naked capitalism

On the one hand, it’s a relief that the stock markets in the US stabilized today, although the Dow recovering only a bit more than 1/10 of its prior day tumble is hardly a rousing vote of confidence. On the other hand, we have to scratch our heads as to how even this wee bit of recovery was achieved.

Perhaps Lazlo Birinyi was right, and we would have had a rebound regardless. But the Nikkei and the European averages were down a second day, and it seems just as likely that we would have had another down day, but likely an only modestly down day, as the worldwide panic was ebbing.

So that it a longwinded way of saying that I believe that Bernanke’s and Greenspan’s remarks had more than a little to do with the stock market recovery today. And I have a problem with that.

Simply put, before Greenspan, Fed chairmen didn’t give a rat’s ass about how the stock market fared. And by its charter, the Fed has no role in the equity markets. The objectives of the Federal Reserve System are to “furnish an elastic currency, to afford a means of rediscounting commercial paper,” and “to furnish a more effective supervision of banking in the United States. As Palgrave’s Dictionary of Money and Finance puts it, “in short, the Fed was to execute monetary policy, act as a lender of last resort, and regulate and supervise banking.”

But Greenspan became keenly interested in the stock market. He put the valuable and scare resource of bright young Fed economists on studying the formation of stock prices, rather than, issues related to the Fed’s charter, such as, the proliferation of various forms of near money and how that affected the Fed’s role as steward of money supply. And his oracular pronouncements came to have great sway over the equity markets, in large measure because market participants believed (correctly, in my mind) that the Fed cared about the health, and perhaps even the performance of the stock markets.

And today’s events would seem to confirm that belief. By a bit of good fortune (if your fortunes happen to be tied to the stock market), Bernanke was scheduled to speak before the House Budget Committee, which gave him a ready platform to dispense reassurance (I don’t know how with a straight face he can forecast a strengthening economy for the second half of the year. If that isn’t pandering to the markets, I don’t know what is). And Greenspan similarly retreated somewhat from his prediction earlier this week, now saying recession was “possible,” not “probable”.

A mere 3% correction is not worth the Fed saying anything. A market move of that magnitude posses no threat to the security of the banking system. Even if we has had another bad day today, a 6-7% downdraft similarly poses no threat to the banking system. The crash of 1987, a far more dramatic decline (25%) did get a bit scary the week after because the Japanese started repatriating capital and stopped buying Treasuries. Some words were apparently said in high places and Japanese banks resumed their Treasury purchases (I was in Japan at the time, and heard this directly from people involved with the Ministry of Finance). That, and orchestrating the bailout of LTCM, which threatened the financial system, is an appropriate use of the Fed’s authority. Acting as a CNBC talking head is not.

Another reason to be less than happy with Bernanke’s testimony is that it represents a transfer of wealth away from middle class Americans to savvy financial players, who pretty much by definition are affluent. Palgrave points out that the reason the early corporate central banks, such as the Bank of the United States, were dissolved was that having wealthy individuals in charge of the federal government’s banking activities was inherently anti-democratic. It further notes, “….there has been a lively element of American politico-economic thinking that any central bank is likely to attend to the interests of the rich and powerful, which – depending on one’s own politics – might or might not coincide with the public interest.”

Dean Baker in his Beat the Press comment, “Should Bernanke Be Stabilizing Financial Markets?” sees Bernanke’s pronouncements today as a sop, perhaps untended, to the smart money crowd:

In his testimony before Congressional today, Ben Bernanke reportedly made an effort to sooth uneasy financial markets. For this he was widely applauded by the business press. But is it the Fed’s job to be soothing financial markets?

Let’s throw out a purely hypothetical scenario. Imagine that the bad news on new home sales, mortgage applications, durable goods orders, and productivity actually translates into an economy that is about go into a recession.

Now let’s suppose that the market has two types of investors. The first type are the high rollers. They move in and out of financial assets on a moment’s notice. Let’s call them “hedge funds.” The second type are naïve investors. They put money into the stock market at regular intervals and let it sit. We’ll call them middle class 401(k) investors.

Okay, now in our hypothetical scenario, because the economy is genuinely facing serious problems, the market is likely to be heading downward in the months ahead. Our hedge fund investors will likely begin to recognize this fact and dump their stock. On the other hand, our middle class 401(k) investors are likely to keep putting new money into the market.

Suppose that Mr. Bernanke recognized that the economy is facing trouble and told Congress that the future looks bleak. The markets would presumably crash, because both the hedge funds and the middle class 401(k) investors would dump their stock. Everyone takes a hit, but the pain would be shared between the hedge funds and the middle class 401(k) investors.

Now, let’s suppose that Mr. Bernanke recognizes bad times ahead, but thinks that it is best to try to calm the financial markets, so he tells Congress that the economy is just fine. While this could be sufficient to assuage the middle class 401(k) investors, the assurances may not be sufficient to calm the hedge fund investors. Suppose they offload their stock over the next few weeks.

In this case, Bernanke’s soothing words would have the effect of keeping the market high while the hedge fund investors offloaded their holdings. The big losers would end up being the middle class 401(k) investors who keep buying into a sinking market.

In this purely hypothetical scenario, it would not be good for Bernanke to soothe financial markets, unless the goal is to redistribute wealth from middle class 401(k) investors to hedge funds. While this scenario may bear no relationship to the actual situation, it is not always true that the Fed should be trying to stabilize financial markets. The press could ask some questions along these lines, instead of just assuming that stable financial markets are always good.

The back-and-forth between Alan Reynolds, senior fellow at the Cato Institute, and Mark Thoma, professor of economics at the University of Oregon, continues at the Cato Unbound site. Alan Reyolds, who has been arguing both at Cato and on the pages of the Wall Street Journal that income inequality has not been rising, posted a narrow response to Mark Thoma’s earlier reply.

The discussion has devolved, since Reynolds complains that the data he cites is being ignored by Thoma et al. Thoma has argued that Reynolds has been cherry-picking information, that some of the information Reynolds’ cites doesn’t necessarily support his conclusions, and that the great preponderance of academic work in this area, using a variety of sources and methodologies, points to increasing rather than decreasing inequality. Reynolds’ last response, “Red Herrings Can Be Interesting,” addresses one complaint made by Thoma, but ignores his larger argument.

Thoma’s latest post, “How Should Changes in Inequality Be Measured and Assessed?,” is a bit discursive, but worth reading if you need to consider this topic in depth. This paragraph sets up his latest comment:

I am pleased to see that Alan Reynolds is finally taking a closer look at some of the evidence that works against his claim that inequality has been stagnant in recent decades, though he predictably dismisses it. I will not convince him the evidence is valid, and he most certainly has not convinced me that it isn’t, so I encourage anyone who is still puzzled about the evidence that profits have been mismeasured and that it matters for assessing changes in inequality in recent years to look at the research and draw their own conclusions. I have no doubt that a fair reading of the evidence will lead to the conclusion that inequality may in fact be worse than we thought which runs opposite of Reynolds’ claims.

