to the real world.
“I had grown disillusioned with academia,” says Denis Dancanet, 43, PDT’s head of futures trading, who has a Ph.D. in computer science from Carnegie Mellon University in Pittsburgh. “Maybe three people care what you do.”
Eli Ofek, a former New York University finance professor, also left academia for PDT. In 1998, Muller offered him a job after attending a class taught by Ofek, who is PDT’s fundamental research chief.

Paint Ball

In Manhattan, researchers gather for free-roaming discussions at the lunch table.
“The range is broad, from the technology to solve Rubik’s Cube, to sports, to politics, to the rate at which flesh-eating bacteria can eat your arm,” says Tushar Shah, 40, PDT’s chief scientist, who has a Ph.D. in physics from MIT and joined the group in 2000.
Muller personally pays for weeklong vacations for the group to locales such as Grenada and Jamaica to celebrate good years. PDT off-site retreats have included white-water rafting in Maine and a paint ball competition in upstate New York. Despite a spate of new hires, Muller says employee tenure at PDT averages 7 1⁄2 years.
Researchers work in teams on PDT’s strategies, with Muller and Shah meeting independently with each group. “There was a hub and spoke structure,” says Giller, who has a Ph.D. in experimental elementary particle physics from Oxford University and worked at PDT from 1996 to 2000. “The ideas were funneled to a central conduit.”

Discrete Markets

There, Muller and his closest cohorts use a program called an optimizer to allocate assets among the different strategies to generate the most profit with the least risk. Nobody else knows its details.
PDT’s strategies often focus on discrete markets such as U.K. equities, former employees say.
In the late 1990s, Shakil Ahmed, a Yale University computer science Ph.D., worked on U.S. equity stat-arb strategies. Wong, who has an M.S. in electrical engineering from MIT, oversaw investments based on fundamentals, such as earnings. Giller built a statistical method utilizing interest-rate forecasts. And Mike Reed, a Ph.D. in electrical engineering from Princeton University, ran a U.K.-based stat-arb equity strategy.
All contributed to PDT’s reputation as a cauldron of white- hot quantitative talent.

Attracted to Puzzles

Muller says his group will expand after it’s spun off and rechristened PDT Partners LLC. Ownership will be spread among 11 partners. They will pursue strategies that may be less predictable than what Morgan Stanley is comfortable with.
“We have strategies that can take large amounts of capital,” Muller says. “But they are not as consistent. They’ll make money almost every year but not almost every quarter.”
A native of Philadelphia, Muller says he was born hard- wired for math. His Austrian-born father, Kurt, was a chemical engineer with Essex Chemical Corp. His mother, Eva, a native of Brazil, was one of the first women to practice medicine there and later became a psychiatrist.
“I was attracted to puzzles and games,” Muller says.
The family moved into a shingled ranch house in the New Jersey suburb of Wayne, 21 miles (34 kilometers) west of New York. At Wayne Valley High School, Muller was named one of two class mathematicians.
“He was one of the top kids that came through Wayne Valley High,” says John Gross, former chairman of the school math department. “He was involved in everything.”

Heads West

Muller, a captain of both the Frisbee and Quiz Bowl clubs, was also a member of the yearbook staff, German club, Honor Society and Model UN club. Muller’s yearbook quote: “All men by nature desire to know.”
At Princeton, Muller’s skill at frisbee caught the eye of classmate Ken Nickerson, who would later help build PDT’s stat- arb business. Muller was a star on the Ultimate Frisbee team in 1983 when it won the mid-Atlantic open championship.
He was a member of the Colonial Club, one of Princeton’s famed eating clubs, founded in 1891 and housed in a sprawling porticoed mansion. Muller would sit down in the club’s parlor and play the grand piano, leading singalongs. He graduated in 1985 with honors and a B.A. in mathematics.
That summer, Muller drove across country to the San Francisco Bay Area and soon took a job as a researcher and programmer at Barra Inc. The pioneering quant firm in Berkeley used complex mathematics to help active fund managers measure and control risk. Muller was soon presenting papers at client conferences, where he became a favorite, partly because he incorporated cartoons into the slides.

