Directors beware

Investors are looking for scalps and insurers have warned that companies worldwide – not just in the US, where shareholder actions are more common – face potentially ruinous litigation claims for losses caused either as a direct result of their own actions and failure to manage risks effectively, or through their exposure to those companies that followed high-risk strategies. Insurance market Lloyd’s of London has warned that businesses could be facing a future liability crisis if they do not face up to growing litigation issues. In its report called “Directors in the Dock – is business facing a liability crisis?” published in May, Lloyd’s urges businesses to anticipate and prepare for future liability risks potentially arising from the credit crunch.

Lloyd’s research has shown that boards everywhere are feeling increasingly challenged by litigation and are spending more time and money addressing these issues. Key findings include the fact that two-thirds of European business leaders expect to spend more time on litigation-related issues over the next three years, and that two in three business leaders believe that the scale of liability claims arising from the credit crunch will exceed those arising from the dotcom crash.

By the end of 2007, the credit crunch had sparked a 58 percent rise in the number of class-action lawsuits filed by US shareholders against companies and their directors. Research has found that lawyers filed 207 class-action cases last year, up from 131 in 2006. The average settlement also soared to $32.2m, up nearly 50 percent on 2006. The median pay-out also hit a high of $10m, according to NERA Economic Consulting, an international firm of economists. So-called mega-settlements, worth $100m or more, accounted for nearly one in 12 of all settlements. Before 2000 they accounted for, at most, two percent of payouts.

The first of the sub-prime related securities class action lawsuits were filed in February 2007, just as the problems in the sub-prime marketplace began to surface. Since then, as the sub-prime-related problems developed into a more generalised credit crisis, the associated litigation has also grown. As of October 1, 2008, there have been 120 sub-prime and credit crisis-related securities class action lawsuits filed, in addition to 23 derivative lawsuits and 15 ERISA lawsuits.

Breaching fiduciary
As might have been predicted, shareholder lawsuits have already been filed against the directors and officers of some of the most prominent companies caught up in the events of Black September 2008. For example, on September 15, 2008, Merrill Lynch shareholders filed a complaint in New York state court against the company, as nominal defendant, and a certain number of directors and officers. The complaint alleges that the company’s planned merger with Bank of America is the result of a “flawed process and unconscionable agreement” and that the defendants had breached their fiduciary duty.

Similarly, on September 18, 2008, AIG shareholders filed a Delaware Chancery Court lawsuit against certain current and former directors and officers of AIG. The lawsuit blames the defendants for the company’s “exposure to and grossly imprudent risk taking in the sub-prime lending market and derivative instruments.” The lawsuit seeks the return to AIG of all compensation paid to AIG’s CEO and to its directors, among other things.

In addition, on September 24, 2008 plaintiffs’ lawyers initiated a securities class action lawsuit in the Southern District of New York against certain directors and officers of Lehman Brothers, on behalf of persons who purchased shares in the company’s February 5, 2008 offering of preferred securities. The complaint also names the offering underwriters as defendants. The complaint alleges, among other things, that the offering documents did not accurately reflect the company’s true financial condition, because the defendants had failed to appropriately write-down both the company’s sub-prime mortgage portfolio and its portfolio of commercial and residential real estate assets.

So far, directors in the UK have managed to avoid litigation for their part in the downfall of their firms. In October nationalised lender Northern Rock said it would not take legal action for negligence against the executives in charge of the bank before its collapse. Management said a review by lawyers and accountants into the management led by Chief Executive Adam Applegarth found “insufficient grounds” to proceed. The probe also concluded that the firm’s auditors should also avoid any action.

But UK lawyers do not discount the possibility that directors of other organisations severely impacted by the credit crisis will not be treated so favourably. “There’s only so long before someone in the UK realises that the courts are the only real recourse he has to get justice for his pension fund being depleted and the shares in the bank he invested in being worthless. Once that happens, directors will need to be very aware of the consequences of their actions and the risks their organisations are taking,” says one UK corporate lawyer.

Pressure cooker
Experts also agree that as companies are under increased pressure to show shareholders that they can still perform well in a depressed economic climate, it is increasingly likely that company directors will need to make sure that risks facing the business are properly assessed, mitigated and controlled and that corners are not cut simply to reduce costs.

The UK’s Companies Act (2006), which came into effect in 2007, states that the duty of directors is to act in a way which they consider most likely to promote the success of the company for the benefit of its shareholders as a whole and that, in doing so, they will need to have regard “where appropriate” to long term factors, the interests of other stakeholders and the community, and the company’s reputation. As a result, risks need to be identified and managed properly. And in an economic downturn, there are arguably more risks to consider.

One of these key risks is whether the directors are keeping a tight rein on the organisation’s operations and ensuring that while the business may be taking an “aggressive” strategy to stay competitive in the current climate of economic turmoil, it is not acting illegally or outside the bounds of corporate governance best practice. If it is, then the directors could well be in the firing line for regulatory action and/or investor lawsuits. 

And it is not just full-time executive directors that can be targeted. Some recent scandals have shown that non-executive directors can be at the centre of colossal fraud trials and damages claims. Recent examples include Lord Wakeham, formerly a non-executive director at disgraced US energy company Enron, who suddenly found himself being summoned to the US to provide testimony in the world’s most notorious corporate fraud trial.

Under UK law, all directors have a legal duty to display not only a reasonable level of skill, care and diligence in the discharge of their functions, but also to bring to bear such knowledge, skill and experience as they have. Furthermore, UK company law does not distinguish between executive and non-executive directors and thus both sets of directors share the same duties and responsibilities to shareholders, regulators and other stakeholders. The dismissive remark once given by executive ITV Chairman Michael Grade about likening non-executives to bidets (“you’re not sure what they’re for, but they add a touch of class”) – which perhaps once captured the passive nature of the role – no longer holds true. Non-executives are equally as culpable as executives.

Risk management
In the case of UK life insurance firm Equitable Life which came close to collapsing in 2000, the troubled insurer’s non-executives were forced – following a regime change at the company’s board – to enter the witness box in the context of a £2bn claim against them to defend their actions. One of the main planks of their defence was to the effect that the risks surrounding guaranteed annuity rates were a highly technical matter on which they had to rely on the good judgement of the actuaries, the other professionals and the executive, and therefore they should not be held equally culpable.

But the UK’s financial services regulator has made it clear that such an attitude is no longer tenable. Shelia Nicoll, director of the FSA retail firms division, has warned that the regulator now plans to interview “more of those applying to hold significant influence functions at the largest firms”. 

In a speech on September 17, Ms Nicholl said: “We certainly expect that those we interview will go on to be approved – those invited to interview as part of our scrutiny process should not feel that they have been singled out for attention. We have run pilots and we expect and hope that those we interview will take up their new roles more conscious of their regulatory responsibilities. You should, however, be clear that FSA approval of significant influence functions is not a ‘tick box’ exercise.”

Ms Nicholl said that while the FSA appreciates that it cannot expect non-executive directors to have the same grasp of detail as executives who work full time for a group, she added that “we expect them to ask the challenging questions, to understand the business models and sources of profit in the firm, along with the risks which those entail. So, if you agree to be a non-executive director of a regulated firm or a group containing regulated firms, you must expect us to assess your competence and to hold you to account if you have not conducted yourself in a way which falls below the standards we reasonably expect of non-executive directors.”

“Boards which are mere paper tigers can be worse than useless because they give false reassurance of high standards – of checks and balances – where none exist,” said Ms Nicholl. “We aren’t ignorant of the difficulties which medium-sized firms have in getting hold of good directors, but my personal view is that a firm is better served by having a smaller number of hard working, well paid non-executive directors than a larger number of token ones.”

Lawyers also believe that the current financial climate may compel directors to take greater credit risks. Danny Davis, partner in the insolvency practice at law firm Mishcon de Reya, points out that while the UK is heading for recession, there is going to be increased pressure on companies to push back payment deadlines with suppliers while trying to get customers to pay more rapidly. As a consequence, he says, there are going to be more instances of companies trading while heading for insolvency.

“The credit crunch is going to make some directors take bigger risks with regards to how they try to manage their cashflow,” says Mr Davis. “It is increasingly likely that more companies will be heading for insolvency in the coming months, and directors need to make sure that their companies do not trade while insolvent – or are about to go insolvent – in an attempt to keep the business running.”

Mr Davis adds that directors should also not make the mistake of thinking that the company’s tax payments are not as important as payments to suppliers. “Time and again we see court cases where companies are filing for insolvency and they haven’t paid the taxman because they mistakenly thought HM Revenue and Customs was the least important creditor. Companies in difficulty often believe that their tax payment can simply be made at a later date – often without telling HMRC why – so that funds can be used ‘constructively’ to pay staff, suppliers, stockholders, utilities, lease holders and so on first. This is nonsense and is not favourably looked upon by the courts.”

Frontier shift

The fact that emerging markets in Asia, Africa and Middle East have managed to stave off the worst effects of the global credit crunch for over a year has impressed investors enough to rethink their fund strategies and shift large amounts of cash to countries which just five years ago they would have been reluctant to touch.

Fund managers feel that many developing countries have shaken off their legacy of debt and that since they now have current account surpluses, they are therefore deemed to be of investment-grade quality. Corporate governance is also improving and many companies are adding shareholder value by offering steady dividend payouts. More importantly, proponents of emerging market investing claim stocks are under-researched, under invested and, therefore, full of untapped potential. Just look at the figures in one emerging market – the Gulf States. The value of rights issues by Gulf-based companies has jumped to a record $15.76bn over the last year, a 242 percent increase on the previous year.