The last post gave the bears’ case. Here is a far more optimistic view, “S&P A/D Reading Worst in Ten Years – Rebound Likely Tomorrow,” from Seeking Alpha. FYI, Birinyi is as noted a bull as Roubini is a bear. And they both could be right. Birinyi, after all, is only forecasting today’s results:

Birinyi’s Ticker Sense submits: As a follow up to our prior post, the S&P 500 A/D line got much worse, along with the performance of the index itself. For the day, just two stocks in the index closed up — RSH and STR, leaving the A/D line at -498. This ties 7/6/01 for the worst reading in the past ten years.

Below, we list the weakest S&P 500 A/D readings since 1997 and show the next day performance of the index as well. As shown, the index has gone up 73% of the time the next day for an average gain of 1.19%.

Oooh, if you read DealBreaker.com, it was really miserable to be a trader in the middle of the carnage yesterday. But it’s hard to muster too much sympathy when you recall that the average pay at Goldman last year was just over $620,000.

The real test of how serious this really is isn’t simply how badly the US market performs today (although a day as bad or worse than yesterday will focus the minds of the powers that be). If the Dow goes down by 200 points or less at its worst and corrects to a smaller loss, the panic phase of this correction will be over, and we’ll see a reassessment, and likely a contination of an equity downtrend, but at a measured pace.

The real test is if and when Bernanke and perhaps Greenspan say something to reassure the markets. If we have another comparably bad day, expect to hear from them fairly pronto. But if we have an only moderatly bad day, and either makes a statement before the end of the week, it’s a sign that they are worried about systemic risk, for example, hedge fund exposures possibly leading to further panic selling, and potentially even losses at prime brokers.

Below we have a cheery outlook, “Economic and Financial Hard Landing Ahead,” from Nouriel Roubini at RGE Monitor, my favorite bear who today looks brilliant (although a cynical friend observes that a stopped clock is right twice a day). His “hard landing” outlook strikes me as sound, but markets rarely move in a linear fashion.

Note that he makes comparisions to 1997 and 1998. Even though those financial panice did selective damage (serious harm to Thailand and Indonesia and emerging markets investors), they did not seriously hurt the world economy, and in retrospect, did not take much air out of the growing asset bubble. So as much as Roubini can point, persuasively, to plenty of evidence of fundamental weakness, we also have a Fed that floods the markets with liquidity when things get bad, and investors that are conditioned to having the Fed bail them out, and therefore buy on corrections. We will know relatively soon whether the true believers or the realists win out.

Today we had a meltdown of many stock markets, first in China, then in Europe, the U.S., emerging markets and globally. What happened today is consistent with my outlook for a U.S. hard landing this year.

The China crash had its source in the stock market bubble in China that is now beginning to burst as Chinese authorities started to crack down on these speculative excesses. This crash may be the beginning of a broader downward adjustment in the stock market in China that may lead to a broader economic slowdown in China.
Housing bubble

We also had contagion from China to other global stock markets. This contagion is a combination of the China crash and of the lousy economic news out of the US. This bad news include a sharply falling investment by US corporations (durable goods orders sharply fell), a worsening housing recession, a meltdown of the sub-prime component of the mortgage market that is leading to a much broader credit crunch in the economy. These bad economic news from the US suggest that the US will enter into a recession this year – as I predicted last summer – as early as Q1 or Q2. Even Alan Greenspan warned yesterday of the risks of a US recession.

So, the China crash and the lousy economic news out of the US led to a stock market crash in the US and in other global markets. This is not the first time that financial contagion happens from emerging markets to advanced economies: in the fall of 1997 when the Asian crisis became global a collapse of the Hong Kong market in October led to a sharp sell-off of the Dow Jones (500 points in one day), as the one we had today. Also the collapse of Russia in August 1998 led – with a short lag – to contagion to US financial markets and to the LTCM near-bankruptcy. So shocks from emerging markets can affect markets and economies in developed countries, especially when the latter have meaningful financial and real vulnerabilities, like the US today.

The US is likely to enter into a recession in 2007; and even a likely and early easing of monetary policy by the Fed will not prevent such a recession as there are too many weaknesses in the US economy: a housing recession, an auto recession, a manufacturing recession, a real investment recession (as corporations are reducing real capital investment and inventories are falling), a US consumer that is on the ropes and at its tipping point; a meltdown in sub-prime mortgages that is leading to a generalized credit crunch in the economy. It is already ugly and it will get uglier in the real economy and in the financial markets. We are likely to observe a vicious cycle where a credit crunch and a persistent sell-off in equities leads to a worsening of the real economy with a hard landing (recession) that then weakens further the financial system. One cannot rule out a broader banking crisis if a deep recession occurs.

A Fed easing – likely in the next two-three months – will not prevent a recession; it will barely put a floor on it. It will not prevent is as we have in the US a glut of housing, a glut of durable goods, a glut of capital goods. Lower interest rates will not help for the same reasons why slashing the Fed Funds from 6.5% to 1% in 2001 and after did not prevent a recession: once a glut and overhang of capital goods occurs (tech goods in 2000, housing and durable goods today) the demand for such goods becomes interest rate insensitive.

What will be the fallout of a US recession for the rest of the world? Europe, Asia and the rest of the world will not decouple from a US hard landing. If the US were to experience a soft landing Europe and the rest of the world will do fine. But if a US recession does occur there will be a significant economic slowdown in Europe, as well as in China, Asia and other emerging markets. China will be a primary victim as its excesses and its dependence on exports to the US are particularly important. So it is still the case that when the US sneezes the rest of the world gets the cold.

A US recession will be the result of the bubbles and excesses of the US economy in the last few years: a housing bubble now going bust; negative household savings; negative government savings (i.e. large budget deficits), low national savings and thus a large current account deficit. The party will be soon over; and the complacency and under-pricing of risk in financial markets will soon be corrected with painful consequences for the US and the global economy. The US economy has been living in a financial bubble for too long. Now this bubble is bursting – yesterday in housing and sub-prime, today in the stock market, soon enough in a wide range of other risky assets. The fallout will be very painful for the US and the world once a US recession and severe financial sector distress interact in a vicious cycle.

No way will Bush do anything seriously hostile towards Iran with the markets in a fragile state.

I trust readers don’t mind the high proportion of Financial Times stories today. You’ve probably figured out that the FT often runs stories that don’t get reported in the US.

While the title of this post is a bit of a mouthful, the concept is pretty simple. As you know, the pricing of risky credit has been very aggressive of late, or to put it more simply, doggy borrowers are getting astoundingly good terms (although with the wreakage in the subprime mortgage market and the China-led fall in global stock markets today, we may be seeing the beginning of the end of this trend).