Renaissance Technologies

He jogged once a month under the full moon with fellow employees. One mentor, former research chief Richard Grinold, recalls discovering a coding problem with Barra’s analytics.
“We thought it was going to take five to six months to fix,” he says. “Peter came up with a solution: one person, two days.”
Muller also worked on a problem for Renaissance Technologies LLC, a Barra client. The hedge fund co-founded by Jim Simons wanted to know which U.S. Treasury maturities would be most efficient for it to park its excess cash in.
After the assignment, Renaissance offered Muller a job. But at the time, Muller was under the spell of the efficient-market hypothesis, which says beating the markets long term -- as Renaissance sought to do -- wasn’t possible. Muller turned down Renaissance’s offer.

Joins Morgan Stanley

By 1992, Muller was becoming restless and cooked up an idea of using Barra’s quantitative techniques to forecast returns rather than just model risk; Barra could manage money itself. Management turned down Muller’s proposal, and the 28-year-old decided it was time to move on.
A headhunter put Muller in touch with Morgan Stanley, which was then looking for a quant strategist to drum up business. Muller had bigger aspirations and cut a deal with Derek Bandeen, a prop-trading executive. Muller had two years to get a profitable trading system running. If he failed, he would perform the strategist’s job. PDT was born.
In 1993, as Muller began building a team at Morgan Stanley’s Sixth Avenue headquarters, his business model and ethos mimicked Barra’s, not Wall Street’s.
“From the beginning, PDT had its own culture,” he says. Muller’s first hire was Kim Elsesser, a Morgan Stanley information technology specialist in its equity division.
“We clicked,” says Elsesser, 46, who, in addition to other jobs, hired programmers to write code that Muller needed.

Money Machine

Within a year, Elsesser says, PDT was making serious money. A computer monitor was set up to show real-time profits and losses.
“We had a little party when we made our first million dollars,” she says. “At the time, it seemed like a lot of money.”
Muller struck an agreement with management. If PDT met its profit targets for one week, PDT employees could dress casually the next. By 1996, PDT was sizzling. “It was like an express train,” marvels Giller, the former analyst. “It was generating millions of dollars a day. It would just appear on the screen. It was surreal.”
As profits grew, PDT employees talked often about splitting off from Morgan Stanley. Muller says he negotiated with management for a greater slice for himself and his colleagues.
“We don’t need to be paid as if we are running our own hedge fund, but it needs to be close enough so we don’t feel taken advantage of,” he says he told Morgan Stanley executives.

Subway Gigs

Muller could play hardball with compensation, which led to a lot of back-and-forth negotiations. “It wasn’t specifically based on the performance,” Giller says. “It was always an unpleasant experience.”
By 1999, after seven years running the group, Muller was burned out and negotiated a sabbatical with a steep pay cut. Ahmed, who was managing stat-arb strategies, stepped in for the founder. Muller traveled, kayaking in the Grand Canyon and trekking to the kingdom of Bhutan.
The multimillionaire also took his electronic keyboard into New York’s subways to busk -- performing for dollar bills and change. “One of the things that makes me feel most alive is performing live,” he says.
Muller returned to work a year later on a reduced schedule while he recorded CDs and played in coffeehouses. Over the next five years, Muller’s role evolved into that of a chairman. During that time, he says, innovation slowed within the group. There were fewer new hires developing fresh ideas and that showed in the group’s returns, with competitors gaining on PDT.

Mack Backs PDT

“The gap between our results and those that we considered the best was narrowing,” Muller says. “The pace of research and innovation was not at a level that would keep us competitive.”
Ahmed declined to comment. A person close to the situation disputed Muller’s view, saying under Ahmed there were new hires and strategies and that relative performance was strong.
In 2006, Muller successfully lobbied management to reinstate him as sole head of PDT. Ahmed left the group and later joined Citigroup.
Muller pushed Morgan Stanley executives to hire new staff and raise outside capital to invest alongside it. Muller says then-CEO John Mack, who had rejoined Morgan Stanley the previous year after a five-year hiatus, offered to furnish whatever capital PDT felt it could handle. Mack, 66, declined to comment.

PDT’s Mistakes

In August 2007, Muller confronted the greatest financial storm of his lifetime. Tightening credit markets triggered a panic as leveraged quant funds tried to exit many of the same positions.
“We were all trying to figure out how much selling pressure there was and when it was going to abate,” Muller says.
The PDT founder says he wanted to hold on to his money- losing positions, betting on a reversion. But ultimately Muller agreed with Mack that PDT should reduce its leverage and increase cash.
“If we had traded the model without cutting risk, we would have had our best year ever,” Muller says.
The bank and PDT made a similar mistake the very next year, as the subprime contagion morphed into a global rout in the fourth quarter of 2008. Morgan Stanley cut back capital, and the group lost money for the quarter.
In late 2009, Muller says, he approached then-co-president James Gorman to ask for three changes at PDT: Employees should be allowed to directly invest in its funds, PDT should be permitted to employ new strategies to attract outside capital and employees should own the group in whole or part.