Growth rates for the regions also sit well. The IMF predicts an average 6.8 percent growth each year for the next five years for developing markets. While that may be some way short of the double-digit growth enjoyed to date, it still outstrips the 2.7 percent forecasted for developed markets.

Furthermore, the Investment Management Association (IMA) Global Emerging Markets sector, which consists of 33 funds primarily invested in Latin America, Emerging Europe, the Middle East, Africa and Asia, has demonstrated the capacity for developing markets to outperform.

Over three years on a cumulative basis to 30 June the average return was 80.1 percent, according to Morningstar, the fund research firm. This compares with the Global Growth sector, which returned just 25.5 percent. Given that most analysts agree that the credit crunch is now beginning to hit emerging markets, that figure is likely to have dropped. But economists insist that developing and frontier markets still have plenty to offer for investors.

Real estate is a particular favourite. According to Real Capital Analytics (RCA), a research and consulting firm, the volume of real estate deals in the industrialised world fell 54 percent in the first quarter of 2008 compared with a year ago. But at the same time, the number of transactions in emerging markets jumped 43 percent in the first quarter. And the big investors are jumping in. A Citigroup survey of 50 major pension funds in the US and Europe found that portfolio managers want to commit some $370bn to real estate over the next three years, in spite of the slowdown in their domestic markets.

Big chunks of that money are beginning to flow into countries such as China, India, Russia and the emerging economies of eastern Europe. Charles Schwab’s $228m Global Real Estate Fund made its first foray into emerging markets in March. Although China is the emerging real estate giant, it is hardly alone. India saw property sales volume jump 210 percent in the first quarter over the first three months of last year, making it the world’s fastest growing real estate market. Analysts at Morgan Stanley are extremely upbeat that they expect a secular boom in emerging market property over the next ten years. They think developing nations will spend a massive $22,000bn on core infrastructure projects during the period. Half of that, about $11,000bn, will go towards construction.

The theme of infrastructure spending in emerging markets is not new and many investors have been exploring this opportunity for several years.

By 2015, almost half the population of emerging markets (nearly three quarters of the world’s urban population) will live in urban areas, thus accelerating demand for power generation, transportation, and sanitation. This may slow in the current credit environment but will ultimately come through.

Working on the frontline
Frontier markets are also looking particularly attractive. These are popular with investors because they are largely uncorrelated with global markets, with other emerging markets, and with each other, which means that they are less likely to suffer from economic wobbles when other countries’ stock markets take a tumble. EPFR Global, a Boston-based company that tracks international fund flows, says that so far this year, inflows into the Middle East and North Africa have been competitive. The turnaround is due to economic reforms, a better banking climate and a growing credit sector.

In the past, Africa has attracted more retail than institutional investors as the latter have shied away from some of the continent’s small and illiquid stock markets. But now that the credit crunch has dented confidence in the world’s best-regarded exchanges, attitudes to frontier markets are beginning to change. Swiss banking group Julius Baer, which rolled out its Northern Africa Fund last September and recently launched it in the UK, has seen the fund grow from just $15m at the beginning of the year to $170m, with investment largely coming from the institutional side.

Up until September this year, Africa’s main economies had remained largely unaffected by the financial crisis. For example, Nigeria has been largely immune to the short-term volatility roiling more established emerging markets. But some cracks are beginning to show. Analysts warn that the turmoil on Wall Street could pose longer-term risks to prospects for a recovery in sub-Saharan Africa’s second biggest stock exchange if it fuels a global slowdown that saps prices for oil exports.
Nigeria enjoyed one of the strongest performances of any emerging market last year on the back of surging demand for banking stocks following a successful consolidation exercise. Flush with cash, banks such as United Bank for Africa, First Bank and Access Bank used the funds to expand across the continent. But growing global concerns over bank valuations helped trigger a steep correction in Lagos – where banks make up about two-thirds of the total market capitalisation of $85bn. As a consequence, the NSE All Share Index has lost 31.44 percent since March 5, according to Afri-Finance, the advisory firm.

Although foreign investors have played a role in influencing sentiment in Nigeria, last year they accounted for only about 12 percent of the value of transactions, limiting their potential to cause havoc with a hasty retreat. Nigerian banks are, however, concerned that the credit crunch will make it harder to secure credit lines in the US and Europe for trade finance. Another worry is how banks will manage their losses in the local market. Much of last year’s gains were driven by banks lending money for share purchases that have soured.

Asia is also showing signs of weakening. The South Korean won has fallen almost 30 percent this year to become the worst performing important currency and South Korea is expected to suffer its first annual current account deficit since the 1997-98 Asian financial crisis.

On November 1, the Reserve Bank of India (RBI) took emergency action to pump liquidity into the local banking system amid mounting concerns that the global financial crisis will cut significantly India’s economic growth.

The threat of a slowdown is also being felt by India’s richest 10 billionaires, who control some of the country’s biggest companies and have suffered $206.5bn in paper losses this year. With foreign investors helping drive down Mumbai’s main stock market index by 52 percent since January, the valuations of their listed companies have been battered.

The RBI cut the repo rate 50 basis points to 7.5 percent, lowering the key short-term interest rate for the second time in two weeks. It also reduced the cash reserve ratio, the amount of money banks have to hold with the central bank, 100 basis points to 5.5 percent, releasing about $8.1bn into the banking system. The measures to protect Asia’s third largest economy followed rate cuts by the central banks of Japan and China a week earlier.

Tycoon spirit
While the stock market tumble has affected tycoons across most sectors of the economy, the biggest loser has been Mukesh Ambani, India’s richest man, whose companies Reliance Industries and Reliance Petroleum lost $53.1bn in value, exacerbated by the drop in commodity prices. His brother Anil Ambani, India’s second richest person, has seen $52bn wiped off the valuations of his telecom, power, financial services and infrastructure groups.

The $200bn in paper losses by India’s super-rich – which is close to the GDP of neighbouring Bangladesh – is a clear indicator of how badly the exodus of foreign investors has hit the equity markets. Foreign institutions have made net sales of $8bn worth of stocks since the beginning of the year compared to the net purchase of $15bn the previous year, said the Securities and Exchange Board of India, the market regulator. Furthermore, the Morgan Stanley Capital International (MSCI) Emerging Markets index, designed to measure equity market performance in global emerging markets, has fallen by well over 50 percent since the start of the year, compared with about 35 percent for the Dow Jones Industrial Average.

Nevertheless, emerging market sovereign bonds might just turn out to be the safest place for investors’ money. Ashmore Investment Management, which manages $32bn of emerging market securities, says that there are two main reasons for this. The first is the weakness of US finances, and the second is the strength of emerging market balance sheets.

“People are saying this downturn is terrible for emerging markets,” says Jerome Booth, Head of Research at Ashmore. “But they are forgetting that emerging economies are the only ones with surpluses.”

Emerging market economies have accumulated reserves and other savings pools of $9,000bn, compared with less than $100bn in the US and the UK combined, and are in far better shape to weather a severe downturn.

In addition, whereas some western economies are expected to grow at one percent or less next year, Chinese growth will “moderate” to nine percent and India’s economy will slow to a respectable six percent growth rate, investors point out.

Emerging markets already command 30 percent of the world’s gross domestic product and this will rise to 50 percent in 15 years, Ashmore believes.

In other words, capital is likely to flow to these countries in future years, strengthening their currencies and making their bonds even more attractive. As a result, institutional investors still have a keen appetite for emerging markets in spite of volatility and heavy falls across stock exchanges this year. Already, three-quarters of northern European investors are planning to raise exposure to emerging markets equities over the next three years, according to a survey by Nomura Asset Management UK.

“Many institutional investors are looking at emerging markets as a long-term strategic investment,” said David da Silva, who runs Nomura’s regional emerging market strategy. “These countries in general continue to grow faster than their developed counterparts, and although they are facing difficulties in the current climate, high savings rates and strong fiscal positions remain a feature of many emerging markets,” he added.

Out of the 20 institutions surveyed, a quarter will raise their emerging market exposure between four percent to 10 percent, while the rest have more modest plans of increasing exposure by up to four percent.

Where the money is
Emerging markets are now the largest economic bloc and provide a stimulus to the global economy. Prior to recent events, emerging market economies were expected to deliver more than 60 percent of all global growth in 2008, with the funding of this growth not dependent on foreign sources of capital.

While the figures may have changed, the fact remains that emerging markets are funding the developed world.

Although no one denies the importance of the US in the global trade context, the trend has clearly been in favour of emerging markets. Emerging countries are trading more with each other and less with the US as demand in emerging economies booms. Intra-emerging markets exports have risen significantly since 2000, while exports to the US have decreased.

Fewer big emerging market countries are heavily dependent on overseas investors than in previous episodes and their public finances, in particular, are in much better shape. A decade after the Asian and Russian financial crises, emerging Asian countries have maintained current account surpluses – last year averaging five percent of gross domestic product – and built up hefty official foreign exchange reserves.

Michel Camdessus, the former managing director of the IMF, perhaps sums up the mood of many investors who still look to emerging markets – and their infrastructure projects – as a safe haven. In a speech in Manila in October, Mr Camdessus forecast that “thanks to the dynamism of Asia, the global economy will avoid recession”.