One consequence that hasn’t been noted heretofore is the effect it has had on private equity firms. One of the legitimate concerns is that a private equity firm could simply load up an acquired company with a lot of debt, pay itself a big special dividend, do some short-term, unsustainable cost cuts to make the results look artificially good, and dump the company back on the public markets (you’d think the markets would be smart enough to assign an appropriately low price to a debt-ridden IPO, but never underestimate the ability of a good road show to dress up a bad investment proposition). Moreover, if they can pull out enough cash, the buyout firm does not need to sell the company to realize a good return. Any proceeds upon sale is gravy.

Tony Jackson, in “Derivative risk threatens private equity,” explains how one of the checks on private equity firms overleveraging an acquired company, namely, the prudence of banks making the loans, no longer works the way it did before. (As an aside, one can’t necessarily rely on bank conservatism either. In the last big buyout cycle of the mid-late 1980s, banks lent to quite a few dodgy deals that later went bust, simply because they were keen to book the huge up front fees thay paid. So if the not-so-good old days look comparatively good, you can imagine how frothy things are now, at least in the credit markets).

Jackson describes the role of collateralized loan obligations, and how their pricing says that no one is taking risk into consideration:

In practice, it is perfectly possible for private equity to load a company with excess debt, then strip the cash out as a dividend. If this is done on a big enough scale, the fund can profit handsomely even if the company goes bust.

In previous cycles, there was an obvious safeguard against this: the banks would not lend more than a company could bear. But that has all changed with the advent of credit derivatives.

Today, a bank can grant a leveraged loan with impunity, since it can offload the credit risk. And market demand for that risk is insatiable. The form of credit derivative known as the collateralised loan obligation, or CLO, feeds on just such loans. Hence presumably the fact, as reported by Standard & Poor’s, that there is no known case lately of a European issuer of a leveraged loan failing to get it placed.

In itself, this kind of securitisation of loans – the spreading of risk across the investment community – is a natural enough development, and not obviously harmful. But the problem right now is that the credit derivatives market seems to have taken leave of its senses.

Some recent work by Absolute Strategy Research illustrates the scale of this. As is well known, premiums on credit default swaps (CDSs) have been falling for several years, and are now at an all-time low. In other words, the cost of insuring against default is increasingly negligible.

What I did not know, though, was how differentials between different types of risk had fallen as well. Across Europe, it appears, premiums for cyclical stocks and industries are now almost the same as for non-cyclicals. That is, the cost of insuring against default is almost the same for industrial or high-tech companies as it is for pharmaceutical firms or utilities.

If that sounds daft, so does the fact that over the past year, premiums on 10-year CDSs have fallen markedly in relation to 1-year CDSs. So as the expected turn in the credit cycle has failed to materialise, it seems investors have come to assume it never will – or not over the next decade, anyway.

The reality, no doubt, is somewhat less rational. What we have here is our old friend, the hunt for yield. Bigger risks offer a bigger return, so bid up those risks and depress the return.

If that seems rather remote from our starting point, consider the link once more. Private equity houses are in a position to overload companies with debt because at the other end of the line, those underwriting the risk are quite insensitive to the dangers this poses.

When the music stops, of course, a lot of people will get burnt – most obviously, holders of credit derivatives. But some private equity houses will presumably get caught as well, if they have not managed to extract enough cash before their companies hit trouble.

And the fallout could be a lot wider. Pension funds are big investors in private equity, and some dabble in credit derivatives. Pensioners aside, people in bankrupt companies are going to lose their jobs, without any benefit to the economy whatever. And if that happens, the abuse we are seeing today will only be a taster.

The Wall Street Journal reported today, in “No Worries: Banks Keeping
Less Money in Reserve,” that banks have been lowering their reserves for loan losses to the point where regulators are now beginning to question whether they are adequate.

Now this isn’t exactly surprising. Banks, despite their reputation for being conservative, follow the herd. And it’s virtually a given that, at the end of a credit cycle, they will be in a period of extending loans to riskier and riskier borrowers at a time when they have also lowered their reserves. The incentive, in both cases, is the hunt for more earnings. Riskier credits look most enticing after a period of economic growth, when they look safer than they really are by virtue of favorable recent history. And cutting (the term of art is “reversing”) loss reserves boosts earnings.

What is odd about the WSJ piece is it fails to mention Basel 2, the international agreement governing bank capital adequacy, which may also have something to do with the tougher view banking regulators are taking. The Economist, in a recent story, “A twist or two of Basel,” gives an overview:

Since January 1st many European banks have begun implementing the new rules, which govern how much capital they must set aside to cushion themselves from various calamities….The more capital they must squirrel away to satisfy regulators, the more insulated they are from untoward events—but the less money remains to be put to work in order to make profits.

Happily for the bottom lines of big European banks, regulatory capital is expected to drop under the new regime—perhaps dramatically. Under Basel 2, the amount of capital a bank must sit on depends on the riskiness of its loans and other assets….

Banks in America, on the other hand, are glum. Their regulators have taken fright over studies showing that banks’ required capital could fall by an average of 16% if they embraced the new accord. European regulators are inclined to let regulatory capital fall (subject to the discretion of national authorities). American regulators are not. They have now proposed changes in America’s version of Basel 2 that will delay its implementation until at least January 2009. Under their proposals American banks will be subject to a number of “safeguards” that keep capital cushions plump…. America’s regulators are too uneasy about the Basel 2 project to lighten up. They think the accord relies too heavily on banks’ in-house risk models, which are fallible and “highly subjective”, as one regulator put it. Quietly, some also worry about European banks, which already have much higher levels of leverage than American ones and hold less capital to offset it.

Others fret about a lack of transparency. Under Basel 2, national regulators can force individual banks to boost capital reserves if they see fit. But in Europe it is unclear what an unacceptable level of capital might be, or how bank regulators would react if a bank edged towards it.

There is no such ambiguity in America, where banks have been held to a stringent regime known as “prompt corrective action”. This came into law in 1991 in the wake of America’s savings-and-loan debacle, in which more than 2,900 banks failed. Then, regulators repeatedly threw lifelines to struggling banks, which only postponed their inevitable collapse. Now, they have much less scope for leniency. They must take specific, and increasingly severe, actions—from curbing lending to closing a bank—as a bank’s capital ratios deteriorate. The idea is to intervene before banks get into trouble, and to make the consequences of falling into the red zone clear to banks and investors well before anything bad happens

With this background, the regulatory posture described in the Journal shouldn’t be as surprising as its writers make it out to be:

As more consumers and companies start having difficulty paying their debts, the funds that banks set aside to cover soured loans stand at the lowest level since at least 1990.

The situation is causing consternation among regulators. And as credit quality begins to deteriorate from unusually strong levels, the issue also is causing jitters on Wall Street, where analysts predict the need to boost loan-loss reserves will cut into banking-industry profits this year….

Typically, investors and regulators fret that banks overestimate these charges during good times so they will have a cookie-jar to dip into when times are rougher. Now, though, the worry is that banks haven’t put aside enough money to cover bad loans because times have been so good and because they haven’t wanted to damp profit growth.