Dodd-Frank Act

Gorman, 52, said he could work on addressing the first two requests but resisted him on the third, people familiar with the matter say. Gorman, who became CEO in January 2010, declined to comment.
Today, as regulators write rules for the Dodd-Frank Act, Muller is poised to see his third wish fulfilled. Regulators are set to release a final proposal in October for implementing the ban on prop trading at banks. The Federal Reserve said in February that banks would generally have two years to comply once the rule takes effect.
Quants are laying odds that PDT will prosper on its own. “It’s an incredible opportunity to be spun out,” GMO’s Divecha says. “They have this wonderful machine that prints money. Now, they’ll be using it to print money for themselves rather than Morgan Stanley.”

Spanish Conquistador

As investors still bruised from past losses steer clear of quant funds, Muller is confident that PDT’s reputation will lure money his way. People close to PDT say institutions looking to make investments have already approached Muller.
Muller will also need to contend with critical matters unrelated to trading -- accounting, legal, compliance -- and build a marketing department.
“Anytime a manager goes from a proprietary-trading desk in a large investment bank to an independent business, it can be difficult,” says Robert Frey, who left Morgan Stanley in 1988 to start Kepler Financial Management, a fund he later merged into Renaissance Technologies. “It can be like taking a beautiful hothouse flower and planting it outside.”
About a decade ago, Muller co-wrote the song “I Wish I Had a Madman,” which could be the anthem for his new firm. It’s about the Spanish conquistador Hernan Cortes, who torched most of his fleet upon arrival in Mexico in 1519 to prevent his crew from deserting him on his odyssey of epic plunder.
“The men knew they had to go forward,” Muller sings. “No looking shoreward, forward to glory and gold.”
To contact the reporter on this story: Richard Teitelbaum in New York at rteitelbaum1@bloomberg.net.
To contact the editor responsible for this story: Michael Serrill at mserrill@bloomberg.net.

The Sorrow and the Pity of Another Liquidity Trap: Brad DeLong

There is only one real law of economics: the law of supply and demand. If the quantity supplied goes up, the price goes down.
Back in the third quarter of 2008, the public held about $5.3 trillion of U.S. Treasury bills, notes and bonds. As the recession hit, tax revenue plummeted, and government spending rose, that total reached $9.4 trillion by mid-2011.
We’re on target to have $10.7 trillion outstanding by mid- 2012 -- doubling the Treasury debt held by the public in just four years. Supply and demand tells us that a steep rise in Treasury borrowings should produce a commensurate fall in Treasury bond prices and thus higher interest rates -- and that increase should crowd out other forms of interest-sensitive spending, slowing productivity growth.
Yet the market has swallowed all these issues without so much as a burp. By all accounts, it’s smacking its lips in anticipation of the next tranches.
In the years of the Clinton budget surpluses -- remember those? -- the U.S. government was repaying $60 billion of debt each quarter. The Bush administration worked hard to make that surplus evaporate. It succeeded.
From 2002 to 2007, the Treasury issued, on average, $70 billion of debt per quarter. Like many watching this shift, I concluded that this expanded supply would exert substantial pressure on interest rates to rise.

Treasury Demand

The demand for Treasuries was inordinately high, in part because the supply of alternatives was low. Lacking confidence, corporate executives held back investment, reducing private issues of bonds. In addition, China and other emerging economies, eager to keep their currency values low, directed dollars earned from exports into U.S. Treasury debt. Reinforcing this demand, wealthy individuals around the world purchased Treasuries as a hedge.
Thus by late 2007, the 10-year U.S. Treasury rate was exactly where it had been when the Clinton surpluses ended at the close of 2001. “How long could this go on?” we wondered. Eventually the market’s appetite for Treasury bonds at high prices and low interest rates had to reach its limit, right? Supply and demand isn’t just a good idea -- it’s the law.

