Thursday, December 31, 2009
Bond people like to think of bonds as an entirely separate asset class from stocks, but the performance of fixed income markets in 2008 taught them a stark lesson: bonds have plenty of equity risk. Until the Lehman bankruptcy in September 2008, the equity market was living in its own world. But the Lehman default brought home the truth that equity holders are ultimately taking the bulk of the enterprise risk in the marketplace. Since then, virtually every class of bonds other than Treasuries have tracked the gyrations of the equity markets. Conceptually, this makes sense: Equity markets are where the collective animal spirits live, and increasing risk aversion is experienced first hand when one meets equity markets in a freefall.
The well-known Merton model that links credit spreads to equities is indeed based on the relationship between a corporation’s underlying assets and its equity and debt, and so it’s hardly surprising that a drop in the asset value of a company impacts both corporate stocks and bonds. What is shocking is that so many asset classes having nothing to do with corporate assets have become so correlated to equities. Recently, many so-called “pure alpha” strategies have actually shown little alpha and lots of equity market beta.
All Risk Leads to Equities
Over the last few months, a watchful investor could generally guess the daily direction of bond prices, the yield curve, currencies, commodities and credit by just observing the changes in the equity market. This correlation of assets at the macro level has driven home the point that much of the real risk of investments resides in the equity markets, and when the cuts from deleveraging get as close to the backbone of finance as they did last year, the equity market becomes the final risk shock absorber.
Even though the stock market itself has remained fairly liquid through the crisis (so far), falling equity prices are more likely than rising equity prices to result in a decrease in liquidity for other asset classes. At the end of the day – in a leveraged economy in which assets are being supported by a diminishing equity base – each unit of falling equity prices drastically magnifies the economy-wide leverage. If we are on a path of deleveraging that hasn’t ended, then this “denominator effect” (where equity is the denominator and the net assets are the numerator) will require a further downward adjustment of the numerator, i.e., of asset valuation broadly. Indeed, as Leibowitz and Bova have observed recently,1 widely diversified asset portfolios show an uncanny lack of risk reduction. The benefit of asset class diversification is not so much to reduce risk, they observe, but to provide sources of excess alpha.
In 2008, the explosive environment that destroyed the structured credit markets drastically simplified investing and asset allocation by calling into question decades-old paradigms of asset class diversification as a mechanism for risk reduction. Long-term investing lore says that a 60/30/10 (equity, bond, cash) mix is a stable long-term portfolio. There are other handy aids that preceded mean-variance optimizers and structured products, such as subtracting an investor’s age from 100 to determine the ideal percentage allocation to equities. In light of the fallacy of asset class diversification, I believe that these rules of thumb are just as good (or maybe even better) than classic asset allocation optimization, provided the portion not in equities is really not exposed to the equity market.
Looking for Stocks in All the Bond Places
Major fixed income indices that represent the broad bond market actually have considerable exposure to equity market risk because they contain significant amounts of mortgages and corporate bonds. It’s easy to see why this equity risk in bonds exists – traditional bond indices operate on the convention of market weighting. In other words, issuers with the largest outstanding bond issues have the highest representation in the index. Keeping in mind that issuing bonds means borrowing, it follows that the more a corporation borrows, the more it is represented in traditional bond indices. But more borrowing – typically referred to as leverage – is positively related to the probability of a severe default. Would you lend money to a neighbor who has already maxed out his credit cards?
As borrowing goes up, so does the risk of a default, which causes bond prices to fall. Similarly, the typical causes of falling equity prices – declining profitability, capital shortages, or the prospect of significant shareholder dilution – also raise the risk of default and cause bond prices to fall. Thus, it follows that most representative bond indices have a lot of equity risk, or default risk, mixed in. In periods of market stress, that means that a “diversified portfolio,” such as a 60/30/10 mix, will behave as if it’s almost completely in equities! The largest issuers in the most widely followed index of fixed income markets (the Barclays Capital U.S. Aggregate Index) are Fannie Mae and Freddie Mac!