In a December advisory, regulators reminded bank executives that they should use the leeway available to them in calculating reserves because “we do believe there is risk building in the system,” says Kathryn Dick, deputy comptroller for credit and market risk at the Office of the Comptroller of the Currency, which regulates banks.

That guidance “was a heads up, a shot across the bow, if you will, to the banks,” said Lynn Turner, managing director of proxy advisory and accounting-research firm Glass Lewis & Co. and a former chief accountant with the Securities and Exchange Commission….

Banks set aside an average of 1.09% of the total value of their loans at the end of last year, according to data from 518 publicly traded banks compiled by SNL Financial for The Wall Street Journal. That is a dip from 1.14% in 2005 and from 1.63% in 1992 and 1.48% in 1990. The SNL figures date to 1990.

“There is a growing concern about loan quality and it isn’t reflected at all in the reserves,” says Brian Shullaw, an associate director at SNL, a Charlottesville, Va., research firm that focuses on the financial-services industry….

Over the past few years, investors have benefited from the lower reserve levels because they helped boost profits. The banks say that they have been draining their reserves because few borrowers have defaulted on their loans. From 2004 to 2006, the nation’s biggest banks received 37% of their earnings growth from reductions in their loan-loss reserves, according to a Feb. 12 Morgan Stanley report. Big regional banks got a bigger boost, with the freed-up reserves accounting for 52% of earnings growth, according to Betsy Graseck, a Morgan Stanley banking analyst.

A number of banks have drawn down their reserves for bad loans to “apparently unsustainably low levels,” according to a recent report from the Center for Financial Research & Analysis, a Rockville, Md., accounting-research firm.

Indeed, banks are expected to soon start reversing course and building reserves amid growing expectations that the boom times are drawing to an end. Although loan defaults and charge-offs remain at historically low levels, bank executives predict that credit quality, which has weakened, will erode further this year.

Ms. Graseck, who is predicting that big-bank earnings will rise 5% this year, estimates that a 10% increase in reserves could reduce that earnings growth by four percentage points.

The trend comes at a time when bank profits are also expected to be hurt this year by short-term interest rates going higher than long-term ones — the so-called inverted yield curve. Banks typically profit by borrowing short-term and lending long-term, so when the yield curve inverts, profit margins get squeezed.

“All of these banks are perfectly sound, but I do think a number of banks will miss earnings estimates based on rising loan provisioning,” says Kevin St. Pierre, a banking analyst at Sanford C. Bernstein & Co.

Historically, banks tend to see their provisions for bad loans increase when interest rates start to rise because higher rates cause problems for weaker borrowers and slow the economy. But that hasn’t yet happened, even as the Federal Reserve has steadily raised rates to a current level of 5.25% from historic lows.

Whether and when banks should take additional provisions for loans that might not be repaid is a point of contention among bankers, regulators and accounting rule makers. Many bankers would like to set aside funds for possible bad loans in good times, forming a cushion for when things get tough. But that isn’t permitted because such moves can be abused to manipulate earnings.

As a result, accounting rules generally don’t allow banks to use provisions as “rainy-day funds.” Instead, they require banks to take a provision when it is “probable” that a loan has gone bad. So, a bank can’t establish a provision for, say, 2% of a loan portfolio just because that is the amount that typically tends to turn bad. Instead, it must assess an array of events that lead it to believe a loss is probable.

China and to a lesser degree India have been forcefully asserting the right to pollute as much per capita as the US in the pursuit of economic development. However, the signs of climate change are already sufficiently advanced in their countries that, despite the combattive posturing, officials recognize that these countries too will have to find ways to use energy more efficiently and reduce carbon emissions.

From a story in the Financial Times, “China and India face up to curbs on carbon:”

Beijing’s eerily mild winter has provoked anxious media coverage in the Chinese capital. In India, the melting of the Himalayan glaciers that feed the country’s great river systems is alarming policymakers. The world’s two fastest-growing large economies are growing increasingly conscious of the global warming in which their rapid development is playing a part….

After a quarter-century of improvements, China’s surge of investment in heavy industry and power capacity since 2000 has seen energy efficiency levels retreat and pollution measurements soar. China added power capacity last year equal to the entire grids of the UK and Thailand combined, 90 per cent of it coal-fired, to feed its growing stack of steel, aluminium and cement plants and the like.

By 2009, says the International Energy Agency, China will have overtaken the US as the largest emitter of the portion of greenhouse gases that are energy-related….

Although China and India acknowledge their emissions are rising, they argue that, per capita, they remain a tiny fraction of those from developed countries. Moreover, China’s cumulative emissions are only one-third of those of the US and one-sixth of those of all the developed countries grouped in the Organisation for Economic Co-operation and Development, according to the World Bank. The cumulative emissions of India, which has a higher energy efficiency rate than China, are about one-tenth those of the US.

The initial reaction in both countries to international pressure has been to point to the refusal of the US and rich fellow-travellers such as Australia to sign the Kyoto protocol for mandatory emissions caps….

Gao Guangsheng, the director of China’s Climate Change Co-ordination Office, pointedly singled out Australia, population 20m, at a recent conference in Nairobi, saying that if it had as many people as China’s 1.3bn, its carbon emissions would total 8.6bn tonnes a year. China’s emissions are now about 1.3bn tonnes a year.

“China uses coal not because we love coal but because that is the resource we have,” he said.

The US and Australia in turn cite China and to some extent India to justify their own refusal to move on the issue, arguing that new caps are pointless until Beijing and New Delhi come on board….

China is in the crosshairs of the global community more so than India because its economy has grown faster than that of its neighbour, is more reliant on heavy industry and is thus more energy intensive. In recognition of the problem, China’s top leaders have set stringent numerical targets for improving energy efficiency per unit of economic output by 4 per cent annually in the five years from 2006. So far, however, they have failed to meet the benchmark, an embarrassment for Beijing as it was one of only two numerical targets in the latest five-year economic plan….

Both China and India suffer from acute air and water pollution. In 83 Indian cities for which air quality monitoring data are available, more than 84 per cent of the population was in 2004 forced to inhale poor, bad or dangerous air. Only 3 per cent had access to air that was rated good. China is home to 16 of the world’s 20 most polluted cities, with dirty air causing the premature deaths of 400,000 people a year. About 340m people, about one-quarter of the population, do not have access to clean water.

With such pressing short-term issues on the desks of central and local government leaders, the ability of the political system to tackle global warming may be limited, even if the urgency is recognised. “If China can’t even get traction on cleaning up the water supply, it is difficult to see how it can get traction on this,” says Ms Lin.

Still, both China and India are clearly concerned about climate change for their own sakes, let alone the impact on the rest of the world. In China, scientists warn that the impact of rising temperatures on the Qinghai-Tibet plateau could alter the amount of water flowing into the Yangtze and Yellow rivers, which originate in the region. The same sort of impact may be felt in key Indian river systems. Glacial melt would lead to increased summer flows in some directions for a few decades, followed by a reduction as glaciers disappear.

