naked capitalism

This story hasn’t gotten much coverage in the US, but Australia, which has never had abundant water, has gone through a prolonged drought which appears to be becoming semi-permanent.

This is particularly problematic, not simply in terms of quality of living, but also because Australia is a major agricultural exporter (wheat and cattle), and a team that built a model of the physical inputs and outputs of the economy a few years ago found that Australia was inadequately compensated for the value of the water in its agricultural goods.

A BBC story gives an image of how Sydney will go from being one of the most habitable cities in the world to a more difficult setting:

A new report on the effects of climate change in Australia paints an alarming picture of life in the city of Sydney. It warns that if residents do not cut water consumption by more than 50% over the next 20 years, the city will become unsustainable.

The Commonwealth Scientific and Industrial Research Organisation report also warns that temperatures could rise 5C above the predicted global average.

This would leave the city facing an almost permanent state of drought….

It warns of severe droughts nine out of every 10 years, a dramatic rise in the number of bush fires, and freak storm surges which could devastate the coastline.

Scientists predict that rainfall will fall by 40% by 2070, not only creating a massive water crisis, but producing double the number of bush fires. Heat-related deaths would soar from a current average of 176 a year to 1,300. Sydney would come to resemble the harsh, dry and inhospitable conditions of remote inland towns.

The government of New South Wales, which commissioned the report, has been alarmed by its findings.

Along with America, Australia has refused to sign the Kyoto Protocol, the only two major industrialised nations to do so.

The problem has become so dire that Prime Minister John Howard, neither a tree-hugging nor interventionist type (he actually emulates George Bush, to the horror of many Australians), has proposed a full-bore attempt to deal with the coming water crisis (although without addressing the greenhouse gas emissions that are contributing to the problem). The Financial Times provided a summary in a story titled “Australian drought spurs Howard to A$10bn water plan:”

John Howard, the Australian prime minister, yesterday announced the most ambitious attempt yet to overhaul the drought-ridden country’s inefficient water management system and improve his environmental credentials ahead of elections later this year.

But the success of the A$10bn (US$7.8bn, €6bn, £4bn) plan could hinge on whether Mr Howard can persuade the six state governments, which dictate water policy, to cede most of that power to the federal government – including management of the Murray-Darling basin, Australia’s most important water resource.

The key part of the plan foresees investing almost A$6bn in new infrastructure such as water pipes in an attempt to save 3,000 giga-litres of water a year. As a sweetener to regain control over the Murray-Darling basin, Canberra is also setting aside A$3bn to buy back water licences from irrigators along the basin, which stretches from Queensland in the north-east to Adelaide, the main city of South Australia….

Australia is enduring its worst drought in a century, pushing the country into what Peter Costello, the treasurer, has called “rural recession”. The last wheat harvest was the lowest in 12 years, crippling exports and helping to send global wheat prices soaring.

“If the drought continues, water will dominate the elections,” said Daniel Connell, a water policy specialist at the Australian National University. “Even if we have a reasonable winter, the water system is fundamentally not in good shape, and this will be a very big political issue for a number of years.”

While water experts welcomed a multi-billion investment in improved water infrastructure, some said it could still prove too little, too late in a country where changes in water management continue to cause fierce controversy.

Politicians in Sydney, which recycles only 2.3 per cent of its water, have been debating for years whether to build a desalination plant.

Meanwhile, inhabitants of Toowoomba rejected a plan last July to make the town the first in Australia to use purified sewage as its key water supply, in what was seen as a litmus test for future water policy.

Kane Goldsworthy, an aquatic scientist working for local councils around Sydney, said: “Any extra money is a good thing but really nothing is going to solve the problem except changing attitudes towards the use of water.”

Courtesy Seeking Alpha, an extensive compilation of recent stories on the housing market, called “Housing Bubble and Real Estate Market Tracker.”

We have been hard on the Journal for its tendency to politicize news coverage and omit stories that point to systemic financial risk. So we would like to give credit to the Journal when credit is due.

This morning, the Wall Street Journal had a first page story on the stock market mania in China, while the Financial Times’ comparable story on a semi-official but nevertheless direct warning on the Chinese stock market bubble, will run in the following day’s print issue.

Both articles are worth reading in full. From the WSJ’s “Stock Frenzy in China Stokes Official Concern:”

As China’s stock market continues its record-breaking rally, regulators are increasingly expressing concern that the country’s growing ranks of investors are doing everything from mortgaging their homes to borrowing against their credit cards to get in on the action.

China’s stock-market benchmark, the Shanghai Composite Index, rose 130% in 2006 and has continued to soar this year, placing Chinese stocks among the world’s top performers. Yesterday, the index gained 2.2% to 2945.26.

In a frenzy that recalls the late-1990s dot-com boom in the U.S., the rally has drawn in a new generation of investors. Online trading is spreading rapidly, and in recent weeks individuals have been opening stock-trading accounts at the rate of about 90,000 per day, 35 times the pace of a year earlier….

Regulators say they are increasingly seeing signs that investors, caught up in the stock mania, are pledging their homes as collateral for personal loans, or teaming up with merchants to, in effect, borrow from their credit cards, presumably hoping that stocks will rise enough before the bill comes due to pay off the debt….

Data on practices like these are scarce. But they are becoming common enough that the government is starting to take notice. In a recent directive to credit-card issuers, the China Banking Regulatory Commission warned banks to be on the lookout for suspicious credit-card transactions….