Discovering the Limit

At the end of 2008, as the economy collapsed and the pace of net Treasury debt increases quintupled, it seemed we were about to discover that limit. I presumed we had a little time for expansionary fiscal policy to boost the economy -- a year, maybe 18 months -- before the bond-market vigilantes would arrive. They would demand higher interest rates on Treasury bonds, which would begin seriously crowding out the benefits of fiscal stimulus. The U.S. government would have to react, pivoting from fighting joblessness, via deficit spending, to reassuring the bond market via long-run tax increases and spending cuts to Medicare and Medicaid.
But it didn’t happen in 2009. It didn’t happen in 2010. And it isn’t happening in 2011. There are no signs from asset prices that the market is betting heavily that it will happen in 2012. Looking at the yield curve, it appears the market intends to swallow every single bond that the Treasury will issue in the foreseeable future -- and at high prices. The prices of inflation-protected bonds suggest that the market expects the new Treasury issues to be devoured without any acceleration in inflation.

Keynes Disciple

Although I worked for three years in the Clinton Treasury Department, and am a card-carrying member of the economist guild, I predicted none of this. Like most of my peers, I was wrong. Yet the most interesting thing is that I could have -- should have -- been right. I had read economist John Hicks; I just didn’t quite believe him.
Hicks, one of the clever young Brits dotting i’s and crossing t’s in the writings of John Maynard Keynes in the 1930s, was responsible for the workhorse formulation of Keynesian economics -- the IS-LM model -- that has been the bane of many an intermediate macroeconomics student. It was his version of the IS-LM model that formalized and elevated a key insight: that interest rates paid by creditworthy governments would remain low after a financial crisis. This formulation holds even in the face of enormous budget deficits that greatly expand the supply of government bonds.
A financial crisis initiates a sudden flight to safety among bondholders -- widening interest-rate spreads, diminishing the private sector’s desire to sell bonds to raise capital and encouraging individuals to save more and consume less as they, too, hunker down. Thus bond prices rise, and interest rates drop. As rates fall, firms see that they can get capital on attractive terms and so issue more bonds; households see the low interest rate earned on their savings and lose some of their desire to save. The market heads toward equilibrium.

Safeguarding Wealth

But something else happens on the path to equilibrium. The decline in interest rates and the rise in savings are accompanied by an increased desire among businesses and households to safeguard more of their wealth in cash. As a result, the speed with which cash turns over in the economy, the velocity of money, falls. And as the velocity of money falls, total spending falls, workers are fired, and their savings evaporate with their incomes.
Thus the equilibrium turns negative, with high unemployment and low capacity utilization.
In responding to a small financial disruption, the Federal Reserve can inject more money into the economy by buying bonds for cash, increasing the amount of cash so that even at the lower velocity of money we retain the same volume of spending. This eases the decline in interest rates, spending, employment and production into a decline in interest rates alone.

Little Difference

But when rates become so low that there’s little difference between cash and short-term government bonds, open-market operations cease having an effect; they simply swap one zero- yielding government asset for another, with their hunger to hold more safe, liquid assets unsatisfied.
This is the liquidity trap.
In this situation we need deficit spending. The government spends and borrows, creating more of the safe, cashlike assets that private investors want. As these bonds hit the market, people who otherwise would have socked their money away in cash -- diminishing monetary velocity and slowing spending -- buy bonds instead. A large, timely government deficit thus short- circuits the adjustment mechanism, avoiding the collapse in monetary velocity.
Hicks’s conclusion: As long as output remains depressed and there is slack in the economy, printing more bonds will have negligible effect in increasing interest rates.

Special Case

I had read Hicks. I even knew Hicks. But I thought that his era, the Great Depression, had passed. Sitting in my first graduate economics class in 1980, I listened to Marty Feldstein and Olivier Blanchard -- two of the smartest humans I am ever likely to see -- assure me that Hicks’s liquidity trap was a very special case, into which the economy was unlikely to wedge itself again. Yet it did.
On my shelf is a slim, turn-of-the-millennium volume by Paul Krugman titled “The Return of Depression Economics.” In it he argued that we mainstream economists had been too quick to ditch the insights of Hicks -- and of economists Walter Bagehot and Hyman Minsky. Krugman warned that their analysis was still relevant, and that if we dismissed it we would be sorry.
I am sorry.
(Brad DeLong, a former deputy assistant secretary of the U.S. Treasury, is a professor of economics at the University of California at Berkeley, where he is chair of the political economy major. The opinions expressed are his own.)
Read more Bloomberg View op-eds.
To contact the writer on this story: Brad DeLong at delong@econ.berkeley.edu.
To contact the editor responsible for this story: Francis Wilkinson at fwilkinson1@bloomberg.net.