On the boards

This is, by general consensus, about the worst time to be a broker since 1929 – and possibly since 1914 and the start of the First World War. Both retail brokerage and prime brokerage firms have been kicked around by the crisis of the past few months, and both will emerge changed, even ignoring the way some firms have simply disappeared off the map. There is going to be a much more risk-averse culture from clients and among the owners of brokers, there is going to be greater pressure on analysts (who might find their remuneration changes to “payment for accurate prediction”), and there is almost certainly going to be regulation to ensure firms have to measure risk better, and show that they are measuring risk better.

After all, if even Alan Greenspan, Chairman of the Federal Reserve Bank for 18 years until 2006, confesses himself “in a state of shocked disbelief” over the global financial crisis, then one can be safe in drawing the conclusion that the system did not work the way it was meant to. Mr Greenspan said as much himself, on October 23, when he told a congressional committee in Washington that he regretted opposing regulatory curbs on the types of financial derivatives that led to banks in the US, the City of London and elsewhere with billions upon billions of dollars of liabilities. “I made a mistake in presuming that the self-interests of organisations, specifically banks and others were such that they were best capable of protecting their own shareholders and their equity in the firms,” Mr Greenspan told Congressmen on the House oversight committee.

The problem, as Mr Greenspan now seems to be realising, is that you can only assess risk, and protect your company and your shareholders against too much risk, if you understand the game that is being played. Those at the top of banks knew too little about what their subordinates were doing in bundling up all sorts of derivatives and trading them on.

They believed what they were told about the risk, or lack of it, in these new sorts of financial instruments. They did not understand how what was being bought and sold in their companies’ names really worked, and so they were unable to make a judgment on their real safety. Nor did they have in place systems to properly evaluate and report on the risks these instruments really posed. Instead, they saw the large profits being made, and ignored any qualms they may have felt, until suddenly too much of what was being passed as prime assets turned out to have the solidity of dry sand. Trust collapsed, as banks realised they could not believe their fellows’ balance sheets and could not be certain to get any loans back, and credit – which relies on trust – dried up.

If and when the dust settles
With so powerful a free-market flagwaver as Mr Greenspan giving the nod towards greater regulation in a post-credit crunch world, there seems little doubt that financial institutions are going to be working in a very different regulatory environment once the dust finally settles after the collapse of such former banking giants as Lehman Brothers, with debts of more than $613bn.

On the other hand, as Mr Greenspan also told the congressional committee, in words rather less widely reported than his comment about “shocked disbelief”, self-interest, properly applied, is still more powerful than regulation: “Whatever regulatory changes are made,” he said, “they will pale in comparison to the change already evident in today’s markets. Those markets, for an indefinite future, will be far more restrained than would any currently contemplated new regulatory regime.” Clients are going to remain risk-averse for a long time, and the leaders of financial institutions are going to be ensuring their own organisations are pursuing risk-averse policies for a long time: even without legislative compulsion to do so, out of protective self-interest banks and other financial institutions are going to set up internal systems to review risk much more thoroughly than they have been doing.

That is unlikely to be enough for politicians. Already some are fearing a knee-jerk rush by governments and legislators to, effectively, punish the global financial services industry with new regulations as a payback for the pain the perceived excesses of the banks and financial institutions are causing the world economy right now. One US politician, the Republican Congressman Chris Shays, spoke for many when he told the House Financial Services Committee on regulatory reform at the end of October: “No one has the right to juggle knives on a public bus.” Attacking the highly leveraged share dealing practised by hedge funds and backed by prime brokers such as Lehman Brothers, Mr Shays said that “high-risk ventures that threaten systemic integrity need to be fully capitalised by their private sponsors or prohibited altogether.”

Despite bankers’ natural aversion to regulation, there is unlikely to be too much fuss made about new regulatory oversight of risk and risk management. The financial world is so interlinked that, just like in the child’s game Ker Plunk, pulling out one vital stick can suddenly make the whole thing collapse. Banks are likely to say: “We know we’re all right, but we want new regulations to prevent our rivals from putting themselves, and us, in danger.” Tim Ryan, Chief Executive of the US Securities Industry and Financial Markets Association, one of a number of trade groups representing brokers, banks and insurers. Who gave evidence to the House Financial Services Committee on regulatory reform, called for “a financial-market-stability regulator that has access to information about financial institutions of all kinds that may be systemically important, including banks, broker-dealers, insurance companies, hedge funds, private-equity funds and others.”

Suspicious minds
Advocates of the idea of a new “systemic regulator” disagree whether or not there should be a “market stability regulator” separate from a body focused on business conduct; and indeed whether there ought to be two separate stability regulators, one for banks, broker-dealers, hedge funds and other securities industry participants, and another for “systemically important institutions”, which would include larger hedge funds and other financial entities that “could not be allowed to fail”. How you define “too important to be allowed to fail”, though, will always be a political rather than a financial choice: it looks as if Lehman’s was allowed to fail because it happened to be the first (or at least the first far enough after Bear Stearns): other banks were shored up, not because they were more important than Lehman’s but because their collapse right after Lehman’s would have brought a general run on the entire financial system.

Speaking to the same congressional committee as Mr Greenspan, Christopher Cox, Chairman of the US Securities and Exchange Commission, declared: “We have learned that voluntary regulation does not work.” Regulation on broker-dealers and their investment bank holding companies “must be mandatory, and it must be backed by statutory authority,” he said. The holding company in the case of Lehman Brothers, for example, Mr Cox said, consisted of more than 200 subsidiaries, including over-the-counter derivatives businesses, trust companies, mortgage companies, offshore banks, broker-dealers, and reinsurance companies. The SEC was not the statutory regulator for 193 of them. The current regulatory system is “a hodge-podge of divided responsibility and regulatory seams” where coordination among regulators is difficult, and a new scheme is necessary, he said. Mr Cox wants to abolish “outdated” laws that treat broker-dealers “dramatically differently” from investment advisers.

Paradoxically, part of the blame for the current crisis is being put on a complicated piece of regulation introduced by the Federal Accounting Standards Board in the US and enforced by the SEC, supposedly in the name of transparency, covering “marking to market”, which regulates, among other things, how banks value every day the assets they hold and how brokers value assets and make margin calls on accounts. Critics, such as William Isaac, former chairman of the Federal Deposit Insurance Corporation in the US, which guarantees bank deposits, claimed that the Securities and Exchange Commission’s “senseless” insistence on firms “marking to market” assets for which there was no proper market to assess value by that has destroyed $5trn of bank lending. Mr Issac said: “That’s a major issue in the credit crunch right now. The banks just don’t have the capital to start lending, because of these horrendous markdowns that the SEC’s approach required.” The problems with regulating the proper valuation of assets whose real value can’t be known until they are sold at some time in the future by marking to an effectively imaginary market, whether or not those regulations added to the credit crisis, certainly show that framing regulations without running into the Law of Unintended Consequences is not easy.


There is certainly going to be a new take on risk from all sides of the financial world. Hedge funds, who might have been expected to know more about risk than anybody – after all, it is meant to be how they make their money, evaluating risk more accurately than the market as a whole – found themselves badly hammered when a risk they never expected, the bankruptcy of Lehman Brothers, the biggest in the world reared. Many hedge funds used Lehman’s as their prime broker, and found their assets stranded when the bank went down – assets of up to $1.5bn for a single fund, in some cases. At least one hedge fund is said to be closing, because of Lehman brothers’ bankruptcy. Since the rule now has to be “if it can happen to Lehman’s, it can happen to anybody”, clients who use banks for prime brokerage operations in future are going to be putting pressure on those banks for greater transparency, and better safeguarding of their funds.

The prime brokerage market was previously dominated by three big American players, Goldman Sachs, Morgan Stanley and Bear Stearns (sold to JP Morgan Chase in March this year for $10 a share, down from $93 a share only a month earlier, after investors’ confidence evaporated in the face of the sub-prime mortgages crisis). Going forward, the industry looks likely to be divided up more evenly between six key players, with hedge funds spreading their own assets around these six firms rather than having a single main prime broker.

Retail brokers have been surprisingly busy so far this year, with volumes high even as prices plunged. Many brokers derive a high proportion of their revenue from trading fees, so that prices are of less concern than they might at first appear. But with the storm that has taken place in September and October likely to lead to a reduction in retail trading, brokers could see fee income fall, at the same time as lower interest rates hit the amount they can charge for leveraging loans.

If clients prefer to sit on their assets, or seek safety outside stock markets, then the retail brokerage industry round the world is going to see a wave of closures and mergers. There are certainly not going to be too many company flotations to keep brokers busy over the next few months.

Not everybody agrees that more regulation is the way forward. The FSA in the UK stepped in quickly to ban short-selling during the crisis, but Hector Sants, head of the organisation told the Hedge 2008 conference in London at the end of October that increased regulation is not needed. “There is pressure for more regulation in a rather general way,” he said. “I don’t particularly think more regulation is needed, but I do think more effective regulation is needed.” What exactly the difference between “more” and “more effective” was, Mr Sants did not say. But he stressed the need for tighter control and increased vigilance by risk managers in the affairs of  banks and broker-dealers, However, with the Bank of England announcing that it will be asking for more powers from the government to intervene directly in markets, it looks as if, in the UK at least, there is going to be a clash between the still laissez-faire FSA and the interventionists in Threadneedle Street.

Defending the indefensible

For a brief moment in October it seemed as if the world’s financial systems were about to implode. What was once unthinkable, and if we are to believe many financial models, unimaginable, was actually happening. Rock solid corporations were crumbling, governments that had long espoused free market capitalism were rushing to bail out banks, in many cases through part or complete nationalisation.