Yesterday, in another indication of rising government concern, state-run China Central Television broadcast a midday program citing the risks of stock-market investing, in particular the “taboo” practice of funding stock purchases using homes as collateral. “Even in a bull market, 30% to 40% of people would suffer losses,” the program’s anchor said. The broadcast “was arranged according to a requirement of the Central Propaganda Department,” says a person with knowledge of the situation.

The Financial Times’ story is titled “Warning on China stock market ‘bubble’:”

The Chinese stock market is developing into a “bubble” and investors are in danger of behaving irrationally, a leading Chinese legislator said on Tuesday in the strongest public expression of concern to come from a senior state figure.

Cheng Siwei, vice-chairman of the National People’s Congress and an influential figure in Beijing financial circles, warned the mainland stock market could be overheating, after a rise of 130 per cent last year.

“There is a bubble going on. Investors should be concerned about the risks,” Mr Cheng said in an interview with the Financial Times.

“But in a bull market, people will invest relatively irrationally. Every investor thinks they can win. But many will end up losing. But that is their risk and their choice….You can’t take administrative measures to change people’s behaviour. The market is based on people’s behaviour. Investors will have to learn their own lessons.”….

Mr Cheng, speaking at the FT China-Middle East summit in Dubai, is not officially involved in financial policy but his public views often reflect the thinking of senior leaders.

His comments came as signs emerged the government was trying to limit speculation in stocks. A sharp fall could hamper plans for large companies to launch domestic flotations this year.

A post from Mark Thoma’s Economist’s View, “Will the Euro Replace the Dollar?,” is useful and informative, but I am surprised that Thoma didn’t mention developemnts that confirm the authors’ thesis, namely, that the euro is becoming a competitor for the dollar as a reserve currency:

Some countries that have been key providers of capital to the US, most notably China and Saudi Arabia, have not merealy announced but actually are diversifying their holdings away from dollars

The Eurobond market is now larger, in terms of value of outstandings, than the US bond markets

Some paranoid-sounding observers argue that the real reason that the US is taking a belligerent posture towards Iran isn’t its nascent nuclear program, but its plans to create an oil trading exchange that would not be denominated in euros (note that oil purchases are not only denominated but are settled in dollars. Opening that up to other currencies threatens the dollar hegemony)

From the post:

The authors of this research “argue that the euro’s rise to major international currency status may no longer be as implausible as many believe”:

The Impact of the Euro and Prospects for the Dollar, by Matt Nesvisky, NBER Digest: Will the euro replace the dollar as the leading international currency? With two-thirds of all international reserves still held in U.S. currency, the challenge of the euro appears remote. Indeed, this was the widely held view when the euro was introduced less than a decade ago. But in Optimal Currency Shares in International Reserves: The Impact of the Euro and the Prospects for the Dollar (NBER Working Paper No. 12333), authors Elias Papaioannou, Richard Portes, and Gregorios Siourounis argue that the euro’s rise to major international currency status may no longer be as implausible as many believe.

The euro’s growing appeal comes from several factors: the euro zone is comparable to the U.S. economy in term[s] of GDP and trade openness; the European Central Bank has kept inflation in check; the EU experiences nothing like America’s current account deficit and external debt, which apply considerable pressures on the dollar. In a 2005 survey of central banks, most respondents said they intended further diversification away from the dollar, and several have recently made public announcements along these lines.

Papaioannou and his colleagues study the composition of central banks’ foreign exchange reserves… Reserve growth in recent years has been dramatic, with emerging markets and developing countries tripling their reserves since 1998. In addition, rising prices for oil and other commodities have increased foreign reserves in fuel-exporting countries. These reserves come primarily from U.S. current account deficits. Even a limited shift out of dollar assets, the researchers say, could result in significant exchange rate movements – in particular, sizable dollar depreciation….

So far, however, this increased internationalization comes primarily at the expense of the yen, Britain’s pound sterling, and the Swiss franc rather than against the dollar.

In addition, in recent years the spreads on transactions in the euro have fallen sharply and have narrowed significantly for other industrial countries’ currencies as well, thus making diversification away from the dollar more attractive. The researchers … perform some simulations for four emerging market countries (Brazil, Russia, India, and China) that have recently accumulated large foreign reserve assets and find larger weights for the euro than the aggregate estimate for the “representative central bank.” This indicates that the euro’s challenge to the dollar might occur sooner than imagined.

Finally, the authors find that the reference currency, or the choice of risk-free asset, is the chief determinant in the optimal composition of reserves… But in practice, where there is a managed exchange rate regime, the reference currency is naturally the currency or currencies to which a country’s own currency is pegged. This suggests a major challenge to the dollar if more countries move away from managing their exchange rates with respect to the dollar and adopt euro-based anchors or baskets in which the euro figures strongly….

The Financial Times, as is often the case, carried a story on hedge fund risks that was not covered in the Wall Street Journal or the New York Times. Titled “Regulators concerned at hedge fund collateral,” it discusses how an international group of financial regulators is working with some of the biggest Wall Street firms to see if they can develop a “consolidated supervised entities programme.”

What is striking is the number of bodies involved: the Fed, the SEC, the Office of the Comptroller of the Currency, the UK’s FSA and European regulators. It’s hard simply to have US authorities get over their turf issues and work together. You seldom see this level of cooperation in the absence of a crisis, which suggests how deeply worried they are.

US, UK and European regulators have expressed concern in recent meetings that investment banks may be allowing hedge funds to increase their borrowing capacity using collateral that could lose its value rapidly in a financial crisis.