India’s agricultural productivity, already flagging, is thought likely to suffer because of high temperatures, drought, flood and soil degradation. The Chinese media have cited similar scenarios, including a fall in grain output by 10 per cent a year from 2030. Such threats run counter to the maintenance of food security, which both governments prize.

This means, as in the developed world, that both industry and consumers will need to be cajoled to change their ways. “It is the unbridled luxury consumption of its affluent classes that is driving the giddy rise in India’s greenhouse gas emissions,” maintains Praful Bidwai, a social and economic commentator. “The majority of Indians remain as frugal as ever in their use of resources. This makes it imperative that India move towards accepting deep cuts in emissions, in particular those relating to private vehicles, the profligate use of energy and water by the rich and the skyrocketing consumption of air conditioners, washing machines, microwave ovens and plasma and liquid crystal display television sets.”

The more industrial China is eyeing fuels such as coalbed methane. Extracting methane from China’s bountiful coal reserves can transform a dirty, carbon-heavy by-product of a dangerous mining industry into a relatively clean and potentially competitive fuel.

In both countries, traditional coal fuels will still be the dominant source of energy in 2020. But nearly all of the energy-consuming products that will be in existence by then have yet to be manufactured, giving the two governments scope to encourage citizens and businesses to choose efficient examples of goods such as refrigerators, air conditioners and boilers.

A Beijing-based economist says he has a simple message he uses to remind Chinese officials of the urgency of the issue. “There are a lot of low-lying areas in China,” he says. “And if the Greenland ice caps melt, [landlocked] Mongolia will have a coastline.”

That’s the title of an article in today’s Financial Times, describing how concerns about the implosion of the subprime mortgage market has led to concerns about the broader mortgage market. As the piece sets forth, this isn’t simple speculative precaution; it turns out delinquencies are running higher than expected in mortgages that are rated just above subprime. We pointed to the possibility of contagion earlier, when most commentators were maintaining that the subprime meltdown was an isolated phenomenon. From the FT:

Treasury prices rose on Monday as fixed income investors sought a safe haven amid fears that repayment problems involving “subprime” US mortgage borrowers could have knock-on effects in the broader $8,000bn mortgage market and beyond.

The latest concerns centre on the Alt-A market, in which consumers with slightly better credit than the weakest subprime borrowers can obtain loans with loose terms – such as no proof of income. Late payments and defaults on such loans are running at four times the historical rate.

“The delinquency numbers for the 2006 Alt-A originations are materially worse than a lot of people would have expected,” said Charles Sorrentino, mortgage analyst at Merrill Lynch.

The flight of investors into more secure investments helped send yields on 10-year Treasuries down four basis points to 4.633 per cent. The price of insuring against default on subprime mortgage bonds also remained near record levels. The annual cost of credit protection on the ABX index of mortgage bonds rated BBB- rose to 14 per cent, up from 13 per cent at the start of the day and just slightly off last week’s record of 15 per cent. Three weeks ago, the price of such protection was 2.5 per cent.

There are particular concerns about the estimated $600bn of adjustable rate mortgages – of which two-thirds are subprime – that are scheduled to reset at a higher interest rate this year. Analysts worry that higher rates will lead to more foreclosures and lower consumer spending.

“The sub-prime story seems to have developed legs as Treasury traders seized on the idea that ABX [index)] woes may seep into other markets and create a credit dilemma,” said William O’Donnell, interest rate strategist at UBS. He said subprime problems were “topic number one in the US rates market place”.

Michael Kastner, portfolio manager at SterlingStamos, said: “Investors are not fully pricing in the risk of contagion, but as structured deals start to go sour and get downgraded, the pain will spread.”

Shares in subprime lenders were also hit hard on Monday. Novastar Financial slid 6.1 per cent to $7.96, and New Century Financial fell 1.8 per cent to $15.24. Shares in Countrywide, were off 1.5 per cent at $38.72.

“Subprime is hitting some financial institutions hard, though typically this market is dominated by independent mortgage companies and the knock-on systemic impact to the broader lending market should remain restrained,” said Alan Ruskin, chief international strategist at RBS Greenwich Capital.

It is singularly odd (one might even say out of line) for a former Fed chairman to intrude on the turf of the current Fed chief. So why is Greenspan making predictions about the US economy, ones that seem to be at odds (at least in tone) with Bernanke’s?

You may recall that the week before last, Bernanke appeared before the House banking committee and gave such a reassuring performance that the Dow went to new highs. He said he wasn’t very worried about inflation, and if anything strengthened that message this week, indicating he was more interested in lowering unemployment (when it is already at what is considered to be a low level) than in preventing inflation.

In Hong Kong, by contrast, this week we have Greenspan signaling that this cycle may be coming to its close and we may have a recession before the year end. Now technically that may not contradict Bernanke’s posture (Bernanke has said he is biased towards stimulus), but Bernanke most certainly did not say that the economy might need more stimulus.

So what gives? We have one theory from Dean Baker, “Greenspan Warns of Recession Risk“:

Apparently, former Federal Reserve Board Chairman Alan Greenspan has gone to the other side of the world to issue his first warnings about a potential recession later this year. In a speech in Hong Kong, he warned that the recovery is getting old and that weakening profit margins could be the first sign of an imminent recession. He also assured his audience that the housing market posed no problem for the economy, with a soft landing producing no spillover effects.

Greenspan’s comments should warrant some serious media scrutiny. If there is a housing crash driven recession, as some people have predicted, then Greenspan’s fingerprints are all over it. He let the housing bubble expand to dangerous levels and ignored the rapid growth in questionable mortgage lending practices. On the other hand, if the business cycle expansion runs its natural course, then no one can blame the former Fed chairman.

As far as this latter view, the current recovery is less than five and a half years old, the 90s expansion lasted for ten full years. The 80s cycle lasted for seven and a half years. It seems a bit pre-mature to claim that the recovery is about to die from old age. The profit margin story can’t hold water either. The profit peak in the 90s was in 1997, the economy continued to sustain strong growth for 4 more years.

With mortgage default rates soaring, the sub-prime segment of the mortgage market tightening rapidly, and inventories of unsold homes at near record levels, it is easy to tell a recession story based on the collapse of the housing bubble. It is not clear that Mr. Greenspan can produce a credible alternative story, but his efforts in this direction deserve serious attention nonetheless.

I don’t disagree that this is plausible. Greenspan’s biggest flaw as a Fed chairman was his need to be liked, so delivering a message to shore up his reputation certainly fits his pattern. And I believe corporate profits are vulnerable (they’ve been running on cost cuts and overleveraged consumers, neither of which are sustainable). And even though the powers that be tout every scrap of positive news about the housing market, there is still tons of inventory overhang, and things could well get worse before they get better.