As is always the case, along with the woe, there was plenty of finger wagging. A once in a lifetime financial crisis is bound to be accompanied by some serious recrimination. And so it has proved.

In the frame are a number of people and practises associated with the crisis. But perhaps three are mentioned more than most as the principle offenders: banking bonuses; light touch regulation; and financial innovation. All three have been identified as culprits at the heart of the current debacle. But how culpable are they?

Executive compensation and the bonus system
The accusation: The compensation system for many employees in the financial services industry is rigged in a way that encourages and rewards excessive risk taking.
When those risks pay off, profits are privatised in the form of huge salaries and bonuses for senior executives, traders and other employees. Yet when the risks prove a bridge too far, resulting in staggering losses, and, in some cases, destroying companies and billions of dollars in value, the losses are socialised. Banks are recapitalised. Ordinary shareholders and taxpayers lose out.

Plus golden parachute deals, and other aspects of executive compensation, mean that senior executives can still receive significant payoffs when they step down (or are removed), despite presiding over, and presumably approving, the risky, often highly leveraged activities that underpin the slump in the value of many financial stocks.

In defence: If you don’t pay the market rate, the best talent will go elsewhere, whether it is another firm, or another industry. Moreover, financial service firms operate in a global market. So the level of compensation must match the best available globally.

And only a small number of people have the experience and skills required to operate as senior executives, or in various specialist jobs, at firms like commercial or investment banks. Therefore these people can justify what might appear extravagant compensation deals, including golden handcuffs and parachutes. Also, employees need incentives to perform well; the greater the incentive, the better the performance. The prospect of significant profit related bonuses as a major percentage of a compensation plan, drives performance.

The verdict: It is true that in competitive markets, firms must pay attractive rates to attract talent. This needs addressing. If people are rewarded according to performance, then some will be tempted to focus on hitting short-term targets to trigger maximum rewards rather than concentrating on the long-term consequences of the business they are doing.

One suggestion is to introduce some kind of time and performance linked provision with bonuses, such as placing them in escrow, thus allowing claw back in the case of poor performance. As for the global market for talent argument, that is not persuasive. The compensation differential may need to be fairly significant to get people to uproot their lives and relocate to another country. And it should not be assumed that experience gained in one country or market will translate to another.

Light touch regulation
The accusation: That the financial services industry failed to appreciate lessons learnt following US stock market crashes in 1907 and 1929. After the 1907 crash, betting on whether shares went up or down without actually owning those stocks was outlawed. After the 1929 Wall Street Crash, the Glass-Steagall Act passed in 1933 separated the operations of commercial and investment banking.

By the 1970s, however, despite decades of relative financial systemic stability, senior executives grew restless for better growth and shareholder returns. The Glass-Steagall Act was finally repealed in 1999. The Commodity Futures Modernisation Act of 2000 removed derivatives from federal oversight, and rendered the bucket shop laws obsolete.

It is no coincidence that, as the regulations were relaxed, systemic financial crises mounted up.

In defence: External regulation stifles financial innovation, and the ability of firms to provide the best service for their customers, and the maximum value for shareholders. Compliance with external regulation is often very costly, having an adverse competitive impact on business within a particular jurisdiction, with respect to businesses outside that jurisdiction. While oversight is required, it is best provided by the people who have the most appropriate industry specific experience – in this case the financial services sector itself. This is a free market after all, and supply and demand should be left to fend for themselves.

The verdict: The concept of self regulation has been hugely discredited in the wake of the current crisis. Surely if light touch regulation is effective the global financial system wouldn’t be in this mess. However, with the financial services sector playing a significant role in economic growth, particularly in the US and UK, governments are reluctant to interfere when things appear to be going well. And financial institutions are a powerful lobbying force.

Inadequate regulation has played a fundamental role in the credit crisis. But, despite the obvious regulatory shortcomings, and the expected tightening of the regulatory environment through legislation in the short term, history suggests that after an initial rush to regulate, lobbying by powerful corporations, and the lure of significant returns, will once again lead to deregulation over the longer term.

Financial innovation
The accusation: Warren Buffett is right – derivatives are financial weapons of mass destruction. Brilliant engineers at investment banks used their talents to create exotic financial instruments, which in turn were used, among other things, to move loan default risk away from lenders to other investors, and in ways that make it very difficult to understand the level of risk involved in the underlying investment.

Collateral debt obligations (CDOs), as sub-prime mortgages, bundled together, sliced up, repackaged, credit rated and sold on, were used to create a vehicle for speculation on the repayment of mortgages. Then credit default swaps, a $54trn market, invented ostensibly to be able to hedge the risk of default on the CDOs, were used to bet on the future solvency of companies.

In defence: Financial innovation is essential for economic growth. After all, many aspects of finance that we take for granted, such as credit cards, or mortgages, are the product of financial innovation. Nor is there anything intrinsically wrong with derivatives. They are an important and useful device for reducing risk through hedging strategies.

The verdict: One unfortunate outcome from the existing crisis is that financial innovation has a bad reputation. Yet it must be encouraged, not legislated. Alongside that innovation must be transparency. Derivatives are a $500trn market. Credit default swaps a $50trn market. These products need to be regulated and traded in transparent markets. Financial innovation is a good thing, providing it is used responsibly.

Regulators could ensure that originators of loans, and those parties that sell them on, are required to leave some risk on their own books, rather than offloading to a third party, thus leaving the originators of the loans, and those that securitise them, with no incentive to do due diligence.

Accounting rules only fair

Accounting rules are boring, technical and understood by only a very few people. That makes them the perfect target for bankers and politicians scrambling around for a credit crunch scapegoat. It wasn’t our greed, stupidity or complacency that caused the crisis, they can argue, it was those idiotic accounting rules. Or rather, it was one particular accounting principle that pushed share markets and the financial sector to the brink of meltdown: the idea that financial assets should be reported at the “fair value” they could achieve in a market, rather than the price the company paid for them. This, of course, is rubbish, but the clamour for reform of fair value accounting has grown nonetheless.

The Institute of International Finance, a group of 375 financial services companies, was one of the first bodies to call for a fair value rethink, in a report it published in April. At the time, Lehman Brothers was still a respected name on Wall Street and you could argue that the worst of the crunch was over without someone laughing in your face. The situation has grown rather worse since then. The IIF’s report on the crunch pointed the finger at risk-management standards, disclosure practices and compensation policies – and also at fair value accounting.

In a statement that it released in May, the organisation said fair value accounting had been very useful in promoting transparency and market discipline and was still generally reliable in liquid markets. But there should be an open debate about the methods used to calculate fair values that are “useful, relevant, accurate and transparent.” In other words, when markets are highly volatile – or when the market for a particular security has dried up entirely – fair value does not work.

One could counter that the difficulty of arriving at a fair value for some of these assets reflects the simple fact that they no longer have any value: the bubble has been burst; the ruse rumbled. But the banking industry insists that as the markets recover these assets will have a “fair value”, but forcing financial firms to recognise a massive loss now will further destabilise the industry and make any recovery less likely.

Distinct lack of confidence

The Bank of England showed that it had some sympathy for this view when, in April, it published its Financial Stability Report. Loss estimates based on market prices were likely to overstate significantly banks’ losses as they will reflect factors such as illiquidity and uncertainty, which are unrelated to credit fundamentals and should ease over time, it said. Likewise, the Financial Stability Forum – a grouping of central bankers and regulators – has published a report stating that financial institutions and auditors were working together to improve valuation approaches and related disclosures in end-year financial accounts, “But further work is needed to provide confidence that valuation methodologies and related loss estimates are adequate, to clearly highlight the uncertainties associated with valuations, and to allow for more meaningful comparisons across firms.”

Some of the improvements it wanted to see were alternative valuation methodologies for illiquid market conditions, more consistency on this point between US accounting rules and the International Financial Reporting Standards used in most of the rest of the world, and more flexibility in allowing firms to shift certain assets from the “trading” category in their accounts to the “held to maturity” category, which would in effect protect these assets from fair value fluctuations.

The IIF was careful not to threaten the principle of fair value accounting. Its managing director, Charles Dallara, said it “remains an essential element of global capital markets as it fosters transparency, discipline and accountability.” He also accepted that accounting standards already give financial firms the flexibility to “mark-to-model” – which means basing a value on a theoretical calculation, rather than a market price – where there was no useable market data. “Appropriate use of such latitude is fully consistent with fair value accounting and has been embraced by accounting standard-setters,” said Mr Dallara.

The problem is that it is difficult for banks to use this latitude, especially when it comes to shifting assets beyond the scope of fair value. For one, their regulators have, in the past, not allowed it. Furthermore, it sends a worrying signal to investors: “what is the bank trying to hide by shunting assets around?” they might rightly ask. Dallara accepts that this is a problem. “There is the risk that, however well-framed the proposals, the intentions of those advocating changes could be misunderstood by investors at this stage,” he said.

That was the position in May; by October, with banks facing the prospect of punishing third-quarter fair value write-offs, the pressure to ease the accounting rules had become intense. Eventually, the banks got the changes they were asking for.

First, the US Financial Accounting Standards Board issued guidance to banks that wanted to use a fair-value opt out on the basis that there was no active market for their assets. This was reported as an easing of the rules, but those in the standard-setting community insisted that the board was simply explaining how to apply an existing rule.