China Trade Surplus Climbs to Seven-Month High as Import Growth Moderates

China’s trade surplus widened more than forecast to $22.3 billion in June, the highest level in seven months, as imports grew at the slowest pace since 2009.
The gap exceeded all the 21 estimates in a Bloomberg News survey of economists, with the median projection at $14.2 billion. The surplus was $13.1 billion the previous month and $20 billion a year earlier. The customs bureau released the data in an online webcast today.
The surplus adds to the cash flooding the economy and complicates Premier Wen Jiabao’s efforts to cool the fastest inflation in three years. Policy makers are seeking to rein in price gains that are stoking social discontent without choking off growth that’s already showing signs of slowing.
“We don’t think the PBOC will halt monetary tightening soon,” said Liu Li-Gang, head of Greater China economic research at Australia & New Zealand Banking Corp. in Hong Kong. The central bank will increase bill sales to soak up the extra liquidity from the trade surplus and prevent it from boosting money supply, he said.
The People’s Bank of China has raised interest rates five times since mid-October, the latest on July 5, and increased banks’ reserve requirements nine times since November to a record level to rein in liquidity. Consumer prices climbed 6.4 percent last month, the most in three years.
Growth Slowing
Liu said the central bank may need to raise reserve requirements further in the second half if trade surpluses are “persistently large” and will also need to increase benchmark rates as returns on savings are still below inflation.
A report on July 13 will show China’s gross domestic product advanced 9.3 percent in the second quarter from a year earlier, down from 9.7 percent in the first quarter, according to the median estimate in a Bloomberg News survey.
China’s trade surplus last month was the biggest this year and the widest June gap since 2007.
Exports climbed 17.9 percent, the least since December after excluding seasonal distortions from the Chinese New Year holiday, to a record $162 billion. Imports jumped 19.3 percent to $139.7 billion, the customs bureau said, the weakest expansion since gains resumed in November 2009 after a year-long decline.
Yuan Pressure
Analysts’ median forecasts were for an 18.6 percent gain in overseas shipments and a 25.3 percent increase in imports.
“The still-large trade surplus may add to yuan appreciation pressure in the short term, but faster gains may hurt export growth, which has been on track to slow down,” Shen Minggao, an economist with Citigroup Inc., said in a telephone interview. Slower import gains indicate the economy is cooling “but a hard landing is almost impossible, policies won’t be significantly relaxed in the second half,” he said.
Shen estimates the yuan will appreciate around 4 percent this year. U.S. officials and lawmakers from Treasury Secretary Timothy F. Geithner to New York Senator Charles Schumer have sought bigger gains in the yuan to help curb the bilateral trade gap.
China, the world’s biggest consumer of energy, iron ore and soybeans, has seen its import bill surge over the past year as commodity costs climbed.
Higher global prices are increasing inflationary pressure in China, and led to a 14.7 percent increase in the overall price of imported commodities in the first half, Zhao Fudi, a customs bureau spokesman, said in an online broadcast today.
Import Tariffs
Import growth in June was held back by a 12 percent drop in net crude oil shipments, the first year-on-year decline since December, customs data show. At the same time, the average cost of crude imports in June was $110 a barrel last month compared with $77 a year earlier, the data show.
The government is cutting duties to help ease the impact on imported inflation from surging commodity prices. The finance ministry said June 24 it would remove import tariffs on diesel and jet fuel and cut levies on gasoline, fuel oil, zinc and some blended cotton fabrics effective July 1.
Higher costs are crimping profit at oil refiners and steelmakers. Angang Steel Co. said July 8 its first-half net income may have dropped 92 percent because of the “significant” increase in the price of raw materials and fuel which “substantially exceeded” the increase in selling prices.
“China has to use currency gains to curb imported inflation,” Edmond Law, deputy head of foreign exchange at BWC Capital Markets in Hong Kong, said before today’s data. “Policy makers aren’t left with many monetary tools after the recent interest-rate hike.”
Sluggish Recovery
The yuan closed at 6.4650 per dollar in Shanghai on July 8. The currency touched 6.4599 on July 4, the strongest level since the country unified official and market exchange rates at the end of 1993. Non-deliverable forwards indicate a gain of about 1.3 percent against the dollar in the next 12 months.
Exports to the European Union and U.S., the two biggest trading partners, rose 16.9 percent in the first half, compared with overall export growth of 24 percent, Zheng Yuesheng, head of the customs bureau’s statistics department, said today. “The weak economic situation in main export markets has posed serious challenges to China’s efforts to maintain stable export growth.”
The U.S. unemployment rate unexpectedly climbed in June and employers added the fewest workers in nine months, a government report showed on July 8, posing a threat to consumer spending in the world’s biggest economy. The European Central Bank raised its benchmark interest rate on July 7 even as euro zone countries grapple with a worsening sovereign debt crisis.
Losing Competitiveness
China’s competitive advantage is also being tested by higher labor costs and yuan appreciation, Zheng from the customs bureau said today.
Companies including Nike Inc. are switching production to Asian countries where wages are lower, contributing to the moderation in export growth. Vietnam surpassed China last year to become the biggest supplier of footwear to the world’s largest sportswear company, according to its annual report.
China’s trade surplus in the first six months of the year dropped 18 percent from a year earlier to $44.9 billion, the bureau said today, the lowest in seven years.
The excess, which has fallen from a record $295 billion in 2008, may drop further to about $150 billion this year as slowing global demand affects exports, according to Wang Tao, a UBS AG economist.
--Victoria Ruan, John Liu, Lily Lou, Zheng Lifei. With assistance Chua Baizhen in Beijing and Ailing Tan in Singapore. Editors: Paul Panckhurst, Nerys Avery,
To contact Bloomberg News staff on this story: Victoria Ruan in Beijing at +86-10-6649-7570 vruan1@bloomberg.net
To contact the editor responsible for this story: Paul Panckhurst in Hong Kong at ppanckhurst@bloomberg.net