But let me offer another thought. It really is unprecedented for a former Fed chairman to speak out like this. Volcker never never did so. Which to me says this is in fact a sanctioned comment. Bernanke may well want to take a bit of the frothiness out of the markets (we’ve commented many times on complacency towards risk and signs of excessive speculation). When Greenspan himself spoke out against speculation, in his famous “irrational exuberance” comment, the Dow took a 145 point dive. Perhaps he and Bernanke are now trying a good cop, bad cop act to instill a little, but not too much, fear into the markets.

UC Berkeley Economics Professor Brad DeLong in his blog has a recurrent item, “Why Can’t We Have a Better Press Corps?” One of today’s posts, “Where Is the Budget Reporting?” nominally falls in that category, but points to something more serious.

DeLong cites Stan Collender’s lament that no one, really no one, is covering the federal budget this year:

Like many Washington-based analysts, I generally believe that every word I utter not only is quotable but should be quoted. That’s why this time of year is usually so ego fulfilling: the submission of the president’s budget to Congress generally means I get calls from lots of people who want to hear what I have to say. That didn’t happen this year…. At first I thought it was me…. I assumed that… I was over the hill….

But two days after the president’s budget had been sent to Congress, at an informal monthly breakfast of budget analysts I’ve been attending for more than two decades, I found out that virtually everyone else who is usually quoted heavily this time of year also wasn’t getting called. Because of this, the breakfast partly turned into a support group…. It was therapeutic….

It turns out that the reason for this change is actually quite simple: most major media outlets have decided that the budget is not much of a story this year and are not covering it….

This is yet another nail in the coffin of our democracy. The one way Congress might be able to rein in Bush is via its power to withhold approval of the budget, or at least make him and his underlings squirm a bit. But no, even though it’s the dead of winter and there are no major sports playoffs to compete for attention, the media assumes the public doesn’t care. And they may well be right.

But this lack of press attention degrades one of the key checks and balances of our democracy. One has to wonder if the Republicans somehow orchestrated this turn of events, because it certainly works in their interest. If the Democrats want to oppose anything in the budget, they are going to have to make even more noise to get the press to wake up, and to get any credit for whatever victory they achieve.

Or put it another way, it reduces the payoff for the Democrats to fight the president’s budget.

It also makes it much easier for the Republicans to practice revisionist or distorted history. In the next election, they can make misleading or flat out untrue claims about the budget. Not only will the public at large have no memory of what happened, since it wasn’t on TV or in the press, but it will even be more difficult for them to find the information on the Internet (there might be wonky analyses, but few neutral lay reports).

Environmentalists have been cheering that, to win approval of the proposed leveraged buyout of Texas utility TXU Corp., acquirers KKR, Texas Pacific Group, and Goldman Sachs have agreed to drop plans to build 8 of 11 coal-fired electricity plants that TXU had aggressively pursued. According to a story in CNN Money, “Green Groups Strut Their Stuff on Wall Street,”

Before announcing the biggest buyout on record, the private equity buyers of utility TXU Corp. came calling on environmental groups, the latest sign of how the green lobby is increasingly shaping the agenda on Wall Street….

Critics who had howled at TXU’s initial plan to build 11 plants powered by coal hailed the decision as a victory, saying it would prevent 56 million tons of carbon emissions a year.

“The buyout and turnaround of TXU’s position on global warming is an earthquake that happened in Texas, but shock waves are going to be felt from Wall Street to Washington,” Dave Hawkins, director of the Natural Resource Defense Council’s Climate Center, said on a conference call Monday afternoon.

In addition to revising its coal plant strategy, TXU Corp. has pledged to support programs that regulate carbon emissions….

It also will invest $400 million over the next five years in conservation and energy efficiency.

Unfortunately, there is less to this than meets the eye. The decision to cut the number of plants was a pragmatic economic decision; the green spin was gravy. However, the one victory the green lobby can claim is that, by making approvals more time consuming and costly, they are raising the cost of nasty conventional energy sources. But that is a much more limited victory than they are claiming. From the Financial Times, “Green promises help with TXU endorsement,”

In dressing up their bid for TXU, the Texas-based utility, in a shiny green mantel, Kohlberg Kravis Roberts and Texas Pacific Group showed their presentational skills at their best.

Their promises to reshape TXU’s environmental strategy, including the cancellation of eight of the 11 coal-fired power plants that the company planned to build in Texas, won them the endorsement of campaign groups such as the Natural Resources Defence Council – potentially valuable allies in what could be a contentious bid.

The environmental issues raised by the bid are genuine, and the commitments made by KKR and TPG are sincere.

As the US moves towards policies to curb carbon emissions, it is significant that the buyout partners say that TXU will throw its weight behind the campaign for mandatory limits on carbon dioxide emissions, and will cut its own emissions in the next decade….

But there are also some very sound reasons for TXU to drop its planned investment in power plants that are more hard-nosed than high-minded.

The plan to add 11 power plants generating about 9,000 megawatts to TXU’s capacity was both commercially and politically ambitious.

Politically, it stirred up a storm of criticism from environmental groups, and ran into trouble with the Texas authorities.

Commercially, it involved a heavy spending programme. TXU boasted last year that while it was building its new plants it was likely to be investing more in Texas than the refining and micro-electronics industries put together. Its capital spending would have been about 135 per cent of its earnings from 2006-10.

For a lean, cost-conscious private equity owner, such a large investment programme was never going to be appealing.

Even without the bid, TXU might have had to think again about its spending, according to Anthony Damiano of Wood Mackenzie, the consultancy, in Houston. The delays put into the programme by the political opposition, and rising costs for big capital projects, were threatening its viability.

“TXU made it very clear that part of the reason for doing this expansion so quickly was to keep the costs down, and delays getting the permits had raised the costs,” Mr Damiano said.

“It raises the question of whether this deal is a way to get out of TXU’s difficulties in achieving this plan. If so, you have to say it has been brilliant, both for the PR spin and in terms of getting a getting a good valuation.”

An article in today’s Wall Street Journal, “Wrong Way? Street Signs Point to Speed,” contained some data that does much to explain the current problems with corporate governance:

According to Sanford C. Bernstein chief investment officer Vadim Zlotnikov, the average holding period for stocks on the New York Stock Exchange and American Stock Exchange last year was less than seven months. In 1999 — stereotyped as a time of rapid-fire day trading — the average holding period was more than a year.

One has to ask, why should such short-term shareholders exepct to have any say over corporate matters, like what CEOs pay themselves? If they do happen to time their ownership so as to have a vote in one year’s proxy, they won’t the next. No wonder boards and CEOs act as if they aren’t accountable to the funds and individuals who hold their shares on a transitory basis. These investors aren’t shareholders in any meaningful sense of the word. They are speculators.

The irony is that the “activist shareholders” that the corporate establishment likes to demonize are in fact far more deserving that the average 7 month duration shareholder. Activists typically hold their positions for 9-10 months. They typically accumulate reasonably large stakes, in the 5-10% range (even more if several are acting together). And they are seeking to effect changes that will benefit all shareholders, even if they are self-interested.