Then the International Accounting Standards Board (IASB) responded to pressure and eased its rules. This was a far more significant move. At a meeting on October 13 the board rushed through amendments to IAS 39 Financial Instruments: Recognition and Measurement and IFRS 7 Financial Instruments: Disclosures. The changes gave banks what they were asking for – the ability to reclassify some of their financial assets, which in practice meant they can avoid carrying them in their books at fair value. The board had earlier voted to suspend its due process rules so that it could implement the change with immediate effect.

By this time the IASB was under intense pressure from European Union politicians, who had complained that international accounting rules were putting the trading bloc’s banks at a disadvantage to their US rivals. Banks reporting under IFRS were unable to reclassify assets in a way permitted under US GAAP, they argued.

The weekend before the IASB agreed the rule change, the European Commission said it would step in and rewrite the relevant reporting standards if the board failed to act.

The new rules allow banks to reclassify assets – apart from derivatives – which they no longer plan to sell or repurchase in the near term. They can then be reported in the financial statements at the fair value they held on July 1, before the latest crisis hit, with tests for impairment.

IASB chairman Sir David Tweedie described the reclassification rule change as a “short-term fix” and a “necessary evil”. The board was happy with its existing standard, he said, “but we did understand people saying ‘look, we are getting slaughtered compared to the American banks’.”

The board had not caved in to political pressure, insisted Tweedie, and its independence is intact. “What we’ve done is show that we are aware, in a crisis situation, that it is important that banks worldwide have exactly the same playing field and we’ve done our best to create that,” he said. “The board recognised that it had almost a duty to help other countries that felt they were at a big disadvantage.”

The politicians and bankers might be happy to see the rules eased, but investors should be “very concerned”, according to a research note issued by JP Morgan Securities analysts Sarah Deans and Dane Mott.

The board had decided to put political concerns ahead of accounting principles, they said, which established an “unfortunate precedent”. Moreover, the step would reduce the consistency and comparability of financial statements because not all banks would reclassify assets to the same extent.

A further concern raised in the JP Morgan note is whether the board’s revised standard is open to abuse. While banks can now reclassify certain assets, they can only do so in “rare” circumstances (although that restriction does not apply to loans). Tweedie says it is for a bank and its auditor to decide whether the business faces rare circumstances, but he made clear that the current financial turmoil clearly fitted the bill. The question is: what happens when – or if – the markets calm down?

Proposing new instruments
The IASB’s rule-change brings IFRS into line with US GAAP, which already allowed banks to reclassify certain assets in rare circumstances. However, until the recent crisis, the SEC had never allowed a bank to actually use this get-out. The SEC is allowing reclassifications now, but the assumption is that it would revert to its normal practice once markets stabilise. Banks outside the US would also need their national regulator to approve a reclassification and there is concern that not all of them would be as tough as the SEC about what “rare” means. The upshot is that some banks could carry on shoving assets beyond the reach of fair value measurement after others have been told to stop.

Tweedie said that the reclassification rule change comes with a heap of disclosure requirements so that investors can see exactly what banks are doing. “If you transfer assets you have to show the fair value of the amount you are transferring and the affect that there would have been in the profit and loss account had you not transferred,” he said: Any investor will be able to look at the financial statements and work out what the key figures would have been without the rule change.

Tweedie insisted that allowing banks to avoid fair value treatments in some areas did not mean its commitment to the principle was fading. “We put a discussion paper out in March where we talked about the complexity of accounting for financial instruments and in that we made it quite clear that we think the ultimate answer for all financial instruments is fair value,” he said. “That will probably take some time to get to, but in the medium and long term that is the answer.”

Pauline Wallace, a senior partner in the global IFRS team at PricewaterhouseCoopers and an expert in financial instruments accounting, described the rule change as “an incredible boost that will help banks a lot.” Critics of fair value accounting were wrong to blame it for the current turmoil she said: “This is not a problem around fair value. This is a problem of the markets deteriorating. All fair value does is report what the markets are doing. If what you are looking for is transparency, you need to know fair value.”

Wallace praised the IASB for acting quickly. “The board has not caved in, but it has recognised that for some banks this is an option that they might want to look at,” she said. There were drawbacks for banks considering a reclassification. If markets recover, they will not be able to recognise gains. “The other disadvantage is that there is masses of disclosure,” she said. “If you do this you are going to have to write loads about it. It is not an easy ride.” Nevertheless, there is concern that, having conceded this point, the IASB might be bullied into further concessions. The Corporate Reporting Users Forum, a pan European grouping of investment analysts, says that further changes would “risk severely undermining the confidence users have in the accounts produced by European companies.” Now especially, investors need comparability and transparency, not further uncertainty and inconsistency, it argued.

“The accounts should portray the situation facing companies as it is in reality, and the fair value approach is important to this,” says Peter Montagnon, director of investment affairs at shareholder group the Association of British Insurers. “We recognise that the application of fair value in very volatile conditions has exposed problems. These need to be addressed in a considered way, but now is not the moment for turning our backs on an important principle. If we are to have faith in accounting standards, fair value should be applied when the going is hard, as well as when it is fair.”

Abandoning the principle now would give banks some short-term comfort and strengthen their claim that fair value accounting was partly responsible for the crunch. But markets – especially when they are spooked – demand transparency. The banks need to be honest about what caused the crunch, and honest about how badly it has hurt them financially. Fair value must stay.

Sins of the few

A central banker to his finger tips, Jean-Pierre Roth said it through clenched teeth: “We are not giving UBS a present”. Here was the head of the Swiss National Bank, the bailiff of bank bail-outs, not to mention the current chairman of the BIS, doing exactly what he said he wasn’t. Namely, giving Switzerland’s most unpopular bank a gift-wrapped package.

The taxpayer will pick up 90 percent of UBS’s toxic debt through the ministry’s $53bn rescue package. Hard-headed observers like Rudolf Strahm, Switzerland’s retired price regulator, point out that even a 300 percent increase in value won’t lift much of the burden off the government/taxpayer.
It is hard to see where UBS is taking the hit, except that it is very much in the hands of the Swiss authorities who will show little mercy.

You cannot blame Mr Roth for putting a brave face on a bail-out that must have pained him deeply, especially as he lambasted US banks way back in August 2007 for their disgraceful lending practices.

Now that the capital-boosting regulations demanded by Basel II have been deemed to be fatally flawed, mainly because they left the job of internal risk assessment to the banks and various incompetent third parties, the whole issue is up for grabs and the hard-liners are in the ascendant.

The Swiss have often punched above their weight in the great regulatory debates and the view of Mr Roth will be important, particularly as head of the BIS but also because of his remarkable prescience throughout this crisis.

Way back in 2007, he predicted “massive losses” across the financial sector. And even before then, as early as December 2006 when most regulators were still hibernating from reality, he warned that we were not facing “lasting prosperity”.

As he told reporters recently: “From a central bank point of view, more [capital] is better than less.”

You can see why, when UBS’s final provision against bad debts comes out at around fifty times higher than its original estimate.

He’s also winning support from the private sector. For one, new Fortis Chief Executive Herman Verwilst muses: “Under Basel II one thought [that] if we measure risks adequately, then we as banks can operate with less capital. That image has changed completely. Perhaps one should hold even more capital.”

There’s an element of retribution in much bank-talk. As Richard Meier, former head of the Swiss stock exchange, warned recently: “Many of the discussions in US, Germany and other countries sound more like taking revenge on these banks rather than helping them.”

However, we now face the danger of the blunt instrument, a response to the crisis that could end up by bludgeoning banks so hard they have difficulty in producing legitimate profits off sensible multiples of leverage.

While sky-high provisioning might indeed have warded off at least the worst of this crisis (for now), there may be simpler, cheaper and in the long-run safer methods of fire-proofing the banks.

George Soros makes the point that profitable banks are generally the safest.

Specifically, he suggests that Hank Paulson’s recapitalisation scheme should be temporarily accompanied by lower minimum capital requirements “so that banks compete for new business. This would also make sense, argues the great fund manager, in the event of the continuing decline in house prices, which of course also affect banks’ capital integrity.

Then with the panic over, normality should strike. “Once the economy returns to normal, minimum capital requirements of banks would be raised again”. This is not the time to punish all the banking sector for the sins of a few.

Indubitably, bank capital-asset ratios have been at historically low levels. According to the BIS, they stand at an average of about seven percent of total assets on a non-risk-weighted basis. And many banks have implicitly recognised this by mega programmes of recapitalisation.

However this has taken the form of panic responses to the frozen interbank markets which, in turn, were triggered by lousy risk assessment programmes.
Here we may have the solution. As more detached observers suggest, why not just improve the method of risk assessment? Ultimately an exercise in best practice, it would be undertaken by gilt-edged third parties rather than left to the banks.

The next thing to address would be the speed of response through, say, the “prompt correction action” procedures that worked so well in the nineties in the US. As Professor Harold Benink points out, a PCA system would have got bank supervisors running at the double into institutions whose capital levels were triggering flashing red lights.

Thus the best banks are not punished by the sins of the few. As Mr Roth knows better than anybody, Switzerland’s regional banks in the communes and cantons acted far more responsibly than UBS.

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EU and IMF offer Greek government support in unified market politics

The $140bn support package that the Greek government has finally received from its EU partners and the IMF gives it the breathing space needed to undertake the difficult job of putting its finances in order. The package may or may not prevent Spain and Portugal from becoming undone in a similar fashion, or indeed even head off an eventual Greek default. Whatever the outcome, it is clear that the Greek debacle has given the EU a black eye.