AIG Joins Citigroup, GM in Deferred Tax Asset ‘Hall of Fame’

American International Group Inc. (AIG), Citigroup Inc. (C) and General Motors Co. (GM), once the largest insurer, bank and automaker, hold a new distinction after losses forced them to take bailouts. The firms accumulated some of the biggest deferred tax assets that may lower obligations to the government that rescued them.
Losses at New York-based AIG and its subsidiaries helped rack up more than $25 billion in the assets. That’s worth more to AIG’s share price than its plane-leasing business with 933 aircraft, according to Bank of America Corp.
“They’re in the same class of GM and Citigroup in terms of the largest I’ve ever seen,” Robert Willens, an independent tax consultant in New York, said of AIG. “Any one of them is in the hall of fame of large deferred tax assets.”
The firms were able to hold the assets through their bailouts as a result of government rulings that started in 2008, around the time that taxpayers began propping up private companies. Normally, the benefits are cut when a firm changes hands. The tax assets provided an impetus for investors to purchase shares in the companies as the U.S. Treasury Department sold stakes.
“If they didn’t get these benefits, then the government would have gotten much less” from selling stock, said Charles Mulford, an accounting professor at Georgia Institute of Technology in Atlanta. “Taxpayers would have been paying it anyway” through lower sale proceeds.
Citigroup and Detroit-based GM each have more than $20 billion of so-called carry-forwards among their deferred tax assets, according to regulatory filings.

‘Source of Funds’

AIG Chief Executive Officer Robert Benmosche, 67, touted tax benefits before a share sale in May that raised $8.7 billion and reduced the Treasury’s stake to 77 percent. The assets are a “source of funds” for when AIG is prepared to repurchase stock, he said on a May 6 conference call.
The assets may be worth $6 a share for AIG, compared with $3 for the International Lease Finance Corp. plane unit, said Jay Cohen, a Bank of America analyst, in a June 9 note, when he advised investors to buy the stock. Analysts at JPMorgan Chase & Co. and Barclays Plc have said the tax benefit may be worth at least $5 a share. The insurer closed at $30.21 yesterday on the New York Stock Exchange, down 37 percent from Dec. 31.
“For AIG, a dollar of profit is essentially more than a dollar of profit for another company,” said Paul Newsome, an analyst at Sandler O’Neill & Partners LP. He advises investors to buy the company’s stock. Joe Norton, an AIG spokesman, declined to comment.

Carry-Forwards

Citigroup’s $23.2 billion of carry-forwards as of Dec. 31 include benefits from net operating losses and foreign tax credits. The New York-based bank expects to use its entire U.S. federal net operating loss carry-forward this year, according to a regulatory filing. The company valued that asset at about $3.9 billion at the end of last year. Jon Diat, a spokesman for Citigroup, declined to comment.
GM reported $20.1 billion in tax carry-forwards. The automaker amassed tax assets as it posted losses from 2005 to its bankruptcy in 2009, and in some regions outside the U.S. last year. GM is poised to become the No. 1 automaker by sales this year after being passed in 2008 by Toyota Motor Corp.
The sum means the company may not pay taxes to the U.S. until 2018, Adam Jonas, a Morgan Stanley analyst, said in a July 6 research note. Jonas, who swapped GM for Ford Motor Co. as his top U.S. auto pick in the report, said the assets are worth about $9 per share, more than the value of the company’s joint ventures in China. Jim Cain, a spokesman for GM, declined to comment.