Consider the beta of various bonds and bond indices versus the S&P 500. By definition, the beta of the stock market to itself is 1. The beta of any other security is the correlation of its returns multiplied by the ratio of its volatility to the stock market’s volatility. If a security such as a Treasury bond has a beta of −0.10, it means that its returns are negatively correlated to the stock market. On the other hand, high yield bonds typically show an equity beta of almost 1, meaning that not only are they positively correlated to the stock market, but they have volatility in the same order of magnitude as the equity market. One would want to buy such a security only if the compensation for holding the default risk exceeded the risk of equity market volatility by a wide margin. Many hedge funds and other absolute return strategies turned out significantly negative performance in 2008 for similar reasons – they were long hidden equity, or (what amounts to the same) liquidity risk. Higher equity beta should, in efficient markets, compensate with higher returns over the long term, or so says the Capital Asset Pricing Model. But higher equity beta also means higher drawdown and “tail risk” during times of market crisis.
The Human Factor
This all leads to the question of what can be done to limit the equity risk in a bond portfolio. Once uncorrelated and low volatility assets become highly correlated to volatile markets, risk management requires nothing less than aggressive control of the exposure to equity factor risk. Instead of deciding on the allocation to assets by percentage, we can do a much simpler exercise that starts with risk as the key decision variable. If we assume that equities will exhibit volatility of 30% over a long holding horizon (currently, the VIX index that measures short term equity volatility is trading in the 40%–50% range), then a beta of 1 to equities in your portfolio means that you should be willing to tolerate a very high likelihood (almost 35%) of losing 30% of the value of your portfolio over the next year! This, I submit, would be a very hard thing for most people to digest in the economic environment we are facing, even with the understanding that the risk comes with the potential reward of 30% upside with the same 35% probability.
This illustrates the important point that investors aren’t robots and can’t be expected to forget recent history when faced with the possibility of large losses piling on top of large losses. Indeed, I recently heard of a finance professor who believes in rational, efficient markets, and in long-term outperformance of equities, but sold all of his stocks (locking in losses), because he “could not take the pain any more.”
One simple way to control risk is to look across a portfolio and dial down the equity risk factor beta to a level of risk that the investor can tolerate. For example, an investor might be willing to take no more than a 15% annual drawdown, so they could scale their portfolio’s beta down to 0.5 (0.5 times 30% equals 15%). Yes, they might be giving up much of the upside potential, but if they’re like me this year their marginal dollar might mean a lot more in their pocket than it does in the stock market, and in any case, since falling stock markets seem to be associated with falling prices, that marginal dollar buys more goods. And yes, when the equity market is less volatile, the investor would likely want to revisit this risk allocation and see if they believe prospective equity volatility is going to be low or high before they increase their equity risk.
Spreading the Risk
So if we assume that Treasuries have an equity beta of −0.10, cash and Treasury Inflation-Protected Securities (TIPS) have an equity beta of 0, mortgages and municipal bonds have an equity beta of 0.25, corporate bonds have an equity beta of 0.50, and high yield bonds have an equity beta of 1, then I might be comfortable getting some of my equity beta from equities and the rest from bonds. For example, if I put 58% of my risk allocation in equities (100 minus my age), that portion gives me an equity beta of 0.58, which many investors might feel is too large given the risk. So another alternative an investor might choose is to put 30% in equities (with a beta of 0.3), 25% in mortgages or munis (with a beta contribution of 0.06), and the rest of the beta budget in corporate bonds (0.14 beta or roughly 30%). The rest (15%) goes into cash and TIPS. An added plus is that the equity beta from the corporate bond sector is higher up in the capital structure (i.e., if there is a default, the bondholder gets paid before the equity holder), and it should give the investor a yield even as stock dividends are being cut.