Deep down, the crisis is yet another manifestation of what I call “the political trilemma of the world economy”: economic globalisation, political democracy, and the nation state are mutually irreconcilable. We can have at most two at one time. Democracy is compatible with national sovereignty only if we restrict globalisation. If we push for globalisation while retaining the nation state, we must jettison democracy. And if we want democracy along with globalisation, we must shove the nation state aside and strive for greater international governance.

The history of the world economy shows the trilemma at work. The first era of globalisation, which lasted until 1914, was a success as long as economic and monetary policies remained insulated from domestic political pressures. These policies could then be entirely subjugated to the demands of the gold standard and free capital mobility. But once the political franchise was enlarged, the working class got organised, and mass politics became the norm, domestic economic objectives began to compete with (and overwhelm) external rules and constraints.

The classic case is Britain’s short-lived return to gold in the interwar period. The attempt to reconstitute the pre-World War I model of globalisation collapsed in 1931, when domestic politics forced the British government to choose domestic reflation over the gold standard.

The architects of the Bretton Woods regime kept this lesson in mind when they redesigned the world’s monetary system in 1944. They understood that democratic countries would need the space to conduct independent monetary and fiscal policies. So they contemplated only a “thin” globalisation, with capital flows restricted largely to long-term lending and borrowing. John Maynard Keynes, who wrote the rules along with Harry Dexter White, viewed capital controls not as a temporary expedient but as a permanent feature of the global economy.

The Bretton Woods regime collapsed in the 1970s as a result of the inability or unwillingness – it is not entirely clear which – of leading governments to manage the growing tide of capital flows.

The third path identified by the trilemma is to do away with national sovereignty altogether. In this case, economic integration can be married with democracy through political union among states. The loss in national sovereignty is then compensated by the “internationalisation” of democratic politics. Think of this as a global version of federalism.

The US, for example, created a unified national market once its federal government wrested sufficient political control from individual states. This was far from a smooth process, as the American Civil War amply demonstrates.

The EU’s difficulties stem from the fact that the global financial crisis caught Europe midway through a similar process. European leaders always understood that economic union needs to have a political leg to stand on. Even though some, such as the British, wished to give the union as little power as possible, the force of the argument was with those who pressed for political integration alongside economic integration. Still, the European political project fell far short of the economic one.

Greece benefited from a common currency, unified capital markets, and free trade with other EU member states. But it does not have automatic access to a European lender of last resort. Its citizens do not receive unemployment cheques from Brussels the way that, say, Californians do from Washington, DC, when California experiences a recession. Nor, given linguistic and cultural barriers, can unemployed Greeks move just as easily across the border to a more prosperous European state. And Greek banks and firms lose their creditworthiness alongside their government if markets perceive the latter to be insolvent.

The German and French governments, for their part, have had little say over Greece’s budget policies. They could not stop the Greek government from borrowing (indirectly) from the ECB as long as credit rating agencies deemed Greek debt creditworthy. If Greece chooses default, they cannot enforce their banks’ claims on Greek borrowers or seize Greek assets. Nor can they prevent Greece from leaving the eurozone.

What all this means is that the financial crisis has turned out to be a lot deeper and its resolution considerably messier than necessary. The French and German governments have grudgingly come up with a major loan package, but only after considerable delay and with the IMF standing at their side. The ECB has lowered the threshold of creditworthiness that Greek government securities must meet in order to allow continued Greek borrowing.

The success of the rescue is far from assured, in view of the magnitude of belt-tightening that it calls for and the hostility that it has aroused on the part of Greek workers. When push comes to shove, domestic politics trumps foreign creditors.

The crisis has revealed how demanding globalisation’s political prerequisites are. It shows how much European institutions must still evolve to underpin a healthy single market. The choice that the EU faces is the same in other parts of the world: either integrate politically, or ease up on economic unification.

Before the crisis, Europe looked like the most likely candidate to make a successful transition to the first equilibrium – greater political unification. Now its economic project lies in tatters while the leadership needed to rekindle political integration is nowhere to be seen.

The best that can be said is that Europe will no longer be able to delay making the choice that the Greek affair has laid bare. If you are an optimist, you might even conclude that Europe will therefore ultimately emerge stronger.

Dani Rodrik, Professor of Political Economy at Harvard University’s John F. Kennedy School of Government, is the first recipient of the Social Science Research Council’s Albert O. Hirschman Prize. His latest book is One Economics, Many Recipes: Globalisation, Institutions, and Economic Growth.

© Project Syndicate 1995–2010

Plugging the leaks

With pain and misgiving, the United States Congress bailed out Wall Street in order to prevent a meltdown of America’s financial system. But the $700 billion to be used may flow into a leaky bucket, and so may the billions provided by governments throughout the world.

The US financial institutions that went bankrupt in 2008 – or that would have gone bankrupt without government help – were in trouble because they lacked equity capital. They did not lack that capital because they never had it, but because they paid out too much of their abundant earnings in previous years to shareholders, leveraging their operations excessively with debt capital. If no measures are taken to increase the minimum equity requirements for banks and other financial institutions, financial crises like the current one could recur.

Anglo-Saxon financial institutions are known for their high dividend-payout ratios. From a European perspective, the hunger for dividends and the emphasis on short-term performance goals that characterize these institutions is both amazing and frightening. Investment banks, in particular, are known for their minimalist equity approach. While normal banks need an equity-asset ratio of at least 7%, investment banks typically operated on a ratio of only 4 percent.

The lack of equity resulted largely from the concept of “limited liability,” which provided an incentive for excessive leveraging. Earnings left inside a financial institution can easily be lost in turbulent times. Only earnings taken out in time can be secured.

Lack of equity capital, in turn, made risk-averse shareholders hire gamblers to manage their limited-liability investment companies. The managers chose overly risky operations, because they knew that the shareholders would not participate symmetrically in the risks.

While upside risks would be turned into dividends, downside risks would be limited to the stock of equity invested. Claims against the personal wealth of shareholders would be blocked by the limited liability constraint. The banks’ creditors or governments ultimately would bear any losses. The mutual interaction between the incentive to minimize equity capital and the incentive to gamble in order to exploit the upside risks caused America’s crisis.

In theory, bank lenders and the government could anticipate the additional risks they encounter when a company chooses a high-leverage strategy. Lenders may charge higher interest rates, and the government may charge higher taxes or fees.

But this theory fails to match reality. Governments do not tax the return on equity less than debt interest, and lenders do not sufficiently honor the benefits of high equity with lower interest rates, owing to a lack of information about the true repayment probability. This is why equity capital held by financial institutions typically is more than twice as expensive as debt capital and why these institutions try to minimize its use.

The provision of limited liability not only turned Wall Street into a casino, but so-called “Main Street” also was induced to gamble, because homeowners enjoyed a limited liability similar to that of the companies. When low-income borrowers took out a loan to buy their homes – often 100% of the purchase price – they typically could use the home as collateral without warranting the repayment with additional wealth or even their income. Thus, they were protected against the downside risk of falling house prices and profited by speculating on the upside risk of appreciation.

Such homeowners knew that with rising prices they would be able to realize a gain by either selling their homes or increasing their debt, while in the case of falling prices they could simply hand over the keys to their banks. Given the uncertainty about future house prices, they could reasonably expect gains, which induced them to pay even more in the first place. Gambling by Main Street caused the sub-prime crisis.

The crisis spread because the banking system was not sufficiently risk-averse – and in some cases even seemed to relish risk. Mortgage banks kept some claims on their books, but sold most of them to investment banks as “mortgage-backed securities.” The investment banks blended these securities into “asset-backed securities” and “collateralized debt obligations” (CDOs) and sold them on to financial institutions throughout the world. These institutions, attracted by the high rates of return that were promised, invariably neglected the downside risks.

The buyers of the CDOs were often misguided by rating agencies that performed badly and did not provide reliable information. As private rating agencies live on the fees they collect from rated companies, they cannot easily downgrade important clients or the assets they sell. The big American investment banks received excellent ratings up to the last moment, and so did the CDOs with which they betrayed the world.

All of this explains why the US had such a formidable period of growth in recent years, despite the fact that household savings were close to zero, and why foreigners were willing to finance a record US current-account deficit of more than 5 percent of GDP – higher than it has been since 1929. That period is now over.

The US must carry out fundamental reforms of its financial system to plug the equity leaks and recover investors’ confidence. But even then it will have a hard time continuing to sell financial assets to the rest of the world. American households will need to learn to accumulate wealth by cutting consumption rather than speculating on real estate. A painful decade of stagnation for America lies ahead.

Hans-Werner Sinn is Professor of Economics and Finance, University of Munich, and President of the Ifo Institute.

Copyright: Project Syndicate, 2008

Europe’s financial vulnerability

The most notable innovations of the past two decades have been financial. Like technological innovation, financial innovation is concerned with the perpetual search for greater efficiency – in this case, reducing the cost of transferring funds from savers to investors. Cost reductions that represent a net benefit to society should be regarded favorably. But as the current financial crisis demonstrates, where financial innovation is designed to circumvent regulation or taxation, we need to be more circumspect.

Sadly, the financial revolution has been mostly rent-seeking rather than welfare-enhancing in character. It has been based on eliminating, or at least reducing, two key elements of banking costs closely associated with prudential arrangements.

One is the need for banks and other financial institutions to hold liquid reserves. The less liquid a bank’s assets, the greater the need for such reserves. But the yield on such reserves is small, so economizing on them is profitable. Last year’s Northern Rock debacle in the United Kingdom will long remain an example of how not to manage such risk.

