Less can be more. Low-cost carriers tend to fare better than their full-service rivals in recessions, thanks partly to lower dependence on corporate travel and higher starting-points for their operating margins. But a big part of the trick is managing capacity and, longer-term, being in the right place to pick up business as the industry shrinks.
Ryanair has been helping things along. It grounded 80 aircraft - almost 30 per cent of its fleet - this winter, with the result that its passenger traffic, year-on-year, fell by 2 per cent for the first time in its history. But this, in turn, helped the carrier push up its average fare by 17 per cent, to EUR40, in the third quarter to end-December. Revenue rose 13 per cent, and, with costs (excluding fuel) well controlled, the airline made an unexpected EUR15m after-tax profit com-pared to consensus expectations of a EUR16m loss. Full-year guidance goes up by 9 per cent, to EUR440m.
All those jets - plus another 12 deliveries - will be flying again over the summer. But Ryanair expects to repeat the grounding strategy next winter - which is lousy for second-home owners dependent on Ryanair schedules, but bullish for pricing. And in the meantime, the carrier looks well positioned to capitalise on industry shrinkage: Spanair's demise, for example, could offer opportunities out of Barcelona, and the clouds over bmibaby's future let it entrench further in the UK's Midlands.
The extent to which shareholders benefit is another matter. Ryanair shares, trading on a forward earnings multiple of over 11 times, have doubled from 2008 lows but are no higher than in 2002. Increasing its share of intra-European flights may, Ryanair predicts, permit longer-term annual growth of 4-5 per cent - respectable but hardly exciting. Still, there is talk of an ADR buy-back programme and a second special dividend in 2013. For the airline business, at least, that's not bad.
Source: http://www.ft.com/cms/s/3/38dcb5c6-4b4a-11e1-a325-00144feabdc0.html
Tuesday, January 31, 2012
Sany Heavy: China digs in
China flexes its muscles yet again, this time towards the global market for construction machinery. Sany Heavy, the country's biggest maker of cool-sounding machines such as concrete pumps, excavators and cranes, is to buy 90 per cent of German concrete pump-maker Putzmeister for EUR360m. Putzmeister is small fry, with only a 10th of the revenues of Sany. But the deal is significant because it is Sany's first overseas acquisition and will quadruple its foreign sales overnight.
Just 4 per cent of Sany's revenues came from outside China in the first half of last year. By contrast, over four-fifths of Putzmeister's sales come from countries outside of China, Morgan Stanley estimates. Sany gets access to Putzmeister's global distribution and after-sales service channels and there are potential synergies to supply its parts to Putzmeister's assembly plants. With a listing in Shanghai and just a third of its shares freely floating, it is tricky for investors to cash in on Sany's global ambitions yet (it is mulling a Hong Kong listing). Instead, they should worry more about potential damage to market leaders Caterpillar and Komatsu.
A slowdown in construction growth in China has only sharpened Sany's need for overseas growth. It has already built plants in the US, Brazil, India and Germany. And Chinese heavy equipment makers such as Zoomlion, XCMG and LiuGong have been boosting sales in Brazil, in particular. Caterpillar's revenues may be seven times that of Sany's at $60bn last year, but three quarters of them come from outside Asia. With cheaper manufacturing costs at home, Sany benefits from operating margins double those of Caterpillar's. It can afford to be aggressive in growing its share abroad. The construction machinery land-grab is on.
Source: http://www.ft.com/cms/s/3/76ea7780-4b50-11e1-88a3-00144feabdc0.html
Just 4 per cent of Sany's revenues came from outside China in the first half of last year. By contrast, over four-fifths of Putzmeister's sales come from countries outside of China, Morgan Stanley estimates. Sany gets access to Putzmeister's global distribution and after-sales service channels and there are potential synergies to supply its parts to Putzmeister's assembly plants. With a listing in Shanghai and just a third of its shares freely floating, it is tricky for investors to cash in on Sany's global ambitions yet (it is mulling a Hong Kong listing). Instead, they should worry more about potential damage to market leaders Caterpillar and Komatsu.
A slowdown in construction growth in China has only sharpened Sany's need for overseas growth. It has already built plants in the US, Brazil, India and Germany. And Chinese heavy equipment makers such as Zoomlion, XCMG and LiuGong have been boosting sales in Brazil, in particular. Caterpillar's revenues may be seven times that of Sany's at $60bn last year, but three quarters of them come from outside Asia. With cheaper manufacturing costs at home, Sany benefits from operating margins double those of Caterpillar's. It can afford to be aggressive in growing its share abroad. The construction machinery land-grab is on.
Source: http://www.ft.com/cms/s/3/76ea7780-4b50-11e1-88a3-00144feabdc0.html
Low rates: the drug we can all do without
Low interest rates and novel forms of monetary accommodation, such as quantitative easing, have become seen as a panacea for economic ills. The US Federal Reserve has committed to holding rates around zero for the foreseeable future. Faced with deep-seated economic problems, other central banks are likely to follow.
Financial markets have generally reacted positively to low rates, pushing up asset prices. However, low rates point to a worrying lack of economic growth and the increasing risk of deflation. Indeed, the relationship between rates and economic activity is tenuous. The cost of funds is only one factor among several complex drivers of demand.
In the housing market, demand depends on many things – the level of deposit required, existing home equity (the price of a house less outstanding debt), the ability to sell a current property, income levels and employment security.
And businesses, in the absence of growing demand for their products, are unlikely to borrow to invest in new capacity based purely on the low cost of debt.
In reality, low interest rates create economic distortions, especially where real interest rates (nominal rates adjusted for inflation) are low or negative.
Low cost of debt encourages substitution of labour with capital in the production process. Given that 60-70 per cent of activity in developed economies is driven by consumption, this shift reduces aggregate demand as employment and income levels decrease.
Low rates favour borrowing, encouraging substitution of debt for equity in financing structures and increasing financial risk. Where companies and nations are overextended, incentives to reduce debt decrease. In fact, low rates, which lower coupon payments, are economically identical to a disguised reduction of the principal amount of the loan.
Low rates discourage savings, creating a disincentive for the capital accumulation that would reduce overall debt levels. Lower earnings on savings should encourage spending, stimulating economic activity, but may perversely encourage greater saving to provide for future needs, reducing consumption and demand. For an individual saving for retirement, a drop in interest rates from 5 per cent to 4 per cent requires an 18 per cent increase in savings each year to reach the same target sum over 30 years.
Low rates also increase the funding gap for defined benefit pension funds. In the US, for every 1 per cent fall in rates, pension fund liabilities increase by about $180bn.
Low rates also feed asset price inflation. Low costs of borrowing encourage investors to seek investments with income, feeding demand for shares that pay high dividends and for low-grade debt. A resurgence of structured products, where investors take on additional risk, which they have not fully understood, to generate higher income, is driven by low rates. In previous cycles, this has led to large losses and costly disputes between investors and dealers. In this way, low rates encourage mispricing of risk, creating asset bubbles.
Minimal opportunity costs allow investors to hold assets that pay no income in the hope of price increases, evidenced in demand for commodities and alternative investments such as art works. Money tied up in non-productive investments reduces the flow of capital and economic activity.
Low interest rates also provide an artificial subsidy to financial institutions, allowing them to borrow cheaply and then invest in higher yielding safe assets such as government bonds. Assuming bank deposits of $6tn and a difference between borrowing costs and government bond rates of 2 percentage points, this equates to a transfer to the US banking sector of about $120bn.
Low rates do not necessarily increase the supply of credit. Risk aversion and higher returns on capital encourage banks to invest in government securities, eschewing loans. In the US, bank holdings of cash and government securities currently exceed the outstanding volume of commercial and industrial loans.
Internationally, low interest rates distort currency values, and encourage volatile and destabilising short-term capital flows as investors search for higher yields.
A sustained period of low rates, such as the one the world is experiencing, makes it difficult to increase the cost of borrowing. Levels of debt encouraged by low rates rapidly become unsustainable when they increase, as is evident in Europe. This reinforces the financial distortions implicit in the policy.
For the moment, policymakers are relying on the advice of actress Tallulah Bankhead: “Cocaine isn’t habit forming. I should know – I’ve been using it for years.” But reliance on low interest rates, like all addictions, is dangerous. It is also ineffective in addressing the real economic issues.
Source: http://www.ft.com/intl/cms/s/0/372a405c-480e-11e1-b1b4-00144feabdc0.html#axzz1l0bJLxBP
Friday, January 27, 2012
Equities can outstrip bonds in a liquidity trap
Until recently, Keynes’ notion of a liquidity trap was of great interest to macroeconomists, but was viewed by investors as a rare aberration which, outside Japan, could be safely ignored. In the aftermath of the 2008 credit crunch, all that has changed. Many developed economies seem to be falling into a liquidity trap, and may stay there for several years. What does this imply about asset returns?