The regulators have asked banking executives in the meetings on Wall Street to detail exactly how they use portfolio netting, a practice that allows hedge funds to use relatively illiquid securities such as credit default and total return swaps as collateral to reduce overall margin requirements.

The fear among some regulators and outside observers is that in a big market dislocation the funds might be unable to sell those securities, increasing the likelihood of widespread defaults.

“Is it inherently dangerous that funds are doing this? Yes, it is,” said Brian Shapiro, president of CarbonBased Consulting, the New York-based research group. “You just have to trust that these funds are going through adequate risk management, including liquidity risk.”

Brokerage executives say they are careful in their collateral requirements and have legal agreements governing the arrangements.

One Wall Street executive acknowledged that regulators had a “legitimate concern” that such agreements might not be enforceable in the face of a hedge fund collapse. However, he did not believe regulators would find that banks were taking on excessive risk.

The questions are part of a broad new effort by the New York Federal Reserve, the Securities and Exchange Commission, the Office of the Comptroller of the Currency, the UK’s Financial Services Authority and European regulatory bodies to understand better how much exposure large banks have to hedge funds and whether that could present a significant risk to the financial system in the event of a market disruption.

So far, detailed discussions have been held with a group of five of the largest Wall Street securities firms that some time ago agreed to volunteer for a “consolidated supervised entities programme”. Members of the programme are among the most active in lending to hedge funds.

Officials have found that some firms have been extending credit on less liquid instruments but relatively little credit is being extended under these circumstances – and at higher cost to borrowers, regulators say.

While this topic may seem a bit esoteric to some readers, it is just about the most simple-minded trade in the financial markets, which is precisely why so many players are involved in it. You borrow in a currency that has low prevailing interest rates, like the yen, and invest in instruments in a currency where the money market and short term bonds are paying high interest rates, like Australia.

And the short side of the trade, the one in which you are a borrower, looks even better if the currency is weakening. Not only do you pay very little in interest, but you get to pay back less principal than you borrowed. What’s not to like?’

The problem is that everyone seems to be keen on this trade, too keen. The yen has been getting weaker since the Japanese central bank decided not to raise interest rates, and there is now considerable short interest in the currency. As you may know, a large short interest is often considered a bullish sign, since if the market moves at all against the shorts (as in, the yen appreciates), the parties with short positions need to buy to cover their shorts, propelling the market further upwards.

This Financial Times article, “Falling Yen sparks carry trade alert,” points out a scary bit of deja vu. A rapid appreciation in the yen in the wake of the Russian crisis helped precipitate the meltdown of Long Term Capital Management. That debacle threatened the financial system, but proved to be manageable because crisis revolved around one massive player, and all its major counterparties were gathered in a room to devise a bail-out. If we have a similar rapid change, it won’t be one huge player that collapses, but several (many?) smaller ones, and therefore much more questionable that the damage could be contained.

The yen hit a four-year low against the US dollar on Monday, intensifying fears that the rising level of currency-based “carry trades” by hedge fund investors could jolt markets if these positions were suddenly unwound.

The Japanese currency’s sharp fall also prompted European finance ministers to voice concern about its weakness.

Jean-Claude Juncker, the chairman of the eurozone’s 13 finance ministers, said he was “increasingly a little bit worried” about the yen.

The currency dropped to a record low of Y158.60 to the euro last week. On Monday, it fell to Y122.19 against the dollar.

Many economists and bankers suspect that carry trade activity is an important factor behind the yen’s weakness.

Carry trades are deals in which investors borrow in currencies with low interest rates, such as the yen and the Swiss franc, to invest in those that pay higher rates, such as the Australian dollar.

According to Barclays Capital, speculative carry trades have reached their highest level since the Russian crisis in 1998.

It estimates that these amount to $34bn in net terms, calculated in constant 1998 prices for the yen, Swiss franc, sterling and Australian dollar.

The scale of the carry trade – and its concentration in the yen – is raising fears among policymakers that a rapid unwinding of these trades could shake financial markets.

Figures from the Commodities Futures Trading Commission last week indicated that there was a record level of “short” yen positions in the market – trades that bet on further yen weakness.

This trade has produced fat profits for hedge funds in recent months as the yen has weakened and interest rate expectations have remained low.

However, the outlook for the Japanese economy is improving and there are expectations that interest rates could rise this year.

These events could potentially undermine the rationale behind the carry trade, prompting a rapid shift in positions.

Such a shift occurred during the 1998 Russian crisis, when the yen suddenly rose from Y147 to Y112 in a matter of days, helping to trigger the near collapse of Long Term Capital Management, the US hedge fund.

Thanks to footnoted.org, we have an example of the kind of behavior that gives CEOs a bad name. Except this CEO isn’t feeding at the trough of the company he currently heads, but one he USED to head. Oh, and to top it off, the company is already in the sights of shareholder activists because of the disconnect between its performance (lousy) and its executive compensation practices (generous).

The company is Applebee’s International (APPB) and the miscreant is former CEO Lloyd Hill. Well, you can’t hold him solely accountable, and former SEC chairman Richard Breeden, whose firm, Breeden Partners, which owns 5.3% of Applebee’s stock, doesn’t. He addressed these comments to Douglas Conant, Campbell’s (CPB) CEO and chairman of Applebee’s compensation committee:

On 29 occasions from from April 2006 through January 2007, Applebees’s corporate aircraft flew into and out of Galveston, Texas, where former CEO Lloyd Hill happens to own a beach house. The nearest Applebees’s restaurant is more than 40 miles away. Though Mr. Hill ceased to be CEO in September 2006, company planes continue the Galveston shuttle.