Moreover, increasing a bank’s leverage can be very profitable when returns on investments exceed the cost of funding. Reckless balance-sheet expansion in pursuit of profit is kept in check if financial companies adhere to statutory capital requirements, which mandate a capital-asset ratio of about 8%. But many have sought to ignore this restriction, to their cost: the Carlyle Capital Corporation, a subsidiary of the United States-based Carlyle Group, was leveraged up to 32 times – it held one dollar of capital for every 32 dollars of assets – before adverse market developments wiped out the company.

Avoidance of prudential requirements is at the core of today’s financial crisis, exacerbated by the collapse of confidence in a system based on trust. This has exposed the fragility of the banking system, including quasi-banking institutions, as revealed by Bears Sterns, Lehman Brothers, and other US investment banks, and in Europe by Northern Rock, UBS, WestLB, and many more.

Perhaps the most tragic aspect of this story is the exploitation of low-income families involved in the so-called sub-prime mortgage crisis, whereby variable-rate mortgages were offered to customers with a low credit rating. In fact, “variable rate” is a misnomer, since these mortgages’ artificially low initial interest rates were pre-programmed to include a big rate hike after a couple of years. Thereafter, rates would rise with market rates, but never fall when market rates declined. This structure could only have been devised to suck in as many customers as possible with scant regard for long-term consequences.

With the property market booming, prospective capital gains promised untold wealth. And most mortgage holders probably expected to refinance their mortgages before their rising interest-rate trebled or quadrupled monthly repayments. Another hoped-for benefit was that capital gains could be converted into home equity loans, boosting homeowners’ living standards.

The rude awakening came when property values began to decline. For those without an equity cushion, refinancing was not a possibility, and rising interest rates have led to default, foreclosure, and homelessness.

Now we hear that sub-prime mortgage holders have only themselves to blame. No one talks of the bank manager, under pressure to sell “financial products” and eager to sign up customers, even if the products were not in a customer’s best interest. The banker did not question a bonus system that favors one year of super profits, followed by bankruptcy, over two years of moderate, but stable, results.

It is astonishing that sub-prime mortgages and their like were repackaged and resold in securitized form. That these collateralized mortgage obligations (CMOs, or bonds backed by a pool of mortgages) found a ready market, both in the US and abroad, reflects failure on several fronts.

The nature of these CMOs should have been apparent to risk managers. Any financially literate fund manager knows that risk and return are positively correlated. Any fund manager who claims to have been deluded by the apparently favorable risk-yield characteristics of CMOs or related credit instruments can be accused of having fallen for Milton Friedman’s “free lunch.” Risk models do not justify abandoning one’s natural sense of incredulity.

In a world where capital is free to flow across international boundaries, the crisis in the US has spread to Europe. This is a new form of contagion, which transcends national boundaries and is amplified by an international crisis of confidence. This is why the global problem today is many times greater than the Savings & Loan crisis of the 1980’s and 1990’s, which cost American taxpayers an estimated $150 billion to clean up.

Today, the global integration of financial markets means that problems can pop up anywhere, at any time. Central banks are currently attempting to plug one leak as the next appears. But if the financial system’s dykes collapse, we may be headed for a decade of severe deflation, rendering expansionary stimulus useless.

When the US Federal Reserve was created in 1913, its most important function was to serve as a lender of last resort to troubled banks, providing emergency liquidity via the discount facility. The current crisis suggests that this is no longer enough. Central banks worldwide are being forced to act as market makers of last resort in securities markets. The signs are already visible.

The European Central Bank has also failed to tackle local bubbles in Europe. The justification was that the ECB is concerned with inflation, not relative price adjustments. This means that monetary policy is geared towards the needs of large countries, like Germany, not to those of, say, Belgium. But, given the scale of the threat to Europe’s economy from a full-blown financial crisis, this apologia for inactivity has outlived its usefulness.

Copyright: Project Syndicate/Europe’s World, 2008.

Who killed Wall Street?

You don’t have to break a sweat to be a finance skeptic these days. So let’s remind ourselves how compelling the logic of the financial innovation that led us to our current predicament seemed not too long ago.

Who wouldn’t want credit markets to serve the cause of home ownership? So we start by introducing some real competition into the mortgage lending business. We allow non-banks to make home loans and let them offer creative, more affordable mortgages to prospective homeowners not well served by conventional lenders.

Then we enable these loans to be pooled and packaged into securities that can be sold to investors, reducing risk in the process. We divvy up the stream of payments on these home loans further into tranches of varying risk, compensating holders of the riskier kind with higher interest rates. We then call on credit rating agencies to certify that the less risky of these mortgage-backed securities are safe enough for pension funds and insurance companies to invest in. In case anyone is still nervous, we create derivatives that allow investors to purchase insurance against default by issuers of those securities.       

If you wanted to showcase the benefits of financial innovation, you could not have come up with better arrangements. Thanks to them, millions of poorer and hitherto excluded families became homeowners, investors made high returns, and financial intermediaries pocketed the fees and commissions. It might have worked like a dream – and until about a year and a half ago, many financiers, economists, and policymakers thought that it did.

Then it all came crashing down. The crisis that engulfed financial markets in recent months has buried Wall Street and humbled the United States. The near $1 trillion bailout of troubled financial institutions that the US Treasury has had to mount makes emerging-market meltdowns – such as Mexico’s “peso” crisis in 1994 or the Asian financial crisis of 1997-1998 – look like footnotes by comparison.  

But where did it all go wrong? If our remedies do not target the true underlying sources of the crisis, our newfound regulatory zeal might end up killing useful sorts of financial innovation, along with the toxic kind.

The trouble is that there is no shortage of suspects. Was the problem unscrupulous mortgage lenders who devised credit terms – such as “teaser” interest rates and prepayment penalties – that led unsuspecting borrowers into a debt trap? Perhaps, but these strategies would not have made sense for lenders unless they believed that house prices would continue to rise.

So maybe the culprit is the housing bubble that developed in the late 1990’s, and the reluctance of Alan Greenspan’s Federal Reserve to deflate it. Even so, the explosion in the quantity of collateralized debt obligations and similar securities went far beyond what was needed to sustain mortgage lending. That was also true of credit default swaps, which became an instrument of speculation instead of insurance and reached an astounding $62 trillion in volume.

So the crisis might not have reached the scale that it did without financial institutions of all types leveraging themselves to the hilt in pursuit of higher returns. But what, then, were the credit rating agencies doing? Had they done their job properly and issued timely warnings about the risks, these markets would not have sucked in nearly as many investors as they eventually did. Isn’t this the crux of the matter?

Or perhaps the true culprits lie halfway around the world. High-saving Asian households and dollar-hoarding foreign central banks produced a global savings “glut,” which pushed real interest rates into negative territory, in turn stoking the US housing bubble while sending financiers on ever-riskier ventures with borrowed money. Macroeconomic policymakers could have gotten their act together and acted in time to unwind those large and unsustainable current-account imbalances. Then there would not have been so much liquidity sloshing around waiting for an accident to happen.

But perhaps what really got us into the mess is that the US Treasury played its hand poorly as the crisis unfolded. As bad as things were, what caused credit markets to seize up was Treasury Secretary Henry Paulson’s refusal to bail out Lehman Brothers. Immediately after that decision, short-term funding for even the best-capitalized firms virtually collapsed and the entire financial system simply became dysfunctional.

In view of what was about to happen, it might have been better for Paulson to hold his nose and do with Lehman what he had already done with Bear Stearns and would have had to do in a few days with AIG: save them with taxpayer money. Wall Street might have survived, and US taxpayers might have been spared even larger bills.

Perhaps it is futile to look for the single cause without which the financial system would not have blown up in our faces. A comforting thought – if you still want to believe in financial sanity – is that this was a case of a “perfect storm,” a rare failure that required a large number of stars to be in alignment simultaneously.

So what will the post-mortem on Wall Street show? That it was a case of suicide? Murder? Accidental death? Or was it a rare instance of generalized organ failure? We will likely never know. The regulations and precautions that lawmakers will enact to prevent its recurrence will therefore necessarily remain blunt and of uncertain effectiveness.

That is why you can be sure that we will have another major financial crisis sometime in the future, once this one has disappeared into the recesses of our memory. You can bet your life savings on it. In fact, you probably will.

Copyright: Project Syndicate, 2008.

Ethical business

Research recently carried out by Ethical Investment Research Services (EIRIS), a research organisation designed to reflect the investment principles of the group of churches and charities that helped set it up, found that the top listed companies on the London Stock Exchange have made great strides in the past five years to tackle ethical issues head on, spurred on by the demands of “responsible” investors and stakeholders.

According to the research, in the last three years (2005 – 2007) over 80% of company policies and over 70% of management systems with regards to environmental policy are assessed as being “good” or “exceptional”, with a four fold increase in companies assessed as having exceptional environmental policies.

The survey also found that there has been a significant move towards tackling wider corporate responsibilities such as human rights. For example, EIRIS found that 94% of companies operating in countries of concern have some form of human rights policy, and over a third of these (39%) are considered “advanced”.

But some experts query aspects of EIRIS’ research, in particular its focus on the top 100 companies. Mark Chadwick, CEO at environmental management consultancy Carbon Clear, says that there needs to be a much wider review than just to look at the world’s largest 100 companies. “There are thousands of small and medium enterprises out there – just in the UK alone – as well as some other very large companies that aren’t listed on the FTSE that think that ethical and socially responsible behaviour and disclosure do not apply to themselves,” he says.