The term “liquidity trap” means slightly different things to different economists. To Keynes himself, it implied that bond yields had fallen to a lower limit, at which the risk of future capital loss outweighed the prospective return from the coupon. Consequently, cash dominated bonds as an investment vehicle, and interest rates could be reduced no further. To Paul Krugman, the re-inventor of the liquidity trap in the 1990s, it means that short rates have fallen to zero, with inflation expectations so low that the real rate of interest is too high to permit the full utilisation of resources.
I would suggest that a full liquidity trap has three crucial characteristics:
First, short rates should be (in effect) at zero. Second, bond yields should be at their lower limit in the Keynesian risk/return sense. Third, the real economy should be operating below capacity because real interest rates, though very low, are stuck at levels that are too high to produce enough aggregate demand. Underlying inflation rates should, therefore, be declining.
Japan is probably still in a liquidity trap based on these criteria. The rest of the developed world fits the criteria to varying degrees, but it seems clear that the direction of travel for Europe and the US is only in one direction, and that is towards a deeper liquidity trap.
Since a liquidity trap is such a distinctive economic condition, we might expect that relative asset market returns might also be very clear cut. For government bonds, that should indeed be the case. Bond yields should drop to the lower limit implied by Keynes, and then remain there. This may need some help from central bank bond purchases, or it might happen because expectations of low inflation and permanently low short rates become deeply embedded in the yield curve.
That is exactly what happened in Japan in the 1990s, and it now seems to be happening elsewhere. In the Japanese case, the sustainable downside limit on bond yields turned out to be around 1.3 per cent, with occasional spikes below that level not proving durable. If that proves to be the case in other developed economies, then the risk/return in bond markets already looks unattractive.
Even if we make the extreme assumption that yields decline from current levels all the way to the 1.3 per cent lower limit in the next 12 months, then total bond returns would be limited to a maximum of 7 to 8 per cent in the US, Germany, and the UK. On the other hand, if economies escape from the liquidity trap and yields begin to rise to a more normal historic level, capital losses could be very large. Although the most likely case is that bonds continue to provide low positive returns, the risk/return trade off does not seem attractive from here.
What about equities? A natural assumption would be that in the disinflationary environment of a liquidity trap, equity returns should also be very low. That may be true in nominal terms but, in inflation adjusted terms, there may still be a good case for holding equities. Investors who suffered through two decades of negative real equity returns in Japan may be sceptical about this, but the valuation of equities relative to bonds in the US and Europe is currently much more attractive than it ever reached in Japan’s lost decades.
The comparable point to the present day in the Japanese experience was probably around 1997, when short rates were hitting 0.5 per cent for the first time. At that stage, the long term underlying earnings yield on the equity market was hovering around 2-2.5 per cent, roughly the same as the government bond yield. The nominal risk premium on equities relative to bonds was therefore zero.
This contrasts sharply with the present situation in the US and Europe. In the US, the equivalent earnings yield on the S&P 500 is 4.7 per cent, which produces an equity risk premium of almost 3 per cent. In Germany and the UK, the risk premium is more than 4 per cent, while in the peripheral eurozone it is around 5-6 per cent.
In other words, liquidity trap conditions have left bonds looking extremely expensive relative to equities in the developed economies. Nominal equity returns may be held back by low inflation but in real terms they should outperform government bonds, even if the liquidity trap deepens further.
Source: http://www.ft.com/intl/cms/s/0/343c763e-45a8-11e1-acc9-00144feabdc0.html#axzz1kg6hL8t9
Boeing: Faster, faster, faster
THERE are not many businesses in which the next six years’ worth of customers form an orderly queue, putting down fat deposits and topping them up with further instalments as they wait in line. But that is Boeing’s fortunate position. On January 25th it announced a 21% rise in annual net profits, to $4 billion.
Last September, after three years of delay, Boeing made the first deliveries of its newest model, the 787 Dreamliner. A revamped version of the trusty but ageing 747 jumbo has also arrived, two years late. A few airlines got fed up and cancelled, but most had little choice but to keep waiting. Boeing’s main rival, Airbus, has an even longer backlog—up to eight years at current production rates. And the delivery schedule for Airbus’s answer to the Dreamliner, the A350, has been slipping.
Last year, straining to ramp up production to meet soaring demand, the two big planemakers turned out a record 1,011 airliners between them. But for every plane they delivered, they won more than two fresh orders (net of cancellations), so the queue got longer. On January 25th Boeing won its largest-ever order from Europe: Norwegian Air Shuttle is to buy 122 planes worth $11.4 billion at list prices.
The lion’s share of 2011’s advance orders were for the A320neo, a re-engined version of Airbus’s short-haul airliner, which should enter service in 2015. This year the plane most in demand looks to be the 737MAX, a re-engined version of Boeing’s short-haul plane, deliveries of which are due to start in 2017.
At Boeing’s Renton factory near Seattle the existing version of the 737 is now being turned out at a record rate of 35 a month, after a recent speeding-up of the two assembly lines. At the front of assembly line number one, a plane destined for flydubai, an airline that can’t afford capital letters, is ready to roll. Behind it is the latest addition to Ryanair’s huge fleet of 737s, which has just had its engines fitted. Next, a Korean Air plane which is about to receive rows of seats; then an Azerbaijan Airlines jet, its toilet cubicles lined up alongside ready for installation. The plan is to increase the production rate further, to 42 a month by 2014. Fortunately, there is space to squeeze a third assembly line into the giant hangar.
Likewise, at Boeing’s Everett factory to the north of Seattle and another plant in South Carolina, plans are afoot to churn out more of the company’s bigger jets, including the 787. But the 40-odd unfinished Dreamliners scattered around the Everett campus and elsewhere are a reminder of how such attempts to ramp up production can go wrong. Having first suffered from a worldwide shortage of the fasteners that hold bits of the plane together, the 787 was then held back further by other mishaps, including faulty horizontal stabilisers sent by an Italian supplier. Boeing is struggling to correct the problems on the unfinished planes even as it strives to get its production lines turning out ten fault-free 787s a month by the end of next year.
The head of Boeing’s commercial-airliner division, Jim Albaugh, admits that with hindsight too much of the Dreamliner programme was contracted out to other firms. Some work has been brought back in-house so that it can be more closely supervised. The planemaker has also set up a “war room” that constantly monitors the world’s supply of aircraft parts and raw materials. It has signed a long-term deal with a Russian metals firm to ensure a steady supply of crucial components made from titanium. And it has hired hundreds of “examiners” to visit suppliers, to check that they are building up production to meet Boeing’s increasing needs and chivvy them along if not.
Boeing’s assembly plants are the final stage in a long and hugely complex global supply chain. It has about 1,200 “tier-one” suppliers, which provide parts directly to the planemaker from 5,400 factories in 40 countries. These in turn are fed by thousands more “tier-two” suppliers, which themselves receive parts from countless others. Beverly Wyse, who oversees production of the 737, admits that it has sometimes been a job to persuade all these suppliers to invest enough to meet future demand. To do so, Boeing has had to learn to be more open with them about its production plans, and a bit less paranoid about whether such information might reach the ears of its competitors.
Even with all these new measures in place, Boeing’s plans to boost production of the Dreamliner remain “hugely ambitious”, reckons Richard Aboulafia of Teal Group, an aviation consultancy. He wonders if the planemaker is serious about its target of making ten of them a month, or whether it is just bandying about an unrealistic figure to rev up its suppliers. “Not true,” retorts Mr Albaugh. Boeing has every intention of reaching the goal, he says.
Fasten your seat belts
Still, with the world economy looking wobbly and the euro-area crisis far from over, might suppliers not have good reason to fear that the recent surge in aircraft orders could go into reverse thrust? Myles Walton, an aerospace analyst at Deutsche Bank, believes that both Boeing and Airbus have quietly begun double-booking some of their delivery slots, in case a customer collapses. He reckons they have done enough of this to cope with the worst imaginable recession in Europe.
Perhaps the biggest risk on the horizon would be a sustained surge in the price of oil, which could send airlines into a tailspin of losses and bankruptcy. So far, though, the chief worry for Boeing and its main rival is how to get their products flying out of the door faster.
The mortgage market: Home truths
SOMETIMES it takes the interaction of powerful forces for things just to stand still. So it is with Britain’s housing market, which lenders expect to remain characterised this year by low levels of transactions and stable prices. But, quietly, the property market is being transformed.