There are a few other ways of reducing portfolio equity beta. First, as we just illustrated, one can reduce exposure to assets that carry high equity beta by getting rid of them. The second way of reducing equity beta – if you absolutely have to keep your current high equity beta portfolio – is to plan against further equity factor risk by hedging, i.e., via put options (though in today’s environment these might be too expensive). The third way is to look for uncorrelated or negatively correlated securities such as Treasuries (these also might currently be too expensive, given their low yields and precarious situation given impending government borrowing to fund bailouts and stimulus programs). Finally, we could use negatively correlated strategies, such as outright hedging of volatility risk using momentum or trend-following strategies.
Alas, value investors who have grown up in the school of mean-reversion have to allow for the possibility that when markets are in disarray, portfolio risk control and tail risk hedging is not a luxury, but a necessity. In a world where the risk of loss means forced liquidation and a knockout punch, anything short of aggressively managing the left tails of the return distribution is ignoring the clear lessons we learned in 2008.
1 Martin Leibowitz and Anthony Bova, “The Endowment Model: Theory and More Experience,” Morgan Stanley Research (October 9, 2008)
(from Pimco, March 2009)
Pimco Global Opportunities Fund will buy securities and financial instruments “economically tied” to at least three countries, one of which may be the U.S., according to a registration statement filed today with the U.S. Securities and Exchange Commission. The fund will be able to purchase shares in companies of all sizes.
Chief Executive Officer Mohamed El-Erian this month hired Neel Kashkari, former head of the U.S. Treasury’s bank-rescue program, as well as Franklin Resources Inc.’s Anne Gudefin and Charles Lahr, to help the company expand the range of products it’s offering investors. Pimco Global Opportunity could position the Newport Beach, California-based company to reap the benefits of an investor shift from bond to stock funds.
“Pimco is a bond shop, but I think they have a view that bonds will under-perform stocks on a pretty regular basis in the future,” said A. Michael Lipper, the head of Lipper Advisory Services Inc., a Summit, New Jersey-based investment adviser. “Now they are hedging.”
Pimco, a unit of Munich-based insurer Allianz SE, had about $940 billion in assets under management as of Sept. 30. More than 90 percent of that was in bonds.
Team From Franklin
Today’s filing didn’t disclose who will manage the Pimco Global Opportunity Fund. A spokesman for Pimco couldn’t immediately be reached for comment.
Gudefin and Lahr had jointly managed the $15.6 billion Franklin Mutual Global Discovery Fund for San Mateo, California- based Franklin Resources. As of June 30, the Global Discovery fund had generated an average annual return of 7.6 percent since starting in January 2002, according to its semiannual report to shareholders.
Pimco Global Opportunities shares several features with the Franklin fund that Lahr and Gudefin ran, according to filings. Both funds list capital appreciation as their primary investment objective and both employ the Morgan Stanley Capital International World Index and the Standard & Poor’s 500 Index as benchmarks.
The Pimco fund will use a “bottom-up” investment style in which managers seek securities they consider undervalued, the firm said in the filing. Managers at Pimco will base their assessments on criteria such as asset value, book value, cash flow and earnings estimates, according to the document.
In addition to stocks, Pimco Global Opportunity can invest in U.S. and foreign government debt, bank loans and high-yield bonds, the filing said. It can also acquire securities of distressed companies and engage in short sales, a trading strategy that generates profits when stocks decline.
(from Bloomberg.com, December 30, 2009)
Wednesday, December 30, 2009
- Tim Geithner will resign as Treasury Secretary. Sheila Bair will replace him.
- AIG (AIG) will be dismantled. What is good will be sold, what is bad will be shuttered. The end result will be a loss to the U.S. of $40 billion.
The Mid term elections will go to the Republicans. A surprising number of independents will be elected. The Democrats will still have a narrow majority. The end result will be legislative deadlock.
Gold prices will trade as low as $900 and as high as $1,400. $1,400 will come first.
- Fourth quarter GDP will be at -1%.
- Unemployment will fall from 10% as the 800,000 census workers are hired. Outside of that there will be no growth in employment. Ex the census impact and other government hiring, job creation will be negative.