The letter also goes through the gory details of Applebee’s deteriorating performance.

It worth reading the entire post at footnoted.org.

Now the CEO defenders like to dismiss anything regarding benefits as chump change, not worth discussing. And technically, they are right. The cost of these flights is at least two orders of magnitude less than Bob Nardelli’s departure package.

But this was disturbing enough to Breeden’s firm that they bothered obtaining flight records to ferret out the details. And the corporate elite is totally insensitive to the symbolism. The only “little people” who get to run their personal lives through the business are business owners, and even then, the IRS keeps a pretty close eye on the reasonableness of their business expenses. Why do top executives, who have not taken entrepreneurial risk, feel they are entitled to take as much as they can? This is the kind of behavior you expect from the heads of banana republics, not legitimate enterprises.

We’ve taken note of excessive optimism and leverage (see, as examples, “The Rising Tide of Liquidity” and “More Signs of a Toppy Market“).

Now the European Central Bank is also sounding cautionary notes. Ever since Alan Greenspan’s famous “irrational exuberance” observation produced a 140 point (then 2%) fall in the Dow, central bankers have been cautious about commenting on the state of the markets. These remarks are therefore surprisingly direct. From the Financial Times, “ECB warns on ‘unstable’ financial markets:”

Conditions in global financial markets look potentially “unstable”, suggesting investors need to prepare for a “repricing” of some assets, Jean-Claude Trichet, president of the European Central Bank, said over the weekend in Davos.

The recent explosion of structured financial products and derivatives had made it more difficult for regulators and investors to judge current risks in the financial system, Mr Trichet said. “We are currently seeing elements in global financial markets which are not necessarily stable,” Mr Trichet said, pointing to the “low level of rates, spreads and risk premiums” as factors that could trigger a repricing.

“There is now such creativity of new and very sophisticated financial instruments … that we don’t know fully where the risks are located.” He added: “We are trying to understand what is going on but it is a big, big challenge.”

Mr Trichet’s comments reflect a debate in policymaking circles about the implications of the growth in derivatives.

Many investment bankers and some regulators and economists argued at last week’s World Economic Forum in Davos that the growth of the $450,000bn (€350,000bn, £230,000bn) derivatives sector had helped reduce market volatility and made the system more resilient to shocks by spreading credit risk. But other officials fear these instruments may be raising leverage and risk-taking to dangerous levels and keeping the cost of borrowing artificially low, potentially increasing the chance of financial crises.

Senior policymakers admitted it had become hard to track the risks because the sector is opaque, much activity occurs in unregulated hedge funds, and products shift rapidly across markets and between the boundaries of national central banks.

Andrew Crockett, president of JP Morgan international, said: “These new instruments ought to make markets more complete. But there is a lack of transparency … we don’t know how much leverage there is in hedge funds, for example

.”

The Housing Bubble Blog put the question more neutrally in its post headline, “When Did Lending Standards Start Charging So Much?,” but the responses all point in one direction:

Readers suggested a topic on when loan standards changed. “Here’s my question for the gang – when did lending standards start changing so much? I was involved in real estate 20 years ago, mostly as a property manager, but also doing some sales in Capitol Hill/DC, a lot of shells and distressed stuff that was being rehabbed by investors.”

“I remember how difficult it was to get ‘investor’ loans back then, and that rental income was really discounted in terms of qualifying, etc.; as a result, we did a lot of seller-financed deals with a balloon in 3 to 5 years (usually paid off in a year or two when the property was rehabbed and sold).”

“When did it start becoming easy for folks to get these low- and no- doc loans and by 3, 5, 10 — whatever — properties to try and flip? I’d love a history of the change in standards if someone has some good insight — who (agencies/companies) started this shift?”

A reply, “read the Community Banking Bill. Then 911 came and then it was the excuse to open ALL flood gates.”….

“Just because the money was there from the secondary market, it didn’t mean the lenders should of been entitled to stop making prudent loans and resort to fraud and liar loans to meet the quota. The money would of gone to a better place and we would not of had this run-up like we did.”

One took a shot, “Not sure when it started, but I believe that there was a great acceleration in lender stupidity after 2003. Summer 2003 was when fixed rate mortgage rates hit their nadir, and the only way for prices to continue to appreciate was either wage inflation or lowered lending standards. Well, we haven’t had double digit wage increases.”

Another went further back, “I think it started (just a little bit) in 2001 or before. By 2003, ANYONE who wanted a mortgage could get one.”

The Denver Post….“Colorado’s lenders offer mortgages to people who would never have qualified two decades ago. Two in five Colorado home loans are considered high cost (also known as sub-prime) and we shouldn’t be entirely surprised by the result.”

“Prime, fixed-rate mortgages have a foreclosure rate of about 2.5 percent, fairly consistent with historical trends. But for sub-prime loans, the foreclosure rate is about 8 percent. That’s the cause of our historically high rate of foreclosures.”

“In the aftermath of Sept. 11, interest rates plummeted. Many people got themselves into variable rate mortgages, attracted by the low initial rates, only to see their monthly payments double and sometimes triple in the last few years after rates began to rise again.”

The Napa Valley Register. “Real Estate Broker Chuck Sawday attributed part of the city’s appreciation to interest rate levels. ‘More people were able to buy homes because of low interest rates. That pushed a whole new group of people into buying their own home. Then, the person who just sold moves up,’ adding to more sales, he said.”