The forces bearing down on housing are obvious enough. Home sales have fallen sharply since the start of the financial crisis, to around half their 2007 levels. That reflects greater conservatism on the part of lenders—“We don’t assume that home prices will go up, a mistake everyone made in the past,” says one—and of borrowers worried by an uncertain economic outlook at home and endless euro-crisis headlines. Household demand for secured credit fell in the last quarter of 2011, according to the Bank of England.
A slump in volumes has not led to a slide in prices, however. House prices are down by less than 10% from their peak, still well above The Economist’s definition of “fair value”, which is the long-run average ratio of house prices to rents. Prices in America, by contrast, have fallen back to fair value. A shortage of housing supply has helped sustain prices, as have low interest rates: two-thirds of British mortgage-holders are on variable-rate loans. A big rise in unemployment would unsettle this equilibrium, but only if joblessness bites among homeowners rather than, as now, among young people without mortgages.
“This is a broadly flat market and likely to stay that way for the next 12 to 24 months,” says Chris Rhodes of Nationwide, the country’s biggest building society. Regulators are determined to stamp out the speculative element of the market, which helped drive prices up before the financial crisis. The Financial Services Authority is currently consulting on proposals that would require lenders to assess the impact of future rate rises on borrowers’ ability to repay, for instance. That would make it much harder for ordinary folk to take out interest-only mortgages.
A flat market does not mean an unchanging one, however. Parts of the market are livelier than others, and none is more energetic than buy-to-let lending, in which private landlords buy houses to rent out. This sector also suffered during the crisis: gross advances fell from £45 billion ($90 billion) in 2006 to around £13 billion now. But lenders are expecting growth of 10-20% in the buy-to-let segment this year, and are scurrying to beef up their presence in this area.
Some of the rise in renting reflects credit constraints, particularly on first-time buyers. But this cannot explain everything. The proportion of loans allocated to first-timers has remained steady throughout the crisis as parents have stumped up down-payments for their offspring. Loan-to-value ratios are creeping up again. And numbers of first-time buyers and buy-to-let loans are not necessarily mirror images—both were growing just before the crunch, for example (see chart).
Rather than being just a cyclical effect, the growth in demand for private rentals fits into a broader pattern. Loans for first-time buyers were on a downward path well before the crisis, because of high house prices. Meanwhile, immigration and rising numbers of single-person households have driven demand for rented accommodation. “Growth in the private-rental sector is hard-coded into the UK market,” claims John Heron of Paragon Mortgages, a specialist buy-to-let lender.
But so is the aspiration eventually to buy one’s own home. For most people, the housing market still offers a stark choice: rent or take on lots of debt for a house purchase. That could change, however. Castle Trust, a yet-to-be-authorised lender in Britain backed by JC Flowers, a private-equity firm, plans to offer savers investment products tied to a national house-price index. It will use the money it raises to offer mortgage products where borrowers do not pay interest in return for handing over a slice of their equity to the firm. If prices rise, some of the capital gains are shared with the lender; so are a proportion of losses if prices fall.
The marriage of housing and financial innovation may look like an ugly match in light of the crisis. But ideas like these could yet prove one of its lasting legacies.
Private equity under scrutiny: Bain or blessing?
IF STEVE SCHWARZMAN thought it was valid in 2010 to compare Barack Obama’s “war” against business to Hitler’s invasion of Poland, what can he be thinking now? Private-equity executives must be hoping the boss of Blackstone will keep his opinions to himself. More bad publicity is the last thing the industry needs. Other Republican presidential candidates are competing to see who can say the most damning thing about Mitt Romney’s career at Bain Capital. Newt Gingrich’s supporters have even made a sort of horror movie about what happens when private-equity firms like Bain Capital get their hands on otherwise healthy companies.
The buy-out bit of the industry, which buys mature companies, fixes them up and sells them on, is the one on trial (few have a bad word for venture capital, which invests in start-ups). It is charged with destroying the jobs of ordinary people while enriching the likes of Mr Romney.
Examples of dud deals are not hard to come by. The tax code’s treatment of debt (with interest on debt payments being tax-deductible) and private equity’s thirst for profits have at times driven the industry to saddle companies with too much debt. Between 2004 and 2011 private-equity firms heaped more debt on their companies so they could take out a staggering $188 billion in dividends for themselves, according to Standard & Poor’s Leveraged Commentary & Data, which tracks the industry.
But private equity isn’t employment’s grim reaper. Buy-out firms usually set their sights on companies that they can improve, which means they may buy weaker or more bloated ones in the first place. A recent NBER working paper looked at employment after 3,200 leveraged buy-outs in America. It found that private-equity ownership resulted in both more rapid job destruction and faster job creation than other forms of ownership. Two years after a buy-out, employment declines by 3% on average; if acquisitions, divestitures and new sites are included the losses are only 1% of initial employment. Other research has found that wages do not rise as quickly at private-equity-owned firms, probably because buy-out firms try to control costs after a takeover. But wages also don’t plummet, which may be why unions that used to oppose buy-outs have moderated their criticisms.
In any case, it is not the mission of buy-out firms to create jobs. Their mandate is to produce higher risk-adjusted returns, and this is where private-equity firms should be judged more harshly. The industry has long boasted about its earth-shattering performance. Investors, and public-pension funds in particular, have piled into the asset class. But the bulk of investors’ capital has gone into funds that were raised when asset prices were at peak levels (see chart 1). Although fears of a bloodbath among bubble-era buy-outs have not yet been realised, returns for most of these funds are going to be middling at best.
Nor is there conclusive evidence that private equity consistently outperforms public companies, although certain high-performing firms undoubtedly do. A recent attempt to analyse private-equity performance, by Robert Harris of the University of Virginia’s Darden School, Tim Jenkinson of Oxford University’s Saïd Business School and Steven Kaplan of the University of Chicago’s Booth School of Business, concludes that it is “very likely” that private equity outperforms the S&P 500 (after fees). But the outcome looks different depending on which database is used. These vary wildly (see chart 2), and none has returns for all funds. The study emphasises a new data set, which could make things look rosier because the worst-performing funds may not be sufficiently represented.
The bigger issue
There is also a question about how private-equity firms calculate their returns. The internal rate of return (IRR) is the usual measure. But according to a 2010 study by Peter Morris, a former banker, entitled “Private Equity, Public Loss?”, it is rare for two firms to calculate IRR in the same way. This can complicate any attempt to compare funds. IRRs can also overstate the actual returns investors realised, according to Ludovic Phalippou at Amsterdam Business School, since the measure implies that the return was achieved on all the investor’s cash, even if some of it was given back early and reinvested at a lower rate.
The S&P 500 may not even be a fair benchmark for private-equity firms, says Mr Phalippou, since most buy-out firms purchase midsized companies, which have performed better than the big firms included in the S&P 500. An index of mid-cap stocks could offer a more accurate comparison, but also a higher hurdle for private-equity firms to jump.
Why would investors put money with private-equity managers who aren’t that good? It could be that investors herd mindlessly into asset classes. But some of it may also reflect the way the industry manipulates data. “Every private-equity firm you talk to is first-quartile,” quips Gordon Fyfe, the boss of PSP Investments, a C$58 billion ($58 billion) Canadian pension fund.
Oliver Gottschalg of HEC School of Management in Paris looked at 500 funds, and 66% of them could claim to be in the top quartile depending on what “vintage year” they said their fund was. The vintage year is supposed to be when the fund has its final “close” and stops fund-raising. But some firms may decide to use the year they started raising the fund or had their first “soft” close (when a fund is no longer officially open to new money), if it allows them a more favourable benchmark.
If investors can work out a way to place their money with funds that are actually in the top quartile, it is probably worth the fees and the extra risk of investing in this illiquid, leveraged asset class. But that is a big if. David Swensen, the man who runs Yale’s $19.4 billion endowment and a noted proponent of alternative investments, has written that “in the absence of truly superior fund-selection skills (or extraordinary luck), investors should stay far, far away from private-equity investments.”
Abuzz about fees
Buy-out executives have always claimed their interests are perfectly aligned with those of their investors, since they can only eat if their investors do. But that has changed as private-equity firms have morphed from small outfits into behemoths managing billions of dollars. Private-equity firms usually charge a 2% annual fee to manage investors’ capital and then take 20% of the profits. Big firms can now support themselves just from management fees. A study by Andrew Metrick at Yale School of Management and Ayako Yasuda at the University of California, Davis finds that private-equity firms now get around two-thirds of their revenues from fixed fees, regardless of performance.