With whom in the investing community does the company have a long-term relationship? Its equity analysts and the financial press. That explains why companies have become so short-term oriented. It isn’t simply the lack of loyalty and continuity of their shareholders. It’s also the fact that they are heavily influenced by constituencies, the media and the analysts, that benefit from reputational pump and dump. Both gain from touting companies that appear to be on the upswing, and savaging ones that stumble. And enough investors are trading oriented that (despite their protests that they make up their own minds the signals they get from these sources play into their trading calls.

What’s the solution? There is a simple one that will never be implemented. Increase trading costs by imposing a transaction tax. If trading became more expensive, trading volumes would go down and average holding times would go up. Of course, such a change would wreak havoc on Wall Street, which has gotten used to both high trading volumes and cheap cost of entry and exit in its increasingly important principal investing. Similarly, some hedge funds would have trouble adjusting their strategies to a regime that made rapid trading costly (note that others would be relatively unaffected). Spreads would widen with lower trading volumes, which would also increase tranaction costs. And the brokerage firms would probably increase commissions where they could to compensate for lost volume.

But such a simple fix would be depicted as anti-consumer and anti-investor, when it is more like imposing sin taxes, like taxing alcohol or cigarettes. Investors should not be tempted to act like speculators. That should be left to the true pros. But low transaction costs and plenty of hype encourages individuals and fiduciaries to trade to a degree that is not likely to improve their results and is detrimental to investors as a whole.

As readers doubtless know, the efficient market hypothesis states that prices of publicly traded securities incorporate all available information. We’ve also commented on the wide spread evidence that (except for the subprime sector) investors have a pretty cheery outlook these days. The US stock market has had a nice run so far this year, with only a modest pullback in the last few days, risk spreads in virtually all credit markets are very low by historical standards, and volatility measures (such as the VIX) are also low.

Yet I also reaceived a message from MoveOn.org today asking me to sign a petition against military action against Iran. Now a message of this urgency suggests at least some people are seriously worried that the Administration might take some ill-advised initiative against Iran. Yet the markets wouldn’t be in their complacent state if they thought there was a reasonable possibility this might happen.

I suspect the MoveOn message was in part prompted by an article by Sy Hersh in the current New Yorker. MoveOn first:

Last Tuesday, a second US aircraft carrier arrived in the Sea of Oman off the southern coast of Iran1 giving a whole new meaning to the term “escalation.” The Bush administration is hell-bent on sending 48,000 more troops to Iraq against the wishes of most Americans, but now it seems like they might not stop there.

While the war in Iraq grows worse by the day, the White House seems to be turning its sights toward neighboring Iran which could escalate the current conflict into a regional one. This reckless move comes despite the fact that most experts believe diplomacy is the way to go with Iran.

President Bush is out of control, and Congress needs to step in immediately to rein him in….

The President claimed that Iran is aiding the Iraqi insurgency, but analysts continue to cast doubt on the evidence. Even General Peter Pace of the Joint Chiefs of Staff has questioned the claims that the Iranian government is directly involved. After all, we are already in a war founded on disproved claims of WMDs.

But the reporting of this news is just the latest. Already we have two aircraft carriers in the region—unprecedented outside of war—and Patriot missiles have been deployed. Neither of these will help to protect our troops in Iraq where most of the fighting is on the ground.

One thing is clear—military action in Iran would further endanger our troops in Iraq and threaten to destabilize the entire Middle East. It could even prop up the Iranian president who is quickly losing popularity in his own country.

This isn’t the first time we’ve heard sabre rattling on Iran. But the movement of troops and equipment is particularly worrisome. And the Hersh story, “The Redirection,” is chilling:

One contradictory aspect of the new strategy is that, in Iraq, most of the insurgent violence directed at the American military has come from Sunni forces, and not from Shiites. But, from the Administration’s perspective, the most profound—and unintended—strategic consequence of the Iraq war is the empowerment of Iran….

The new American policy, in its broad outlines, has been discussed publicly. In testimony before the Senate Foreign Relations Committee in January, Secretary of State Condoleezza Rice said that there is “a new strategic alignment in the Middle East,” separating “reformers” and “extremists”; she pointed to the Sunni states as centers of moderation, and said that Iran, Syria, and Hezbollah were “on the other side of that divide.”….

Some of the core tactics of the redirection are not public, however. The clandestine operations have been kept secret, in some cases, by leaving the execution or the funding to the Saudis, or by finding other ways to work around the normal congressional appropriations process, current and former officials close to the Administration said….

Martin Indyk, a senior State Department official in the Clinton Administration who also served as Ambassador to Israel, said that “the Middle East is heading into a serious Sunni-Shiite Cold War.” Indyk, who is the director of the Saban Center for Middle East Policy at the Brookings Institution, added that, in his opinion, it was not clear whether the White House was fully aware of the strategic implications of its new policy. “The White House is not just doubling the bet in Iraq,” he said. “It’s doubling the bet across the region. This could get very complicated. Everything is upside down.”….

the Pentagon is continuing intensive planning for a possible bombing attack on Iran, a process that began last year, at the direction of the President. In recent months, the former intelligence official told me, a special planning group has been established in the offices of the Joint Chiefs of Staff, charged with creating a contingency bombing plan for Iran that can be implemented, upon orders from the President, within twenty-four hours.

In the past month, I was told by an Air Force adviser on targeting and the Pentagon consultant on terrorism, the Iran planning group has been handed a new assignment: to identify targets in Iran that may be involved in supplying or aiding militants in Iraq. Previously, the focus had been on the destruction of Iran’s nuclear facilities and possible regime change.

Two carrier strike groups—the Eisenhower and the Stennis—are now in the Arabian Sea. One plan is for them to be relieved early in the spring, but there is worry within the military that they may be ordered to stay in the area after the new carriers arrive, according to several sources. (Among other concerns, war games have shown that the carriers could be vulnerable to swarming tactics involving large numbers of small boats, a technique that the Iranians have practiced in the past; carriers have limited maneuverability in the narrow Strait of Hormuz, off Iran’s southern coast.) The former senior intelligence official said that the current contingency plans allow for an attack order this spring. He added, however, that senior officers on the Joint Chiefs were counting on the White House’s not being “foolish enough to do this in the face of Iraq, and the problems it would give the Republicans in 2008.”

The article is much too long to quote more extensively, but other points it makes are: the ease with which past Presidents have used an existing war to go off on peripherally-related forays (witness Cambodia during the Vietnam War), the many avenues the Administration has for running substantial operations “off the books” and hence out of the view of Congress (Hersh cites several reports that the reason Negroponte stepped down unexpectedly as the Director of Intelligence for a much lower post in the Department of State is that he refused to be part of such an activity, not wanting a repeat of his involvment in Iran-Contra).