“Robin Rose, Coldwell Banker Brokers of the Valley general manager, said new mortgage products and lender competition have also spurred activity. ‘(This) resulted in increased money available for buyers,’ said Rose.”

“Realtor David Barker identified 2001 as a pivotal year for real estate. ‘What really took the market off was after Sept. 11 when the Federal Reserve dropped (interest) rates. That kick-started the housing market. Money was very cheap. It was easier to get a loan.’”

“‘As with any investment there are fluctuations in the market,’ said Rose. ‘So, while sales did decrease, 2006 represented the third-best existing home sale market on record. Remember that 2005 was the record year, so to see a drop off from record levels is not a surprise.’”

A thoughtful essay by Paul Krugman in the New York Review of Books titled,”Who Was Milton Friedman?” This excerpt gives a sense of the piece:

In his 1965 review of Friedman and Schwartz’s Monetary History, the late Yale economist and Nobel laureate James Tobin gently chided the authors for going too far. “Consider the following three propositions,” he wrote. “Money does not matter. It does too matter. Money is all that matters. It is all too easy to slip from the second proposition to the third.” And he added that “in their zeal and exuberance” Friedman and his followers had too often done just that.

A similar sequence seems to have happened in Milton Friedman’s advocacy of laissez-faire. In the aftermath of the Great Depression, there were many people saying that markets can never work. Friedman had the intellectual courage to say that markets can too work, and his showman’s flair combined with his ability to marshal evidence made him the best spokesman for the virtues of free markets since Adam Smith. But he slipped all too easily into claiming both that markets always work and that only markets work. It’s extremely hard to find cases in which Friedman acknowledged the possibility that markets could go wrong, or that government intervention could serve a useful purpose.

Friedman’s laissez-faire absolutism contributed to an intellectual climate in which faith in markets and disdain for government often trumps the evidence. Developing countries rushed to open up their capital markets, despite warnings that this might expose them to financial crises; then, when the crises duly arrived, many observers blamed the countries’ governments, not the instability of international capital flows. Electricity deregulation proceeded despite clear warnings that monopoly power might be a problem; in fact, even as the California electricity crisis was happening, most commentators dismissed concerns about price-rigging as wild conspiracy theories. Conservatives continue to insist that the free market is the answer to the health care crisis, in the teeth of overwhelming evidence to the contrary.

What’s odd about Friedman’s absolutism on the virtues of markets and the vices of government is that in his work as an economist’s economist he was actually a model of restraint. As I pointed out earlier, he made great contributions to economic theory by emphasizing the role of individual rationality—but unlike some of his colleagues, he knew where to stop. Why didn’t he exhibit the same restraint in his role as a public intellectual?….

In the long run, great men are remembered for their strengths, not their weaknesses, and Milton Friedman was a very great man indeed—a man of intellectual courage who was one of the most important economic thinkers of all time, and possibly the most brilliant communicator of economic ideas to the general public that ever lived. But there’s a good case for arguing that Friedmanism, in the end, went too far, both as a doctrine and in its practical applications. When Friedman was beginning his career as a public intellectual, the times were ripe for a counterreformation against Keynesianism and all that went with it. But what the world needs now, I’d argue, is a counter-counterreformation.

http://www.nybooks.com/articles/19857

Free market fundamentalists, most of which have never been within hailing distance of a real market (save perhaps a ceremonial visit to the New York Stock Exchange) view market prices as virtuous and seem woefully ignorant of the games speculators and market-makers play (see our post, “Are Speculators Driving Energy Prices?“)

An article in the Finacial Times, “Flame blame: how traders distort may distort energy costs,” discusses how US municipalities are pushing for greater transparency in US energy trading markets. As energy prices and policies become more politicized, it appears likely that collective interests will collide more forceably with institutional profits. And the same conflict is likely to affect carbon trading markets as they develop.

In a letter to Congress, the two [public utilities associations] warned that a lack of regulatory oversight in the vast over-the-counter energy trading markets meant that the prices consumers paid for the gas to heat their homes might be vulnerable to “manipulation strategies” by traders speculating in these sophisticated markets in New York and London.

“Over-the-counter” markets have become a powerful feature of the way energy is traded globally – anything from petrol and petroleum futures or natural gas and gas futures to more complex derivatives such as energy swaps. Unlike on the New York Mercantile Exchange, the world’s biggest market for oil and natural gas, OTC trading is not conducted in a pit where traders shout orders back and forth and the exchange reports their trades to the Commodity Futures Trading Commission (CFTC), the US regulator empowered to oversee on-exchange energy futures.

Instead, participants anywhere in the world negotiate specially tailored contracts with each other – linked by a telephone or computer screen connected to a special platform such as the Intercontinental Exchange, which operates a rapidly growing electronic crude oil futures trading business out of London.

Such ventures…account for up to 75 per cent of energy trading in the US…. But – to the alarm of the Iowa utility group and others – OTC markets have been only lightly regulated since their emergence as a force in energy dealings. Regular exchanges such as Nymex are fully regulated….

Manipulation typically occurs when traders drive prices up or down, beyond the normal forces of supply and demand – by either buying or selling unusually large amounts of the commodity in question…

OTC markets have not only grown rapidly in the last five years but their size also means they provide a “price discovery” function – that is, participants in the exchange-traded markets increasingly look to OTC prices to signal pricing direction for their trades. Tony Mansfield, former chief trial attorney in the CFTC’s enforcement unit and now with the law firm Heller Ehrman, says: “It’s increasingly difficult to expect that you can understand the on-exchange market if you are not taking time to pay attention to the off-exchange market. Trading strategies incorporate both markets.”