If all that wasn’t bad enough for investors, the prospects for future returns look dim. Higher debt has accounted for as much as 50% of private equity’s returns in the past, according to a 2011 study co-written by Viral Acharya of New York University’s Stern School of Business. But banks are not lending as much as they did five years ago, increasing the amount of equity that firms are having to stump up (see chart 3). That will cap returns. “Employees are going to make less money, and firms are going to make less money. Returns are going to be much more mundane,” is the gloomy prediction of the boss of one of the largest private-equity firms.
Prices have also remained painfully high. Last year the average purchase-price multiple for firms bought by private equity was 8.4 times earnings before interest, tax, depreciation and amortisation, higher than it was in 2006. That’s because the industry is sitting on $370 billion in unused funds, or “dry powder”, that firms need to spend soon or risk giving back to investors, which means there is fierce competition for deals. Many transactions are between private-equity firms, which does little good to investors who have placed money with both the seller and the buyer.
With the option of financial engineering basically gone, private-equity firms have no choice but to improve the businesses they buy. Every private-equity firm boasts about its “operational” skills but sceptics question whether private-equity executives are that good at running companies. A senior adviser at a big buy-out firm and former boss of a company that was bought by private equity says he disagrees that buy-out executives are good managers of businesses: “They’re even less in touch with the real world than public-company managers. They’re a group of very clever, very analytical people paid lots of money whose general feel for the businesses is pretty poor.” Their edge, he says, comes from having a fixed investment term, which helps focus managers’ minds.
With the landscape bleaker than it was, many private-equity firms are reinventing themselves. Most buy-out firms now prefer the fluffy title of “alternative asset manager”. They have started to do more “growth equity” deals, taking minority stakes in companies and using less debt. This has been their strategy in emerging markets like China, where control and highly leveraged deals are not as welcome, but now the approach is also increasingly being used in the West. Big American firms like KKR, Carlyle and Blackstone have all expanded or started other units focused on things like property, hedge funds and distressed debt.
Many private-equity firms will quietly fade away, although Boston Consulting Group’s infamous prediction in 2008 that 20-40% of the 100 largest buy-out firms would go extinct has not yet come true. That is probably because private-equity firms take a long time to die. There are 827 buy-out firms globally, according to Preqin, a research firm. They will not all be able to raise another fund. European private-equity firms are particularly vulnerable because they have not diversified as much as their American competitors.
But Mr Romney’s candidacy will ensure that American firms feel more political heat. Executives’ special tax treatment, under which their profits are taxed as capital gains rather than income, will almost certainly go. The limelight has not yet scared off the 236 buy-out funds that are in the market trying to raise another $172 billion. But it is not as much fun as it was. “Back in 2005 fund-raising was like having a velvet carpet with a rope,” says one buy-out boss. “You had a bouncer and only let the prettiest people in. Now it’s buy one, get one free, and free entrance before 11.”
Wednesday, January 25, 2012
Freighter Oversupply Weighs on Shipowners and Banks
SINGAPORE — The skyscrapers and immaculate beaches of this seaport look out on one of the world’s largest parking lots: mile after mile of empty cargo ships, as far as the eye can see.
Similar fleets bob at anchor, with empty cargo holds, off the coasts of southeast Malaysia and Hong Kong. And dozens of newly built ships float empty near the giant shipyards of South Korea and China, their owners from all over the world reluctant to accept delivery during one of the worst markets ever for the global shipping industry.
As recently as six weeks ago large freighters that can carry bulk commodities like iron ore or grain were fetching charter rates of $15,000 a day. Now, brokers and owners say, the going rate is $6,000 a day. If any customers can even be found.
Although the fault lies partly with doldrums in the global economy, the bigger factor is a glut of new freighters. The oversupply is putting financial pressure on the shipowners that bought them and the already struggling European banks that financed many of the purchases.
Shipping industry leaders hold little hope of a quick recovery.
“If the tunnel is 2012, I can’t see any light at the end of it,” said Tim Huxley, the chief executive of Wah Kwong Maritime Transport Holdings, a Hong Kong-based shipping line with 29 bulk freighters and tankers.
Back during the global commodity boom, which continued through the spring of 2008, the world’s shipowners could hardly place orders for freighters fast enough. But because of the long lead times in shipbuilding, those vessels only now are being delivered by the hundreds — into a very different, much less robust international economy than when they were ordered.
For the shipping industry, the glut means not only lower charter fares, but also steep declines in the value of their vessels. The bigger losers, though, could eventually be some big European banks, many of which are already struggling with big losses on their holdings of government bonds from Greece, Italy and other heavily indebted European nations.
Basil Karatzas, the chief executive of Karatzas Marine Advisors, a ship brokerage and finance advisory firm in Manhattan, estimated that European banks hold about $500 billion in shipping loans on their books and face nearly $100 billion in losses to restructure them.
Just as American banks have grappled with huge loan losses for houses that are worth less than their mortgages, European banks face tens of billions of dollars in potential losses on shipping loans.
The banks’ “biggest concern is what is the write-off, and how do you treat it from an accounting point of view,” Mr. Karatzas said. “They do not know how to deal with these losses.”
Banks in Europe have long been the world leaders in ship financing because many of the biggest fleet owners are based there. But many have abruptly stopped lending money to shipowners. Some, as they scramble to muster capital to meet tougher reserve requirements demanded by European banking regulators, have even tried to raise money by asking some shipowners to prepay loans in exchange for a discount.
There is a scant secondary market for ship loans right now, except at deep discounts that banks are loath to agree to, according to shipping finance experts. Even for loans on which the vessel is still worth more than the mortgage, these experts say, the discount demanded is about 20 percent.
Commerzbank in Germany and the Lloyds Banking Group in Britain are among European institutions that have publicly said they were reducing their exposure to shipping loans.
Société Générale in France also has been looking for ways to reduce its holdings of shipping loans and instead focus on providing financial advice to shipping companies, according to two people with knowledge of the bank’s moves.
The bank declined to provide a comment on its shipping exposure ahead of the release of its annual financial report next month.
Shipowners, meantime, are nervously monitoring an industry benchmark, the Baltic Dry Index of bulk freighter charter rates, which has lost more than half its value since the start of the year. The index is now at its lowest level since January 2009, during the depths of the economic downturn after the bankruptcy of Lehman Brothers.
And as charter rates plummet, so do prices of the vessels themselves. A large tanker that sold for $137 million in early 2008, the Samho Dream, was repossessed by bankers late last year and sold last week in Hong Kong for just $28.3 million.
The world’s tonnage of large freighters is climbing by more than 10 percent a year, with 1,650 large freighters for bulk commodities expected to emerge from shipyards this year alone.
As long as the shipped tonnage of world trade is creeping up at an annual rate of only 2 to 3 percent a year, the oversupply can only grow more burdensome for the seaborne freight industry.
Making the glut especially acute right now is the fact that shipyards have delivered a large number of vessels to owners since the beginning of the year. Just as some car buyers wait to buy a car at the start of a model year — because it will hold its resale value longer — shipowners have traditionally taken delivery of as many vessels as possible in January, so as to have a full calendar year’s use before a vessel celebrates its first birthday, said Natasha Boyden, an analyst at Cantor Fitzgerald in New York.
Buyers who might be tempted to refuse delivery of vessels can lose their deposits, which are typically up to 40 percent of the contract price of the ship. But it is getting harder to borrow money from struggling banks to pay for the remaining 60 percent — particularly with resale values now much lower than the prices at which contracts were signed four or five years ago.
Freight rates are now close to operating costs for many bulk freighters, leaving almost nothing to pay the mortgage, so more old vessels may be scrapped in the coming years, which would eventually reduce oversupply.
Worldwide lending for ships totaled about $100 billion last year, down only slightly from previous years, according to industry estimates. But as much as three-quarters of last year’s loans were to refinance or restructure previous loans that the borrowers were struggling to repay, shipping finance executives said.
One big question is whether the plunge in freight rates might also signal further trouble in the global economy. World oil demand has been fairly flat lately because of weak economic growth, so there has been limited need for more tankers to haul oil.
The biggest market for bulk carriers lies in carrying iron ore to China’s voracious steel mills. But with a real estate slowdown in China undermining demand for steel, the annual growth rate of Chinese iron ore imports has abruptly slowed since October.
Harley Seyedin, the president of the American Chamber of Commerce in South China, said that many construction projects had slowed to a crawl, with barely enough work being done for developers to persuade their bankers to continue financing projects already under way.
Yet the growing glut of vessels, combined with seasonal factors, could skew the reliability of shipping as a global economic indicator. Bad weather lately off Australia and Brazil, the two countries where bulk freighters are most likely to take on iron ore and other cargo, has made companies leery of chartering vessels and risk waiting for days for ports to reopen after storms.