Chartis Losses

AIG must post profits at units such as property-casualty insurer Chartis to use the biggest portion of the tax asset, $11.3 billion in net operating loss carry-forwards, which expire 2028 through 2030. Chartis, AIG’s largest unit by revenue, was unprofitable in the six months ended March 31 on Japan earthquake claims and charges tied to reserves.
AIG also had $9.7 billion in assets that can be used to lower taxes on capital gains through 2015, according to a presentation by the insurer. An additional $4.6 billion is tied to results outside the U.S.
The insurer trails rivals such as Germany’s Allianz SE and France’s Axa SA in terms of assets after losses and unit sales shrunk AIG.
The carry-forwards are shaping AIG’s investment strategy. Chartis has been reducing its municipal-bond holdings as the company has less need for the tax advantages from the securities. AIG had about $43.8 billion in municipal bonds as of March 31.

‘Conservative Stance’

AIG must demonstrate that it can earn enough taxable income to use the assets before getting credit on its balance sheet, said Mulford. The firm has a full valuation allowance against the deferred tax assets and has said in filings that it can’t say whether they’ll be used.
“AIG has taken a fairly conservative stance,” said Mulford. “Their ability in recent years to generate taxable income has been very much in doubt.”
GM also has a full valuation allowance against its U.S. deferred tax assets. Citigroup uses about $13 billion of its deferred tax asset toward satisfying capital levels set by regulators.
Citigroup fell 9.9 percent percent this year through yesterday, compared with the 7.6 percent advance of the Standard & Poor’s 500 Index. GM dropped 14 percent.
The government gave itself an exemption in the tax code as it began rescuing companies, said Edward Kleinbard, a law professor at the University of Southern California. Normally, the benefits are limited after a change in ownership, triggered when shareholders who hold 5 percent or more of the company increase their combined stake by 50 percent over a three-year period, he said.

‘Meaningless Concept’

The law is intended to prevent trafficking in so-called loss corporations, said Kleinbard, who previously served as the chief of staff of the congressional Joint Committee on Taxation. Without the law, a profitable company could shield earnings from taxes by buying such firms.
“The government can’t traffic in” net operating losses, said Kleinbard. “The government’s not a taxpayer. It’s a meaningless concept.” Mark Paustenbach, a spokesman for the Treasury, declined to comment.
AIG was rescued in 2008 in a bailout that swelled to $182.3 billion. Citigroup received $45 billion from the Treasury’s Troubled Asset Relief Program and $301 billion in guarantees on its riskiest assets. The government sold its remaining stake in the bank in December.
GM was bailed out with $49.5 billion in taxpayer funds as the government backed its bankruptcy in 2009. The Treasury reduced its stake to 33 percent last year in a share sale.
To contact the reporter on this story: Noah Buhayar in New York at nbuhayar@bloomberg.net
To contact the editor responsible for this story: Dan Kraut at dkraut2@bloomberg.net

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In Banking, There’s No Such Thing as Too Far Away to Fail: View

According to a new Bloomberg Government report, as many as 100 financial firms with non-U.S. owners will be subject to new rules intended for systemically important institutions, or those whose failure could rock the whole financial system.
That means 79 percent of all the firms that are likely to have to limit proprietary trading and have larger capital cushions, to name two rules, will not be American owned. This is an entirely good thing.
Before the non-U.S. banks get too agitated about being more closely supervised by the U.S. government, they would be well advised to remember which institutions needed help from the Federal Reserve during the intense liquidity squeeze of 2008. Of the $110.7 billion borrowed from the Fed in late October 2008, at least 70 percent was by non-U.S. banks. Credit Suisse Group AG (CS), based in Zurich, borrowed as much as $45 billion, according to Fed documents. Royal Bank of Scotland Group Plc (RBS), based in Edinburgh, got at least $30 billion.
The Fed says those loans have been repaid with interest. At the time, though, no one else in the financial system had the nerve or the resources to make such extensive support available. The Fed was shouldering considerable risk by stepping in as the lender of last resort. It’s understandable -- and, in fact, essential -- that regulators would want to reduce the chances of having to engage in such large-scale interventions again.