Despite the new importance of OTC markets, the CFTC has very limited powers to monitor these trades….OTC energy markets were exempted from such oversight by passage of the Commodity Futures Modernisation Act in 2000…Critics call this the “Enron loophole”.

Now, with Democrats in control of both houses of Congress, there is a clamour to close the loophole by requiring traders in the OTC markets to provide regular reports to the CFTC….

Dianne Feinstein, a Democratic senator from California who has campaigned on the issue since before 2000…has proposed a bill that would require traders to keep records on platforms such as ICE for five years and send regular trading reports – known as “large trader reporting” – to the CFTC. Last week Bart Stupak, a Democratic colleague of hers, introduced a similar bill in the House of Representatives.

But can attempts to close the Enron loophole succeed this time, where previous efforts by Senator Feinstein have repeatedly failed? The first problem is that that no one has yet proved conclusively that there is a link between speculation in the OTC markets and the prices that consumers pay for energy – although three studies have come close….

A second obstacle is the old Enron lobby itself….They have been diligent in wooing both Republicans and key Democrats who are perceived as being keen to keep Wall Street happy….

Some also warn that even if a way could be found of forcing OTC traders to institute reporting – difficult in the large phone-brokered segment of the market – this could drive markets away from the US….

Critics still say that without a regular monitoring role, the CFTC’s powers are limited. Indeed, the CFTC would not have been able to pursue many of the 35 energy-related trading cases it has filed since 2002 had it not been for tip-offs from marketparticipants. Randall Dodd, director of the Financial Policy Forum, a Washington-based non-profit financial research institute, says: “It’s dishonest for the government to say they have a full picture of what’s going on, because they don’t know the extent of activity and there’s no way they can know.”

Regulators are privately concerned that a source of price manipulation may also lie with the companies that control oil and natural gas supply at the scores of hubs scattered across the US….The CFTC is already investigating one Texas-based pipeline operator, Energy Transfer Partners, after reports that a subsidiary artificially lowered the price of natural gas at a gas purchasing hub in an apparent attempt to influence the prices reported to a widely-used gas index publication. That in turn allegedly influenced the outcome of a series of swaps trades on ICE…

Asked whether OTC activity could influence consumer prices, Roger Cooper, vice-president of policy at the American Gas Association, another advocate for local natural gas utilities, says: “The answer is no one knows. Is it possible that all this [hedge fund] money flowing in tends to push up prices a little higher then they would be in illiquid markets? Yes, it is possible.”

But, in the absence of any proof, he adds: “If people raise this question, then we have to have more transparency – if for no other reason than to reduce this uncertainty.”

Firms jealous of Goldman Sachs’ (GS) spectacular profitability often take aim at its appetite for situations rife with conflicts of interest. A few examples: in the recent New York Stock Exchange acquisition of electronic exchange Archipelago, Goldman acted as advisor to both the NYSE and Archipelago even though it was Archipelago’s biggest shareholder and a large customer, and also owned the biggest NYSE specialist. And let’s not forget, an alumnus, John Thain, is the NYSE’s CEO. That’s about as muddy as you can get.

In the summer of 2006, Goldman was fired by the city of Chicago which it was advising on the sale of Midway airport when it learned that Goldman was in negotiating to buy a European infrastructure player that was planning to bid on Midway. Goldman has also gone further than any other firm in becoming a hedge fund, yet is still one of the very biggest prime brokers (meaning hedge funds get financing, clearing, settlement, and trade execution through Goldman).

Now in Wall Street, customers are often competitors. But Goldman seems to be taking its propensities to push the envelope into the brave new world of carbon trading.

Goldman, like other investment banks, has recognized the potential of this business and has made investments. In September of last year, it took a 10.1% stake in Climate Exchange, a UK investor in carbon futures, for $23 million. That deal enabled Carbon Exchange to purchase full control of climate exchanges in London and Chicago in which it had held only minority stakes. Morgan Stanley (MS) has announced plans to invest $3 billion over the next five years, buying and selling carbon credits. JP Morgan (JPM) will invest over $250 million in wind farms. Dresdner Bank and Gazprom just formed a carbon trading joint venture that is expected to be a formidable competitor. Goldman also intends to invest $1 billion in renewable energy.

So far, nothing unusual about this pattern. Firms are trying to get in early on what promises to be a profitable and highly visible market, and many are planning to act both as principal and agent, brokering carbon credits as well as investing in projects.

But Goldman appears to have a particularly astute appreciation of the many ways to extract profit from this new sector. First, it is the most aggressive in taking a position in carbon exchanges (if the market becomes efficient, exchanges will be the point of departure for pricing large OTC trades, and could make OTC trades a marginal activity). Goldman made more investments in electronic trading networks than any other brokerage firm and clearly sees advantages to having a strong position in exchanges.

Similarly, Goldman also seems to exploiting opportunities that others may have not yet recognized. A colleague who played an important role in launching one of the very first carbon exchanges also happens to be a customer and counterparty of Goldman. The firm approached him about a sale of forest land in South Africa. My source has noticed that Goldman has also been buying and selling huge forest acreage in South America. He believes they are flipping the properties and retaining the carbon rights. We’ll know soon enough if he is correct.