Further confusing the picture is that the cost to ship a container from China to the United States or Europe actually jumped in the first two weeks of this year, as factories rushed to fill orders before shutting down for up to a month for the Chinese New Year, which began Monday. But that could be a misleading metric, because container rates temporarily surge every year for the last sailings before the Chinese New Year.
Even if world trade does not slow in the coming months, the shipping industry still has a long way to go before cargo demand can possibly catch up to capacity. Meantime, bulk freighters, container ships, tankers and refrigerator ships by the hundreds may continue to bob idly in the waves here, their hulls showing wide bands of paint that would be submerged if the vessels were fully laden.
Can Big Oil Repeat Its Big Year?
Even today, $1.67 trillion is a lot of money. That is the amount wiped off the combined market capitalization of the top 50 energy companies between the end of 2007 and the end of 2011. Breaking it down offers big clues on Big Oil's prospects for 2012.
Every year, PFC Energy, a Washington, D.C.-based consultancy, ranks the top 50 listed energy companies in the world by market value. The latest, due Monday, has a surprise. The biggest gainers in 2011 were the dinosaurs of oil and gas: the supermajors. Their collective value increased by 8%, compared with a 7% decline for the PFC Energy 50 overall. It is only the second time they have led the field in the ranking's 13-year history.
Conventional wisdom holds this shouldn't be the case. Faith in the supermajors—Exxon Mobil, Chevron, Royal Dutch Shell, BP, ConocoPhillips and Total—has waned as state-backed rivals like PetroChina have emerged and smaller competitors have opened up new frontiers like U.S. shale. Seemingly too big to grow but too small to offset the power of petro-states, the supermajors have been priced for decline.
Why did investors fall in love with them again in 2011? First and foremost: security. The S&P 500 ended 2011 down slightly after wild swings. In choppy markets, scale and cash payouts provide comfort. And the supermajors, with a collective value of $1.2 trillion at year end, provide it in spades. The three U.S. ones alone paid out 9% of all S&P 500 dividends and buybacks in the year ended September 2011, according to data from Standard & Poor's and Capital IQ.
![[oilherd2]](http://si.wsj.net/public/resources/images/MI-BN179_oilher_NS_20120122175409.jpg)
So how about that missing $1.67 trillion? It is gone despite the average price of Brent crude being 53% higher in 2011 than in 2007 (and 13% higher than in 2008, year of the super-spike). About half of that market value was lost by listed state-controlled national oil companies, or NOCs, like PetroChina. State support has its advantages, but it also means NOCs serve two masters: markets and mandarins. That makes them riskier investments.
While the NOCs in the ranking lost 44% of their value between 2007 and 2011, the supermajors declined by just 22%.
But it isn't just safety that helped the supermajors lead the charge in 2011. Chevron, Exxon and Shell likely all delivered cash flow per share growth of 30% in 2011, well ahead of the traditional growth stocks of the exploration and production sector, according to Credit Suisse.
Ed Westlake, analyst at Credit Suisse, says the oil majors are more sensitive to oil prices than many investors think. In part, that is because much of their global natural-gas production is sold at prices linked to oil, rather than at the depressed, de-linked levels that prevail in the U.S.
This year, the supermajors are forecast to make $67 billion in free cash flow, according to FactSet Research Systems. That is down slightly from 2011's expectation but still equates to a healthy free cash flow yield of 5.6%.
Goldman Sachs points out, however, that unlike a year ago, supermajor stocks enter 2012 trading at a slight premium to their smaller integrated oil peers. That, coupled with the fact that 2011's cash-flow surge is unlikely to be repeated, means some investors' gains may be redeployed into other energy stocks.
It seems unlikely that the supermajors will register the biggest gains in the PFC Energy 50 2012. That doesn't make them a bad investment. With markets still unsettled—Europe, in particular, remains unpredictable—Big Oil will likely remain a safe haven. Stocks don't always have to be the biggest winners to be reliable repositories of value.
Source: http://online.wsj.com/article/SB10001424052970203750404577173191238523960.html?mod=WSJ_Heard_LEFTSecondNews
Every year, PFC Energy, a Washington, D.C.-based consultancy, ranks the top 50 listed energy companies in the world by market value. The latest, due Monday, has a surprise. The biggest gainers in 2011 were the dinosaurs of oil and gas: the supermajors. Their collective value increased by 8%, compared with a 7% decline for the PFC Energy 50 overall. It is only the second time they have led the field in the ranking's 13-year history.
Conventional wisdom holds this shouldn't be the case. Faith in the supermajors—Exxon Mobil, Chevron, Royal Dutch Shell, BP, ConocoPhillips and Total—has waned as state-backed rivals like PetroChina have emerged and smaller competitors have opened up new frontiers like U.S. shale. Seemingly too big to grow but too small to offset the power of petro-states, the supermajors have been priced for decline.
Why did investors fall in love with them again in 2011? First and foremost: security. The S&P 500 ended 2011 down slightly after wild swings. In choppy markets, scale and cash payouts provide comfort. And the supermajors, with a collective value of $1.2 trillion at year end, provide it in spades. The three U.S. ones alone paid out 9% of all S&P 500 dividends and buybacks in the year ended September 2011, according to data from Standard & Poor's and Capital IQ.
So how about that missing $1.67 trillion? It is gone despite the average price of Brent crude being 53% higher in 2011 than in 2007 (and 13% higher than in 2008, year of the super-spike). About half of that market value was lost by listed state-controlled national oil companies, or NOCs, like PetroChina. State support has its advantages, but it also means NOCs serve two masters: markets and mandarins. That makes them riskier investments.
While the NOCs in the ranking lost 44% of their value between 2007 and 2011, the supermajors declined by just 22%.
But it isn't just safety that helped the supermajors lead the charge in 2011. Chevron, Exxon and Shell likely all delivered cash flow per share growth of 30% in 2011, well ahead of the traditional growth stocks of the exploration and production sector, according to Credit Suisse.
Ed Westlake, analyst at Credit Suisse, says the oil majors are more sensitive to oil prices than many investors think. In part, that is because much of their global natural-gas production is sold at prices linked to oil, rather than at the depressed, de-linked levels that prevail in the U.S.
This year, the supermajors are forecast to make $67 billion in free cash flow, according to FactSet Research Systems. That is down slightly from 2011's expectation but still equates to a healthy free cash flow yield of 5.6%.
Goldman Sachs points out, however, that unlike a year ago, supermajor stocks enter 2012 trading at a slight premium to their smaller integrated oil peers. That, coupled with the fact that 2011's cash-flow surge is unlikely to be repeated, means some investors' gains may be redeployed into other energy stocks.
It seems unlikely that the supermajors will register the biggest gains in the PFC Energy 50 2012. That doesn't make them a bad investment. With markets still unsettled—Europe, in particular, remains unpredictable—Big Oil will likely remain a safe haven. Stocks don't always have to be the biggest winners to be reliable repositories of value.
Source: http://online.wsj.com/article/SB10001424052970203750404577173191238523960.html?mod=WSJ_Heard_LEFTSecondNews
A Standard, and Poor, Way of Investing
The stock market has treated investors well recently. But taking a longer view, it has been downright abusive.
Even with a gain of 4% since the start of the year, the Standard & Poor's 500-stock index has, with dividends reinvested, lost 8% since reaching its peak in October 2007. Adjust the index for inflation, and the news is worse—it has lost 18% since August 2000. Anybody who put money into an S&P 500 index fund between late 1998 and early 2001 remains in the red.
![[EQUALHERD]](http://si.wsj.net/public/resources/images/BF-AC151_EQUALH_NS_20120120171804.jpg)
When was the last time that so much time elapsed and the U.S. stock market still remained below its inflation-adjusted peak? Never, according to the monthly price and return data from Yale University economist Robert Shiller's reconstruction of the S&P 500 back to 1871. Even investors who bought on the eve of the 1929 crash were briefly above water, in inflation-adjusted terms, in 1937. Of course, since this owes to the deflation experienced during the Great Depression, strictly speaking the mattress was still a better place to put your money.
But while the stock market has been faring poorly, stocks have been doing better. The equal-weighted S&P 500 index, which puts all stocks on the same footing rather than weighting them by market capitalization, has beaten the regular index hands down. Since August 2000, it has returned an inflation-adjusted 52%.
A big reason the equal-weighted S&P has outperformed is that it's a sneaky way of value investing. In the late 1990s, retail investors who bought a vanilla S&P 500 fund, along with investment managers who benchmarked the sector weightings in their portfolios to the index, were loading up on expensive technology stocks. In the mid 2000s, they were buying heavily into the shares of housing and finance-related companies.