The markets are assuming that the Bush Administration would not be so stupid as to attack Iran (or say, have Israel do something provocative so as to incur an attack against Israel, forcing a reply by the US). And by any rational calculus, the damage that the country would take, in the long term, would be staggering. We have already lost virtually all our allies. The only friends we’d have left would be Israel, the Saudis, and maybe Poland and Australia. America lacks the fiscal resources and the manpower to engage in a wider war (unless a draft is reinstituted). The only thing that might lend popular support for a wider war would be an Iranian attack on the US. They don’t have the resources (in terms of an intelligence network) for such an effort. Their ambitions are strictly regional. If such an attack was claimed to have occurred, I’d suspect a false flag event, like the Gulf of Tonkin affair.

And has anyone in the Beltway looked at a map? All the oil from the Middle East, oil on which we depand, goes through the Straits of Hormuz. It’s 21 miles wide. Iran is on one side, Oman on the other. It wouldn’t take a very high tech effort to close the Straits. Oil prices go through the roof, and our economy goes into a tailspin.

That’s why the markets have shrugged off the possibility of an attack on Iran. It’s close to suicidal. But I am still loath to underestimate the stupidity and self-destructiveness of this crowd.

A good piece in today’s Wall Street Journal, “Shareholders Push for Vote on Executive Pay,”recounts the efforts of major institutional investors to exert pressure against excessive CEO pay via non-binding shareholder resolutions.

UK funds have been in the forefront of this effort, because similar regulations are already in force there. Although the UK rules have not had as much of an effect as hoped, the major shareholders feel it has had some impact, and has also increased the amount of direct discussion between the funds and their investee companies.

From the Journal:

Ahead of this year’s annual meetings, activist investors have submitted shareholder proposals at roughly 60 companies seeking an advisory vote on executive pay, according to Institutional Shareholder Services. Targets include Citigroup Inc., Wells Fargo & Co., WellPoint Inc. and Northrop Grumman Corp.

The vote would be nonbinding, but activists hope that public censure, or the threat of it, would prompt directors to curb outsized awards and better link pay with performance….

One company facing a shareholder proposal, insurer Aflac Inc., agreed earlier this month to give investors a nonbinding vote on executive compensation, beginning in 2009. Others, including Pfizer Inc. and Schering-Plough Corp., are discussing the possibility of similar moves.

This week, U.S. Rep. Barney Frank (D., Mass.), the new chairman of the House Financial Services Committee, plans to introduce a revised version of his 2005 bill that aimed to give shareholders power to veto executive-pay deals. He will hold a hearing next week on his latest measure, which instead would require advisory votes.

The activists are taking a page from the British. Since 2003, United Kingdom shareholders have cast advisory votes on corporate compensation policies and how much they pay executives. Investors and companies say the practice, which began after the British government passed a law requiring it for all public companies, has generated more discussion between shareholders and boards.

But it hasn’t necessarily curbed compensation.

“We have better disclosure and better accountability,” says Ian Jones, head of responsible investment at Co-operative Insurance Society Ltd., an insurance company with about $40 billion under management. But “I don’t think it’s had much effect on the amount of remuneration.”

British CEOs have long made less on average than their U.S. counterparts, but pay in both markets has risen at roughly comparable rates in recent years, with some indications pay may have risen faster in the U.K. than in the U.S. The median salary and bonus for CEOs at 250 large and mid-size U.K. companies totaled £610,000 ($1.2 million) in 2005, the latest year for which data are available, according to the U.K. arm of ISS. That’s up 9.9% from 2004 and 35.6% from £450,000 in 2003.

In the U.S., median CEO salary and bonus hit $2.4 million in 2005, up 7.1% from 2004, and up 13.7% from $2.1 million in 2003, at 350 large companies studied by Mercer Human Resource Consulting. The companies in the 2003 and 2005 samples varied somewhat.

Stephen Davis, a fellow at Yale University’s Millstein Center for Corporate Governance and Performance who has studied the U.K. experience, says the advisory vote has strengthened the link between pay and performance. For example, pay consultants say the practice has pushed British companies to shift executive compensation toward bonuses and away from big salary increases. But Mr. Davis says “Investors still feel…that pay is not yet fully aligned with performance in the way that they would like.”

Mr. Davis says companies and investors are on a learning curve, but he says the vote appears to have helped curb severance packages. At the start of the decade, a three-year payout was standard; today, a one-year payout is “virtually universal,” Mr. Davis says. But he says directors worry that investors reviewing dozens of pay plans are issuing “cookie-cutter” judgments rather than evaluating packages individually.

Big U.K. shareholders applaud the increased discussion. Talks, often held in advance of annual meetings, are “more meaningful” than the occasional formal presentations managers used to offer shareholders, says Colin Melvin, head of corporate governance at London-based Hermes Pension Management Ltd., which manages $120 billion in assets.

For instance, in 2003, 50.7% of votes cast by shareholders opposed a pay package for GlaxoSmithKline PLC Chief Executive Jean-Pierre Garnier. The pharmaceutical maker later agreed to overhaul its pay policies and end “what might be deemed ‘payment for failure,’” according to its 2004 letter to shareholders. Dr. Garnier’s total pay package fell slightly in 2004, to $4.56 million from $4.57 million the year before.

Ahead of the 2004 shareholder meeting, Glaxo sent draft copies of its compensation report to large shareholders, according to Richard Singleton, the director of corporate governance at F&C Asset Management. Mr. Singleton emailed Glaxo’s then-chairman, Sir Christopher Hogg, suggesting tougher performance targets for executives to earn bonuses. The company added a clause stating performance targets would consider analysts’ forecasts.

“I was delighted,” Mr. Singleton says. The clause remains part of Glaxo’s compensation policy.

A Glaxo spokesman confirmed the clause was inserted in the 2004 report, but he declined to comment on the process. Sir Christopher couldn’t be reached.

Tlk doesn’t always translate into action. Early last year, London-based investment manager Amvescap PLC decided to pay its departing chairman, Charles W. Brady, a $9 million bonus. ISS’s British arm believed the payment was unjustified, according to director of research David Paterson, and considered opposing the compensation report.

Amvescap’s company secretary, Michael Perman, told an ISS analyst that executives considered the bonus reasonable because Mr. Brady had shepherded Amvescap through a tough period and had hired a new chief executive. The analyst wasn’t convinced, and ISS recommended that investors oppose the compensation report; at the annual meeting, 48% of votes cast did. Mr. Brady did get the bonus.

An Amvescap spokesman declined to comment beyond a written statement from Amvescap Chairman Rex Adams on the day of the vote: “Over the last weeks, Amvescap has initiated direct discussions with many of our company’s major shareholders, and we believe we have a good understanding of their views.”

Despite the shortcomings, U.K. investors are among those pushing U.S. companies to adopt the advisory vote. In January, a group of 13 institutional investors, nine British, wrote SEC Chairman Christopher Cox to endorse the practice. The group, which collectively has $1.5 trillion under management, said the votes would bolster communication between shareholders and directors, better link pay with performance and “provide a counter-weight” to rising executive pay. Companies in Australia, Sweden and the Netherlands also grant shareholders a vote on pay….