A very interesing piece in the Guardian, “Davos ’07: it’s gone green,” points to surprising areas of agreement amongst the commercial cohort at Davos, but also exposes predictable fault lines. First the good news:

Davos has gone green. The first thing you see on entering the conference hall is an invitation to make your visit carbon neutral by way of a handy offset programme. And the agenda is packed with discussions about climate change, often with a surprisingly green flavour.

Thus in one series of debates, business leaders voted against the motion that markets were superior to regulation in leading companies down the path of righteousness; against the idea that a global carbon tax would do more harm than good; and against the idea that nuclear energy and clean coal were the only viable alternatives to oil.

Perhaps it’s the crisp clean mountain air that is turning the delegates’ heads.

If any of these notions survives the trip back to the real world, the most important is that regulation is a more viable way to get companies to take action on climate change than free markets. The problem with the market doctrinnaire persepctive is that it has no way to deal with externalities, namely, the costs of production and sale of goods that are borne by parties external to the transaction. If the elite who went to Davos can sell that to their corporate bretheren, real progress has been made.

However, an ugly but predictable split between the first and third world has come to the fore:

Speakers from China and India are taking every opportunity to make clear that the problem has been caused by the developed economies – and it’s those countries that are going to have to fix it.

The developing world is not going to accept limits to its growth in order to get us out of the mess.

Montek Singh Ahluwalia, deputy chairman of India’s planning commission and right hand man of its prime minister, made the point with absolute clarity. “The fundamental principle of environmental economics,” he said, “was that “every country should have the same per capita rights to pollution.”

Ooof, if we accept that premise, we might as well kiss the earth (as far as human habitation is concerned) goodbye.

And that in turn can undermine the lofty commitment of first world executives. When the EU announced its commitment to moving to a low-carbon economy, some business leaders protested, fearing it could undermine competitiveness. If China and India refuse to take aggressive steps to combat global warming, we could see a continued rush to the bottom as advanced countries insist on staying their current destructive course rather than lose market position.

We’ve commented from time to time on loose credit conditions (see our “Rising Tide of Liquidity“, plus Part 2 and Part 3 on the same topic) and indifference to risk (“Where Has the (Perception of) Risk Gone?“).

The tide may be turning. Today, the New York Times had a lengthy, well researched article, “Tremors at the Door,” on the reversal of fortune in the subprime mortgage market. Defaults by borrowers have risen to a level where the lenders themselves are increasingly in jeopardy:

Wall Street’s big bet on risky mortgages may be souring a lot faster than had been previously thought.

The once booming market for home loans to people with weak credit — known as subprime mortgages and made largely to minorities, the poor and first-time buyers stretching to afford a home — is coming under greater pressure….Now, Wall Street firms, which had helped fuel the growth in the market by bankrolling and investing in subprime mortgage lenders, have begun to pinch off the money spigot.

Several mortgage lenders have recently collapsed. While the failures so far are small in number, some industry officials are concerned that they could be the first in a wave. The subprime sector, which produced loans worth more than $500 billion in the first nine months of last year, could shrink significantly.

A sharp contraction in subprime mortgages would have ripple effects, reducing consumers’ access to credit and affecting investors like foreign central banks, pensions and mutual funds that have been big buyers of mortgage-backed securities….

“Pick a company — small, medium or large — they all have the same problem: capital,” said Marc A. Geredes, who runs a small mortgage company, LownHome Financial, in San Jose, Calif. “The economics of the business do not make sense right now.”….

Across the industry, 2.6 percent of the subprime loans securitized in the second quarter of 2006 had been foreclosed on or repossessed within six months. That is up from 1 percent for loans securitized in the second quarter of 2005, according to Moody’s Investors Service, the ratings agency.

The article mentions in passing that subprime mortgage paper is widely dispersed and its holders include hedge funds, mutual funds, and foreign institutions, including central banks. One of the beliefs about the way things are done now is that the widespread syndication of various credits means that institutions are better protected from risk, since they hold a more diversified portfolio of credits than was possible previously. That may be true, but we have also seen that there has been tremendous hunger for income and yield, and some old greybeards believe that risky credits have been underpriced.

Because subprime and other high-risk assets are now widely held, as those instruments go sour, it’s possible that dispersed, and seemingly diverse investors will all take note of their subprime losses and will pull in their horns as far as speculative (or even not-so-speculative) investments are concerned. In other words, the widespread syndication of risky loans could produce herd behavior in a contraction just as it did in the expansion.

There is a widespread belief in the US that editorializing in the Wall Street Journal is limited to the editorial page. We’ve seen in the past that this just ain’t so (see posts of January 12 and January 16). And today we have a doozy.

We have a real news event, reported as the lead item now on the Financial Times website, which means it will almost certainly be a first page story, “US boardroom excesses under attack:”

Leading global investors on Thursday launched an unprecedented campaign to curb outsized executive pay, urging regulators and companies to give shareholders the right to vote on compensation.

The campaign brings together fund managers such as ABP, Europe’s biggest pension fund, with US pension funds including the New York City Employees’ Retirement System.

A dozen international shareholder groups, managing more than $1,500bn in assets, have written to US regulators, politicians and stock exchanges pressing for a UK-style non-binding shareholder vote on executive compensation packages.

The letter, sent on Thursday, coincided with a similar one sent by the Association of British Insurers, representing a fifth of UK investors, and a move by US pension funds and religious groups to file motions asking for a vote on pay at 44 companies, including ExxonMobil, GE and Citigroup.