Exchange-traded funds may only be making the market more top heavy. Weighing in at $417 billion, the company with the largest market capitalization in the S&P 500 these days is Exxon Mobil. It is, according to ETF Database, among the top-10 holdings of 85 ETFs. (Fun fact: That includes both the WisdomTree LargeCap Growth Fund and the WisdomTree LargeCap Value Fund.) When investors put money into any one of them, they are giving Exxon shares another incremental boost. In contrast, biotech firm PerkinElmer—with a market cap of $2.6 billion and one of the smaller companies in the index—is in the top-10 holdings of just one ETF.
There are a handful of investors who control such huge pools of money that their portfolios can't help but shadow the market-capitalization weighted S&P 500. For the rest, there is no excuse.
Source: http://online.wsj.com/article/SB10001424052970203750404577173053976605904.html?mod=WSJ_Heard_LEFTSecondNews
Even with a gain of 4% since the start of the year, the Standard & Poor's 500-stock index has, with dividends reinvested, lost 8% since reaching its peak in October 2007. Adjust the index for inflation, and the news is worse—it has lost 18% since August 2000. Anybody who put money into an S&P 500 index fund between late 1998 and early 2001 remains in the red.
When was the last time that so much time elapsed and the U.S. stock market still remained below its inflation-adjusted peak? Never, according to the monthly price and return data from Yale University economist Robert Shiller's reconstruction of the S&P 500 back to 1871. Even investors who bought on the eve of the 1929 crash were briefly above water, in inflation-adjusted terms, in 1937. Of course, since this owes to the deflation experienced during the Great Depression, strictly speaking the mattress was still a better place to put your money.
But while the stock market has been faring poorly, stocks have been doing better. The equal-weighted S&P 500 index, which puts all stocks on the same footing rather than weighting them by market capitalization, has beaten the regular index hands down. Since August 2000, it has returned an inflation-adjusted 52%.
A big reason the equal-weighted S&P has outperformed is that it's a sneaky way of value investing. In the late 1990s, retail investors who bought a vanilla S&P 500 fund, along with investment managers who benchmarked the sector weightings in their portfolios to the index, were loading up on expensive technology stocks. In the mid 2000s, they were buying heavily into the shares of housing and finance-related companies.
Exchange-traded funds may only be making the market more top heavy. Weighing in at $417 billion, the company with the largest market capitalization in the S&P 500 these days is Exxon Mobil. It is, according to ETF Database, among the top-10 holdings of 85 ETFs. (Fun fact: That includes both the WisdomTree LargeCap Growth Fund and the WisdomTree LargeCap Value Fund.) When investors put money into any one of them, they are giving Exxon shares another incremental boost. In contrast, biotech firm PerkinElmer—with a market cap of $2.6 billion and one of the smaller companies in the index—is in the top-10 holdings of just one ETF.
There are a handful of investors who control such huge pools of money that their portfolios can't help but shadow the market-capitalization weighted S&P 500. For the rest, there is no excuse.
Source: http://online.wsj.com/article/SB10001424052970203750404577173053976605904.html?mod=WSJ_Heard_LEFTSecondNews
In Europe, a Conflict Over Bank Capital
LONDON — Europe’s banks and regulators are at odds about how financial institutions should increase their capital reserves.
Authorities want European banks to tap existing shareholders and reduce employee bonuses to find a combined $147 billion to increase their core Tier 1 ratios, a measure of a firm’s ability to weather financial shocks, to 9 percent by June. Citigroup estimates that Europe’s financial institutions, minus the Greek banks, had raised at least 40 billion euros, or $51 billion, as of the fourth quarter of 2011.
Banks, however, would prefer to sell or write down unprofitable operations, as well as adjust their balance sheets, to free up cash to meet the new requirements.
One solution could be to increase capital reserves through rights offerings, which allow existing shareholders to buy new stock at a discount. But volatility in the financial markets amid Europe’s sovereign debt crisis has damped investor interest.
Many banks are waiting on the outcome of the Italian bank UniCredit’s 7.5 billion euro rights issue, which closes at the end of this week. After initial investor skepticism, market participants say the Milan-based bank, which must raise almost 8 billion euros by June, is now expected to gain shareholder backing for the multibillion-euro capital increase.“Everyone is looking at the UniCredit deal as a litmus test for future capital raisings,” said a senior investment banker from a leading bank in Europe, who spoke on the condition of anonymity because he was not authorized to talk publicly.
If other options are not attractive, some banks may eventually turn to local governments for a helping hand. Last year, the European Union created the European Financial Stability Facility, a 440 billion euro fund that can be used to shore up firms’ capital reserves.
Banks will soon find out what regulators think of their plans. Financial institutions, including Deutsche Bank of Germany and BNP Paribas of France, had to submit their recapitalization strategies to national regulators by Friday. The European Banking Authority will review the plans in early February, and regulators have the power to veto any capital-raising plan they don’t agree with.
Much of Europe is expected to enter recession this year, so authorities are likely to reject capital-raising efforts, like cutting lending to businesses, that reduce support for the European economy.
The banking authority has called on banks to raise the money through cuts in shareholder dividends and issuance of new stock. It has warned that the sale of any operation, particularly in banks’ home markets, that hurts business lending won’t be allowed.
“Regulators are asking for the impossible,” said Etay Katz, a banking regulatory partner at the law firm Allen & Overy in London. “They want banks to keep lending to the real economy, and there’s an expectation banks will have to swallow the bitter pill of offering new equity at times when investors’ appetite is negative.”
Nonetheless, some banks have been following authorities’ demands. Société Générale must raise 2.1 billion euros, and announced last November it was slashing bonuses and scrapping its 2011 shareholder dividend to meet the new regulatory requirements. It also plans to cut almost 1,600 jobs in its investment bank unit and has offloaded billions of euros of sovereign bonds to reduce its exposure to euro zone debt. As of the end of September, Société Générale’s core Tier 1 ratio stood at 9.5 percent.
Not every European bank, however, can rely on its own earnings. Many midsize banks, especially in Southern Europe, face deteriorating local economic conditions and rising customer defaults. In Spain, for example, authorities say the ratio of bad loans to bank lending has hit a 17-year high. And the European Union expects the country’s economy to grow a mere 0.7 percent this year, compared with 1.5 percent for the United States.
“The outlook is mostly negative for banks in countries like Spain, Italy and Portugal,” said James Longsdon, managing director in Fitch Ratings’ financial institutions group, in London.
Other banks are hoping the sale of so-called noncore assets in overseas markets will help to increase their capital reserves. The fire sale could be enormous. The European financial sector is expected to sell or write down more than $1.8 trillion in loan assets during the next decade, according to the consulting firm PricewaterhouseCoopers. That compares with just $97 billion from 2003 to 2010.
Last week, the Royal Bank of Scotland, which already has met the European Banking Authority’s capital requirements, sold its aircraft leasing business to a consortium of Japanese companies for $7.3 billion. Ireland’s nationalized Anglo Irish Bank also has offloaded $3.3 billion in commercial real estate loans in the United States to Wells Fargo. In all, the Irish bank wants to cut nearly $10 billion in American loans as part of a government requirement to reduce its assets and trim its operations.
Potential buyers, including American private equity firms, are lining up to take advantage, though analysts say the amount of assets up for sale will depress prices. That could reduce the impact on banks’ capital reserves. Local European politicians also may block deals that they believe will hurt domestic consumers.
“Banks may be restricted on deleveraging within Europe,” said Simon McGeary, managing director for European new products at Citigroup in London.
Banks also are restructuring their balance sheets to squeeze out extra capital. In a move known as liability management, banks can improve capital levels without raising additional funds. The strategy involves buying back or exchanging hybrid securities — investments that pay dividends like bonds, but can be converted into equity — at a discount from investors.
Under accounting rules, financial institutions can then book the difference between the original face value of the securities and the current discounted price as a profit toward core Tier 1 equity.
The strategy has been popular. Morgan Stanley estimates financial institutions, including Commerzbank of Germany and the Lloyds Banking Group of Britain, will raise a combined 8.7 billion euros by buying back, or exchanging, hybrid securities from investors.
The adjusting of companies’ balance sheets also includes so-called capital optimization, which involves tweaking banks’ back-office systems to free up funds to meet the capital requirements. Credit Suisse estimates that Spanish banks, which must raise a combined 26.1 billion euros, could free up more than 3 billion euros by fine-tuning how they use capital without raising any new funds.
“The only way for banks to succeed is to be more efficient with the limited capital available,” said Steve Culp, global managing director of the risk management practice at the consulting firm Accenture in London.