Fine-Tuning Governance

Several non-U.S. institutions, such as Deutsche Bank, are fine-tuning the management and governance of their U.S. arms so that they can operate more comfortably under regulations prescribed by the 2010 Dodd-Frank financial reform law. Other non-U.S. institutions may decide to sell their American offshoots. Neither of those responses should be troubling. Banking assets and jobs would presumably remain in the U.S., with greater local control. A not-incidental principle would be underscored: Access to the U.S. market is a privilege, one that comes with the responsibility of obeying U.S. laws.
One of Dodd-Frank’s most pressing missions is to eliminate free-rider problems, in which market participants could pursue aggressive profit-seeking strategies in boom times, knowing that if everything went badly, the losses would be society’s problem. Requiring all large banks, no matter who owns them, to abide by rules meant to prevent systemic failure is a case where the Dodd-Frank remedy is sized just right for an interconnected world.
Read more Bloomberg View editorials.
To contact the Bloomberg View editorial board: view@bloomberg.net.

A world of debt: Six countries that borrowed beyond their means

Richard Blackwell

From Thursday's Globe and Mail

Published Wednesday, Jul. 06, 2011 6:34PM EDT

Last updated Wednesday, Jul. 06, 2011 10:11PM EDT

 

Greece has been living beyond its means for years, and the government has borrowed heavily, partly to pay high public sector wages, iron-clad job security and high pensions for civil servants. At the same time, the government has not been able to collect all the money owed to it, as tax evasion is widespread.
At the moment, debt is about €350-billion, equal to about €30,000 for each of Greece’s 11 million citizens. The debt level will hit about 166 per cent of gross domestic product next year.
Currently, the worry is that the European bailout may be considered a default, and that could trigger insolvencies across the continent

Like Greece, the government of Portugal has been overspending for decades, boosting the size of its civil service while the economy grew only marginally.
At the start of 2011, Portugal implemented a deep austerity plan, which cut civil service pay and jobs, and reduced unemployment benefits. But with borrowing costs rising, that wasn’t enough. Portugal received emergency loans of €78-billion from the International Monetary Fund and European Union in May, making it the first European country after Ireland and Greece to get a bailout.
On Tuesday, Portugal’s credit rating was cut to junk by Moody's Investors Service, which said the country may require a second rescue package.

Ireland was the first European country to fall into recession in 2008, as unemployment rose and a real estate bubble burst. It was a humbling reversal for a county that had become known as the Celtic Tiger. Irish banks, heavily exposed to the housing market after giving cheap loans to almost anyone who wanted to buy or build, required a rescue from the government. Ireland’s debt levels then soared and borrowing costs spiked.
Late in 2010 the government was forced to take emergency loans of €85-billion from the European Union and the IMF. The Irish economy has improved slightly, but the Greek crisis is keeping borrowing costs high and a second bailout is a possibility.

Japan is the most indebted country in the world, a situation built up over many years by a sluggish economy that just can’t seem to get moving. Stalled growth has forced the government to spend heavily on stimulus, while it deals with the massive social costs of an aging population.
The government’s debt is now almost 200 per cent of GDP, compared with just 60 per cent 20 years ago. However, most of it is held by Japanese citizens, not foreign countries or institutions.
The earthquake and tsunami dealt another blow to the economy, although spending on rebuilding could cause a positive jolt.

With more than $14-trillion in federal government debt, the United States is massively in the red. The situation has worsened in recent years thanks to tax cuts, higher government spending, the bailout of the banking system, military spending, and a stubborn economic slump.
In April, Standard & Poor’s underlined the worries over the United States’ financial situation by downgrading the outlook for country’s debt to "negative" from "stable."
President Barack Obama is under enormous pressure to cut spending to reduce the deficit, and he is in intense negotiations with legislators to get that done. He needs a deal so Congress can boost the country’s official debt ceiling – it must be raised by early August or the United States could default on some of its borrowing.

After years of running surpluses (from 1997 to 2008, to be precise), Canada shifted back into deficit in 2009 because of the stimulus required to pull the country out of recession. Many provincial governments also moved from black to red during the downturn, adding to the overall debt.
While total federal debt is now around $560-billion – it’s higher if provincial debt is included – we are in good shape relative to most other countries, with an economy back on a growth track, albeit a slow one.
Finance Minister Jim Flaherty now promises to balance the books by 2015, but he’ll have to find $4-billion a year in savings to accomplish that.