I searched the Wall Street Journal site several ways, and found nothing on this item. Instead, we have this page 1 story, which smacks of being a PR placement and happens to be a direct attack on the efforts to strengthen shareholder rights, “How Borrowed Shares Swing Company Votes:”

Private investment firms have found a simple way to profit from the workings of public companies: Borrow their shares, and then swing the outcomes of their votes.

In some cases, the strategy has allowed speculators to gamble that a company’s stock will drop, and then vote for decisions that will ensure that it does — without their ever having to own any stock themselves. Some outside interests have used the strategy to hide their voting power within a company until the last moment. Often, individual shareholders don’t realize their own stocks, and their voting rights, have been borrowed from their brokerage accounts, until it’s too late.

Fueling the practice — dubbed “empty voting” in a study by two University of Texas professors — is a booming business in lending shares. That business has nearly doubled in the past five years, according to one report, and now earns $8 billion a year for big brokerages and banks plus an unknown amount for institutional investors. Voting rights are lent along with the shares, and increasingly, that is leading to unintended consequences.

Now the way the Journal has connected the dots is sneaky and misleading. They claim that short selling is “fuelling the practice” of empty voting, and by citing an academic study in the same paragraph, they try to buttress this linkage. Yet the vast majority of short selling is in hedge fund long-short and market neutral strategies, which by the very requirements of their investment style, do not engage in shareholder activism. The article goes on further to admit that the professors don’t know how much “empty selling” takes place. Indeed, they found only 22 examples WORLD WIDE from 2001 to 2006, and in 10 of those cases, the “empty shareholders” appeared merely to be hiding their stake rather than trying to swing a contest. Oh, and the two examples the Journal cited as illustrations of why this is bad both occurred outside the US, one involving Henderson Land Development, a Hong Kong company, the other British Land, a UK concern.

If you bother to read the actual paper (the Journal provides a link only to the abstract, and it takes a wee bit of fuss to get the study), the Journal has misrepresented it. The paper discusses the benefits as well as the costs of empty voting, and it cites the British Land example as a beneficial case!

In other words, if this is a problem, it isn’t much of one, particularly as far as US markets are concerned.

This article, posing a trumped-up problem, ignores a much bigger problem, namely, that institutional investors rarely vote against management, because their role as fiduciary conflicts with their business interests. If you are a Wellington or a Fidelity, you want to win the defined benefit and/or 401(k) business of major corporations. You most certainly are not going to alienate management by voting against the incumbents.

Now why do I believe that this story is an attempt to crowd out the real news of big institutions pressuring the SEC to have a greater say in CEO pay and director nomination? Because of a story that ran in the FT earlier in the week (I was tempted to comment on it at the time) that also went unnoticed in the US. Titled “US commissioner in hedge fund alert,” it parallels the Journal piece in some odd respects:

Short-termist activist hedge funds could gain undue influence on companies’ boards as a result of expected new rules allowing shareholders to vote on company directors, Paul Atkins, a commissioner at the Securities and Exchange Commission has warned.

In a speech to company directors and corporate governance experts on Monday night, Mr Atkins said giving investors greater say on the composition of boards could have the unintended consequence of increasing the power of hedge funds.

He said hedge funds’ ability to borrow and short-stock before crucial corporate meetings and use financial derivatives to own shares without having an economic interest in the company could lead to the appointment of “special interest directors”….

The issue of shareholder access to the company proxy is moving centre stage in US corporate governance.

The SEC is expected to revisit the issue in coming weeks, four years after an earlier attempt to allow such access failed. The subject is part of growing calls by investors for greater influence on corporate governance matters after the scandals of the past few years.

This week, Norway’s Norges Bank Investment Management, Hermes of the UK and Dutch duo ABP and PGGM, pressed the SEC on shareholder access to the proxy.

Opponents of such access, chiefly the Business Roundtable and US Chamber of Commerce, have long argued that opening up the proxy for voting purposes could allow companies to be “hijacked” by special interests – usually a reference to unions and environmental activists.

But Mr Atkins said the increasing role of hedge funds and other activist investors in pushing for change to underperforming companies, or influencing the outcome of takeovers, means any debate should now also include the role of such interests…

A 2005 BusinessWeek article discusses how Atkins, a Bush appointee, has fought (and often been the lone holdout against) regulation of hedge funds, large fines against miscreants, and former SEC Chairman William Donaldson’s plan to let shareholders nominate corporate directors. He reportedly plays dirty, complaining about the Commission to the White House and encouraging attacks by outsiders like the Chamber of Commerce (hhm, didn’t we see that name a couple of paragraphs ago?)

So here we have the idea of stronger shareholder democracy might be nixed out of theoretical concerns that “special interest directors” might “hijack” companies. Gee, legitimate shareholders, like Ted Turner in the old Time Warner (TWX) days, who WERE directors by virtue of their large stakes, were only able to make noise.

Even before a special interest shareholder has ever existed, they are assumed to be detrimental. And Commissioner Atkins just happens to be using a very similar sort of bugaboo, barbarians at the gate gaining illegitimate access to the corporate inner sanctum, as the Business Roundtable and Chamber of Commerce have for years, but in their 1.0 version, the bad guys were unions and environmentalists. In the 2.0 release, it’s hedge funds. And both the Journal and Atkins have as the only evidence a single study with very few data points and even fewer negative outcomes from academics at a second rate institution. This is the best reason they can give us for not interjecting some checks on CEO pay?