Banks, particularly in struggling southern European economies, may eventually have to turn to government bailouts. Deals already have been announced. In December, the National Bank of Greece and its local rival Piraeus Bank sold a combined 1.4 billion euros of shares to the government to increase their core Tier 1 ratios.
“There’s no magic bullet to this problem,” said Karl Goggin, a banking analyst at NCB Stockbrokers in Dublin. “The market has a finite appetite for banking stocks, so governments may have to step in.”
Source: http://dealbook.nytimes.com/2012/01/24/in-europe-a-conflict-over-bank-capital/
Tuesday, January 24, 2012
China’s economy: Two twists in the dragon’s tail
DATA points sometimes change faster than debating points. It is conventional wisdom that China’s export-led growth squeezes consumers at home and competitors abroad, even as it adds inexorably to the country’s huge foreign-exchange reserves. But figures released this month complicate these arguments.
China still runs a sizeable trade surplus. But its net exports fell in 2011 (in absolute terms) for only the third time since 2000, subtracting 0.5 percentage points from its growth. Thanks to home-grown spending, China’s economy still managed to expand by 9.2% in 2011, remaining surprisingly strong even in the fourth quarter. This growth owed an unusual amount to consumption (both public and private), which contributed over half for the first time since 2001. As a consequence, the share of consumption in China’s GDP edged up in 2011 after falling for ten years in a row.
The mainstay of China’s growth remains investment, on which its economy remains worryingly dependent. Indeed, when China’s critics are not bashing it for overexporting, they bash it for overinvestment in property. Its housing boom is, however, slowing markedly. China this week reported that the price of new homes fell in 52 out of 70 cities across the country in December, compared with the month before. Households are struggling to obtain mortgages; developers are finding it almost impossible to obtain a loan. The drying up of foreign funds is particularly dramatic, points out North Square Blue Oak, a research firm based in London and Beijing. Foreign capital fell by 65% in December, compared with a year earlier.
The flight of foreigners from property partly explains another unusual twist in the China story. Its foreign-exchange reserves fell in the fourth quarter for the first time since the height of the Asian financial crisis in 1998. The drop was small, from $3.2 trillion to $3.18 trillion, but also a little mysterious. China still exports more than it imports, and attracts more foreign direct investment than it undertakes. These two sources of foreign exchange must, then, have been offset by an unidentified drain.
The worry is that China’s capital controls have sprung a leak. “Hot money”, attracted by the country’s growth, may be flowing out as the property market falters. Some even speculate that China’s rich may begin to smuggle their new-found wealth out of the country en masse.
These fears are overblown, for now. Some of the drop probably reflects a change in the value of China’s euro holdings. Some does represent the departure of short-term money, but an ebb and flow of hot money is not unusual. Moreover, some kinds of hot money are more scalding than others, says Stephen Green of Standard Chartered. At one end of the thermometer, an exporter might delay the conversion of his legitimate foreign-exchange earnings. In other, warmer cases, an importer might illegally overstate the size of his purchases, so as to remit more money out of the country. Capitalists eager to take their money out also have other cards to play. Mr Green estimates that last year about $185 billion might have passed from mainland China through the VIP rooms of Macau’s casinos.
Victor Shih of Northwestern University reckons that China’s richest 1% hold $2 trillion-5 trillion in liquid wealth and property. If they were ever to smuggle that money out, the outflow would dent even China’s reserves. That would be a disaster for China’s economic management, putting heavy downward pressure on the yuan. At least China’s critics could no longer trot out another familiar accusation—that it undervalues the exchange rate.
Working out of debt
The deleveraging process that began in 2008 is proving to be long and painful. Historical experience, particularly post–World War II debt reduction episodes, which the McKinsey Global Institute reviewed in a report two years ago, suggested this would be the case.1 And the eurozone’s debt crisis is just the latest demonstration of how toxic the consequences can be when countries have too much debt and too little growth.
We recently took another look forward and back—at the relevant lessons from history about how governments can support economic recovery amid deleveraging and at the signposts business leaders can watch to see where economies are in that process. We reviewed the experience of the United States, the United Kingdom, and Spain in depth, but the signals should be relevant for any country that’s deleveraging.
Deleveraging: Where are we now?
The financial crisis highlighted the danger of too much debt, a message that has only been reinforced by Europe’s recent sovereign-debt challenges. And new McKinsey Global Institute research shows that the unwinding of debt—or deleveraging—has barely begun. Since 2008, debt ratios have grown rapidly in France, Japan, and Spain and have edged downward only in Australia, South Korea, and the United States. Overall, the ratio of debt to GDP has grown in the world’s ten largest economies.
Overall, the deleveraging process has only just begun. During the past two and a half years, the ratio of debt to GDP, driven by rising government debt, has actually grown in the aggregate in the world’s ten largest developed economies (for more, see sidebar, “Deleveraging: Where are we now?”). Private-sector debt has fallen, however, which is in line with historical experience: overextended households and corporations typically lead the deleveraging process; governments begin to reduce their debts later, once they have supported the economy into recovery.
Different countries, different paths
In the United States, the United Kingdom, and Spain, all of which experienced significant credit bubbles before the financial crisis of 2008, households have been reducing their debt at different speeds. The most significant reduction occurred among US households. Let’s review each country in turn.
The United States: Light at the end of the tunnel
Household debt outstanding has fallen by $584 billion (4 percent) from the end of 2008 through the second quarter of 2011 in the United States. Defaults account for about 70 and 80 percent of the decrease in mortgage debt and consumer credit, respectively. A majority of the defaults reflect financial distress: overextended homeowners who lost jobs during the recession or faced medical emergencies found that they could not afford to keep up with debt payments. It is estimated that up to 35 percent of the defaults resulted from strategic decisions by households to walk away from their homes, since they owed far more than their properties were worth. This option is more available in the United States than in other countries, because in 11 of the 50 states—including hard-hit Arizona and California—mortgages are nonrecourse loans, so lenders cannot pursue the other assets or income of borrowers who default. Even in recourse states, US banks historically have rarely pursued borrowers.
Historical precedent suggests that US households could be up to halfway through the deleveraging process, with one to two years of further debt reduction ahead. We base this estimate partly on the long-term trend line for the ratio of household debt to disposable income. Americans have constantly increased their debt levels over the past 60 years, reflecting the development of mortgage markets, consumer credit, student loans, and other forms of credit. But after 2000, the ratio of household debt to income soared, exceeding the trend line by about 30 percentage points at the peak (Exhibit 1). As of the second quarter of 2011, this ratio had fallen by 11 percent from the peak; at the current rate of deleveraging, it would return to trend by mid-2013. Faster growth of disposable income would, of course, speed this process.
We came to a similar conclusion when we compared the experiences of US households with those of households in Sweden and Finland in the 1990s. During that decade, these Nordic countries endured similar banking crises, recessions, and deleveraging. In both, the ratio of household debt to income declined by roughly 30 percent from its peak. As Exhibit 2 indicates, the United States is closely tracking the Swedish experience, and the picture looks even better considering that clearing the backlog of mortgages already in the foreclosure pipeline could reduce US household debt ratios by an additional six percentage points.
As for the debt service ratio of US households, it’s now down to 11.5 percent—well below the peak of 14.0 percent, in the third quarter of 2007, and lower than it was even at the start of the bubble, in 2000. Given current low interest rates, this metric may overstate the sustainability of current US household debt levels, but it provides another indication that they are moving in the right direction.
Nonetheless, after US consumers finish deleveraging, they probably won’t be as powerful an engine of global growth as they were before the crisis. That’s because home equity loans and cash-out refinancing, which from 2003 to 2007 let US consumers extract $2.2 trillion of equity from their homes—an amount more than twice the size of the US fiscal-stimulus package—will not be available. The refinancing era is over: housing prices have declined, the equity in residential real estate has fallen severely, and lending standards are tighter. Excluding the impact of home equity extraction, real consumption growth in the pre-crisis years would have been around 2 percent per annum—similar to the annualized rate in the third quarter of 2011.
The United Kingdom: Debt has only just begun to fall
Three years after the start of the financial crisis, UK households have deleveraged only slightly, with the ratio of debt to disposable income falling from 156 percent in the fourth quarter of 2008 to 146 percent in second quarter of 2011. This ratio remains significantly higher than that of US households at the bubble’s peak. Moreover, the outstanding stock of household debt has fallen by less than 1 percent. Residential mortgages have continued to grow in the United Kingdom, albeit at a much slower pace than they did before 2008, and this has offset some of the £25 billion decline in consumer credit.