It is fair to say that the level of investor pressure and regulatory obligation for firms outside of the FTSE100 or listed on other exchanges such as the Alternative Investment Market (AIM) is much lower than for those listed on the main exchange. Consequently, those companies do not feel compelled to constantly improve their ethical behaviour or level of disclosure about corporate governance, meaning that EIRIS’ findings are likely to be more than a little skewed.

According to Chadwick, legislation such as the UK’s Carbon Reduction Commitment is going to force more organisations – and not just the largest in terms of revenue – to take more notice of their environmental and social policies. This is because the legislation, a new mandatory emissions trading scheme which begins in January 2010, will force all organisations whose electricity consumption is over 6000 megawatts per hour to bid for further allowances to cover their emissions. At the end of each year the government will compile performance tables to show which organisations have managed to reduce their carbon emissions the most. The government estimates that the rules will affect over 5,000 UK organisations.

“This kind of legislation, which takes a wider view than just focusing on 100 entities, will ultimately compel the majority of organisations in the UK to take their ethical, environmental and social responsibilities more seriously because it’s enshrined in law. We all know that legal risk is one of the key drivers of changing corporate behaviour,” says Chadwick.

Other business monitoring groups believe that the UK’s largest companies have a responsibility to encourage greater disclosure and compliance with industry best practice in the smaller companies that they deal with, such as suppliers and other contractors. They think that the “clout” that larger companies have to dictate terms will be a key driver in enforcing compliance with ethical codes.

Philippa Foster Back, director of the Institute of Business Ethics (IBE), an organisation that promotes ethical business practices, says that “from our research, around 60%-65% of companies in the FTSE350 have codes of ethics, compared to over 90% in the FTSE100. We believe that the world’s largest companies have the opportunity and responsibility to help smaller companies become more ethical because they now think that smaller companies have the obligation to act more ethically.”

But does such encouragement amount to corporate bullying? Already, some firms – particularly those in the US – are forcing suppliers (especially in developing countries like China and India) to sign contracts which stipulate that any ethical breach stays at a local level – meaning that if the US firm is found at fault for unethical behaviour on the part of a foreign supplier (for example, the supplier uses child labour), then the supplier agrees to take the rap.

On paper it may sound fair enough – why should a company in the US take the blame for practices in its supply chain that it does not carry out in its own workplace – but the reality can be quite different. Regulators and enforcement agencies have already picked up on the idea that these companies may be using their suppliers from the developing world as scapegoats, and so are now more inclined to look more deeply at the ethical guidelines that they are asking such companies to abide by.

Gateway to growth

Saudi Arabia is one of the world’s top 10 emerging and developing countries, and the largest Arab economy, with 10 percent of the total GDP of the Middle East.

It has more than 25 percent of the world’s oil reserves and a current estimated revenue surplus of €34bn. Private investors are developing €54bn of energy sector specific projects. The country’s resources go beyond oil, however – it has known gold deposits totalling 20 million tonnes, and an estimated 60 million tonnes of copper deposits that have not yet been exploited.

It also has one of the world’s fastest growing IPO markets, and the largest equity market in the Middle East, with approximately 120 listed companies, which is also ranked as the 11th largest stock market in the world. However, investors outside the GCC – the Gulf Cooperation Council, covering Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates – have been barred until now from participating in the Tadawul, the Saudi stock market, which was founded in the 1930s, although the Tadawul All Share index has a market capitalisation of about €305bn. Indeed, it was only in 1997 that investors from the other GCC states were allowed to participate in the exchange, and even then they were barred from buying shares in banks and insurance companies, a rule that was dropped just a year ago. The result is that around 90 percent of all business on the Tadawul is by individual Saudi investors. The only way Western investors have been able to access the bourse has been through the under-developed mutual funds sector.

Further investment
On August 20, however, the Capital Market Authority of Saudi Arabia (CMA) announced it would be allowing the entry of non-resident foreign investors on the Saudi bourse through a “swap agreement” with what will be termed “authorised persons”.

The “authorised persons” will retain the legal ownership of the shares and agree to transfer the economic benefits of the Saudi companies listed on the Tadawul to non-resident foreigners. Both institutional as well as individual investors from abroad will be allowed to invest, the CMA said.

Bankers operating in Saudi Arabia, which has a population of about 25 million and it is ruled by the Al Saud dynasty, have been pushing for greater liberalisation to allow foreign participation, not only because their overseas customers want to participate in the growth of the Saudi economy, but also, they say, because having foreign retail and institutional investors involved would reduce some of the volatility found in the Saudi stock exchange, which is dominated by retail investors who, it is claimed, buy and sell too much on rumours and emotion rather than market-based analysis.

The Saudi authorities must also be hoping that allowing foreign investors in at last will also help lift the Tadawul, which has been one of the worst-performing markets in the region this year. In 2006, the market fell by more than 50 percent. Although it rose 43 percent in the final quarter of 2007 it has been down about 24 percent this year.

Expanding expertise
However, the CMA is undoubtedly aware that the country’s stock market could be damaged by a flood of fresh liquidity, something that, because of high oil prices, the whole of the GCC area is suffering from an excess of, which threatens to accelerate already rising inflation. For this reason the liberalisation of the Saudi bourse is progressing slowly and cautiously, step by step. One analyst commented after the announcement on August 20: “It is a step towards further liberalisation of the market, but more importantly it shows that the Saudis want to do this very gradually and very slowly for two reasons. One is that opening up the market to foreign investors brings up more liquidity and that’s the last thing they need right now. But what they [the Saudis] are interested in is bringing in expertise, hoping that the presence of foreign investors will slowly force local investors to adopt much more transparent rules of doing business.”

Commentators certainly see big benefits from the liberalisation, however. Another said: “This development will undoubtedly increase foreign capital inflows to the Kingdom’s stock market, promote greater transparency, reduce volatility associated with dominance of the retail investors in the Saudi market, and encourage more comprehensive equity research on listed companies.” The aim, observers believe, is that by gradually opening up the Tadawul, the CMA can encourage Saudi Arabia to become a major competitor with the UAE and Qatar for the title of the region’s financial centre. Just before the announcement that foreigners would finally be allowed to participate in the market, the CMA also issued new regulations saying that investors with stakes of five percent or higher had to disclose their positions, a move intended to increase transparency and reassure other potential investors.

Taking the right steps

One company that has already set up arrangements to act as an “authorised person” for foreign investors, both retail and institutional, looking to take advantage of the new regulations announced by the CMA on August 20 is FALCOM, based in Riyadh, with branches in Jeddah and Khubar. FALCOM, which was established in 2005, provides Islamic investment banking services including asset management, brokerage services, investment advice and treasury products. It now has 150 employees and a capital base of one billion Saudi riyals (€185m), and runs an internet trading service for customers called Tadawuly, and a suite of tools for stock market technical analysis through FALCOM Financial Services was recently awarded the “Best New Investment Bank 2008’ award by Global Finance & Arabian Business, and it is about to open its doors to investors in the GCC region with a licence to operate in Oman.

FALCOM’s Chief Executive, Adib Al Suwailim, said the move by the Saudi Capital Markets Authority to allow non-resident foreign investors access to the stock market through “benefits swap agreements” with authorised licensed intermediaries who would legally own the shares is “a clear sign of liberalisation of the equity markets in the near term. With this move, the CMA has taken yet another investor-friendly step.”

The scale of interest “is likely to be tremendous across the board, and the Saudi market is currently performing well below its historic levels,” Mr al Suwailim said. “The initiative comes at the right time, when sentiments in the local market are down and valuations are attractive. This measure will cheer up the investors who witnessed the meltdown of the bull run in 2006 and fluctuating fortunes over the next two years. The Tadawul All Share Index, the market benchmark, has lost 23.3 percent to date in 2008. Over the longer term, the entry of sophisticated and deep-pocketed investors will lead to reduced volatility.”

FALCOM is now inviting institutional and retail investors to open accounts with it through which they can invest in a total benefits swap and thus gain access to the Saudi Arabian stock exchange. “FALCOM, being a member of the exchange, will execute the transactions, and buy and hold shares in the investor’s name, with an undertaking to transfer unconditionally the economic benefits of the holding to the ultimate beneficiary, the foreign investor, through the counter party broker,” the company said.

The company backs up its services with what it describes as “innovative financial products and wealth maximising solutions, ably assisted by a highly tech-savvy and dedicated professional team committed to support our client needs with benchmark standards of integrity, proficiency and commitment.”

It also provides a report service called FALCOM MarketToday, which covers valuable information such as valuation parameters, TASI support/resistance levels, last 10 days coverage, average prices on the day, money movers, 52-week high/lows and so on, much of it information not covered by any other investment banker, it says, and released by 4.30pm every day. Another of the company’s services, FALCOM MarketWeek, covers not just fundamental information but also stock volatility, weekly performance of stocks, company research, stock market research, strategy reports, and economic research are also regular feature.

Overall, FALCOM says, it believes that the announcement by the CMA will attract huge interest from foreign investors looking to diversify their portfolios. The Saudi stock market is “the most lucrative in the region because of its size and liquidity”, the company says, and the IPO market has been “abuzz with activity over the past two years. In 2007, 25 new companies were listed whereas so far in 2008, 15 new companies have been listed.”

Observers say they expect public companies in Saudi Arabia to open up to foreign investors gradually, albeit on a limited basis, over the next few year, probably under a system like the one in operation in Qatar, where foreigners are restricted to 25 percent ownership in all stock, or the UAE, where foreigners cannot own controlling stakes. All the same, the agreement on all sides is that the CMA’s move is good news for everybody, from Saudis to outsiders.

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