Still, many UK residential mortgages may be in trouble. The Bank of England estimates that up to 12 percent of them may be in some kind of forbearance process, and an additional 2 percent are delinquent— similar to the 14 percent of US mortgages that are in arrears, have been restructured, or are now in the foreclosure pipeline (Exhibit 3). This process of quiet forbearance in the United Kingdom, combined with record-low interest rates, may be masking significant dangers ahead. Some 23 percent of UK households report that they are already “somewhat” or “heavily” burdened in paying off unsecured debt.2 Indeed, the debt payments of UK households are one-third higher than those of their US counterparts—and 10 percent higher than they were in 2000, before the bubble. This statistic is particularly problematic because at least two-thirds of UK mortgages have variable interest rates, which expose borrowers to the potential for soaring debt payments should interest rates rise.
Given the minimal amount of deleveraging among UK households, they do not appear to be following Sweden or Finland on the path of significant, rapid deleveraging. Extrapolating the recent pace of UK household deleveraging, we find that the ratio of household debt to disposable income would not return to its long-term trend until 2020. Alternatively, it’s possible that developments in UK home prices, interest rates, and GDP growth will cause households to reduce debt slowly over the next several years, to levels that are more sustainable but still higher than historic trends. Overall, the United Kingdom needs to steer a difficult course that reduces household debt steadily, but at a pace that doesn’t stifle growth in consumption, which remains the critical driver of UK GDP.
Spain: The long unwinding road
Since the credit crisis first broke, Spain’s ratio of household debt to disposable income has fallen by 4 percent and the outstanding stock of household debt by just 1 percent. As in the United Kingdom, home mortgages and other forms of credit have continued to grow while consumer credit has fallen sharply.
Spain’s mortgage default rate climbed following the crisis but remains relatively low, at approximately 2.5 percent, thanks to low interest rates. The number of mortgages in forbearance has also risen since the crisis broke, however. And more trouble may lie ahead. Almost half of the households in the lowest-income quintile face debt payments representing more than 40 percent of their income, compared with slightly less than 20 percent for low-income US households. Meanwhile, the unemployment rate in Spain is now 21.5 percent, up from 9 percent in 2006. For now, households continue to make payments to avoid the country’s conservative recourse laws, which allow lenders to go after borrowers’ assets and income for a long period.
In Spain, unlike most other developed economies, the corporate sector’s debt levels have risen sharply over the past decade. A significant drop in interest rates after the country joined the eurozone, in 1999, unleashed a run-up in real-estate spending and an enormous expansion in corporate debt. Today, Spanish corporations hold twice as much debt relative to national output as do US companies, and six times as much as German companies. Debt reduction in the corporate sector may weigh on growth in the years to come.
Signposts for recovery
Paring debt and laying a foundation for sustainable long-term growth should take place simultaneously, difficult as that may seem. For economies facing this dual challenge today, a review of history offers key lessons. Three historical episodes of deleveraging are particularly relevant: those of Finland and Sweden in the 1990s and of South Korea after the 1997 financial crisis. All these countries followed a similar path: bank deregulation (or lax regulation) led to a credit boom, which in turn fueled real-estate and other asset bubbles. When they collapsed, these economies fell into deep recession, and debt levels fell.
In all three countries, growth was essential for completing a five- to seven-year-long deleveraging process. Although the private sector may start to reduce debt even as GDP contracts, significant public-sector deleveraging, absent a sovereign default, typically occurs only when GDP growth rebounds, in the later years of deleveraging (Exhibit 4). That’s true because the primary factor causing public deficits to rise after a banking crisis is declining tax revenue, followed by an increase in automatic stabilizer payments, such as unemployment benefits.3 A rebound of economic growth in most deleveraging episodes allows countries to grow out of their debts, as the rate of GDP growth exceeds the rate of credit growth.
No two deleveraging economies are the same, of course. As relatively small economies deleveraging in times of strong global economic expansion, Finland, South Korea, and Sweden could rely on exports to make a substantial contribution to growth. Today’s deleveraging economies are larger and face more difficult circumstances. Still, historical experience suggests five questions that business and government leaders should consider as they evaluate where today’s deleveraging economies are heading and what policy priorities to emphasize.
1. Is the banking system stable?
In Finland and Sweden, banks were recapitalized and some were nationalized. In South Korea, some banks were merged and some were shuttered, and foreign investors for the first time got the right to become majority investors in financial institutions. The decisive resolution of bad loans was critical to kick-start lending in the economic- rebound phase of deleveraging.
The financial sectors in today’s deleveraging economies began to deleverage significantly in 2009, and US banks have accomplished the most in that effort. Even so, banks will generally need to raise significant amounts of additional capital in the years ahead to comply with Basel III and national regulations. In most European countries, business demand for credit has fallen amid slow growth. The supply of credit, to date, has not been severely constrained. A continuation of the eurozone crisis, however, poses a risk of a significant credit contraction in 2012 if banks are forced to reduce lending in the face of funding constraints. Such a forced deleveraging would significantly damage the region’s ability to escape recession.
2. Are structural reforms in place?
In the 1990s, each of the crisis countries embarked on a program of structural reform. For Finland and Sweden, accession to the European Union led to greater economies of scale and higher direct investment. Deregulation in specific industry sectors—for example, retailing—also played an important role.4 South Korea followed a remarkably similar course as it restructured its large corporate conglomerates, or chaebol, and opened its economy wider to foreign investment. These reforms unleashed growth by increasing competition within the economy and pushing companies to raise their productivity.
Today’s troubled economies need reforms tailored to the circumstances of each country. The United States, for instance, ought to streamline and accelerate regulatory approvals for business investment, particularly by foreign companies. The United Kingdom should revise its planning and zoning rules to enable the expansion of successful high-growth cities and to accelerate home building. Spain should drastically simplify business regulations to ease the formation of new companies, help improve productivity by promoting the creation of larger ones, and reform labor laws.5 Such structural changes are particularly important for Spain because the fiscal constraints now buffeting the European Union mean that the country cannot continue to boost its public debt to stimulate the economy. Moreover, as part of the eurozone, Spain does not have the option of currency depreciation to stimulate export growth.
3. Have exports surged?
In Sweden and Finland, exports grew by 10 and 9.4 percent a year, respectively, between 1994 and 1998, when growth rebounded in the later years of deleveraging. This boom was aided by strong export-oriented companies and the significant currency devaluations that occurred during the crisis (34 percent in Sweden from 1991 to 1993). South Korea’s 50 percent devaluation of the won, in 1997, helped the nation boost its share of exports in electronics and automobiles.
Even if exports alone cannot spur a broad recovery, they will be important contributors to economic growth in today’s deleveraging economies. In this fragile environment, policy makers must resist protectionism. Bilateral trade agreements, such as those recently passed by the United States, can help. Salvaging what we can from the Doha round of trade talks will be important. Service exports, including the “hidden” ones that foreign students and tourists generate, can be a key component of export growth in the United Kingdom and the United States.
4. Is private investment rising?
Another important factor that boosted growth in Finland, South Korea, and Sweden was the rapid expansion of investment. In Sweden, it rose by 9.7 percent annually during the economic rebound that began in 1994. Accession to the European Union was part of the impetus. Something similar happened in South Korea after 1998 as barriers to foreign direct investment fell. These soaring inflows helped offset slower private-consumption growth as households deleveraged.
Given the current very low interest rates in the United Kingdom and the United States, there is no better time to embark upon investments. Those for infrastructure represent an important enabler, and today there are ample opportunities to renew the aging energy and transportation networks in those countries. With public funding limited, the private sector can play an important role in providing equity capital, if pricing and regulatory structures enable companies to earn a fair return.
5. Has the housing market stabilized?
During the three historical episodes discussed here, the housing market stabilized and began to expand again as the economy rebounded. In the Nordic countries, equity markets also rebounded strongly at the start of the recovery. This development provided additional support for a sustainable rate of consumption growth by further increasing the “wealth effect” on household balance sheets.
In the United States, new housing starts remain at roughly one-third of their long-term average levels, and home prices have continued to decline in many parts of the country through 2011. Without price stabilization and an uptick in housing starts, a stronger recovery of GDP will be difficult,6 since residential real-estate construction alone contributed 4 to 5 percent of GDP in the United States before the housing bubble. Housing also spurs consumer demand for durable goods such as appliances and furnishings and therefore boosts the sale and manufacture of these products.
At a time when the economic recovery is sputtering, the eurozone crisis threatens to accelerate, and trust in business and the financial sector is at a low point, it may be tempting for senior executives to hunker down and wait out macroeconomic conditions that seem beyond anyone’s control. That approach would be a mistake. Business leaders who understand the signposts, and support government leaders trying to establish the preconditions for growth, can make a difference to their own and the global economy.Source: https://www.mckinseyquarterly.com/Working_out_of_debt_2914
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