- Fiat (FIATY.PK)/Chrysler will introduce some sexy new fuel-efficient cars. They will sell well. GM’s (MTLQQ.PK) Volt will not be in full production. Demand will not be there.
- Boeing (BA) will finish a few Dreamliners but they will face many delays and problems.
- Apple (AAPL) will trade at $300 (tablet) and Google (GOOG) at $750. Amazon’s (AMZN) stock will be lower over the full year.
Overall expect a modest down year for equities. However, the market will be significantly higher and lower than current levels during the year. Expect a high low of +/-15%. Playing the SPY will be tough. This will be a stock pickers market.
- Oil will trade at $100 by midyear, but it will be closer to $75 by year-end as the global slowdown re-emerges.
- The La Nina conditions will revert to El Nino conditions. This will result in a significant increase in Hurricane activity. Four named storms will hit the U.S. coastlines. Total damages will approach $50 billion. There will be no CAT 5 hits on the mainland. But the Yucatan Peninsula is hit with a big one. Storm activity will interrupt Gulf gas production. Nat Gas will trade at $9 at one point in the fall.
- Typhoon activity in Asia will fall from the pace seen in 2009. The result will be a significant increase in Pacific Ocean temperatures.
- 2010 will see another significant increase in ice melt. No meaningful steps will be made toward a global response to climate warming.
- After the Preferred conversion the shares of the Agencies will be delisted. Shareholders will be thrown a bone. They will get a beneficial interest in the REO owned by the Federal government. This could be in the form of a trust or individual transactions where old shares are tendered for individual properties. (Hotels/big stuff). The objective of this will be to remove these properties from the market for a meaningful period of time. The result will be that medium priced homes will stabilize in value. Rental costs will fall.
- High-end home prices (+$1mm) will continue to fall in value. In some areas the decline will be 20%. The absence of a viable mortgage market for these homes is the culprit for these declines. Prime defaults will rise to 8%.
- On September 1, 2010 the Federal Funds target will be at ½%. The 10-year bond will be at 4.5%. During the course of the year the ten-year will trade at 3.5% and also 5%. Interest rates will be lower at the end of the year than they will be on September 1st. There will be no meaningful reduction in the Fed's balance sheet.
- At some point in 2010 there will be a test in the bond market for a government auction. At that time the Federal Reserve will, without hesitation or consent, re-establish a form of the QE policy. They will not permit a “failed’ auction.
- The Federal Reserve will become active in the foreign exchange markets. At different times of the year they will both buy and sell dollars. Their objective will be stability. These efforts will be referred to as “smoothing operations”.
- Volatility for all exchanges and commodities will increase from current levels. Intra-day moves greater than 2% will become common.
- The Sovereign Risk Story will continue to be a major theme. Italy and the U.K. will be lumped into the status of Greece, Spain and Portugal. Eastern Europe will see negative growth.
- There will be no breakup of the Euro. Greece will not pull out. The strong members will provide some relief for the weak. But the problems will not go away and the possibility of some form of two-tiered Euro will be a matter of open discussion. It is in this context that the Fed’s FX intervention takes place.
- There will be no meaningful overhaul of Social Security. This topic will be more controversial than Healthcare. It is too hot a potato for a bi-election year. As a result the SS Trust Fund will be at cash flow breakeven for all of 2010. Down from a surplus of +$200 billion in 2006. This reality will impact bond yields.
- The dollar will trade as high as 1.35 vs. the Euro. The low for the year will be at 1.60. At some point the Yen could weaken to as low as 110 to the dollar. Trade the extremes.
- China will surprise us all and revalue the Yuan by 10%. The currency will still be undervalued. China’s GDP will grow at 10% for the year. But the prospect for 2011 will be in doubt. China will not lose its rank as number 2 in global GDP.
- Mexico will devalue the Peso by 15% and Brazil will revalue the Real by the same amount. The Canadian Dollar will exceed 1 to 1 versus the US dollar.
- The Treasury will not sell the 10 billion of Citicorp (C) shares that it holds. The argument put forth will be to maximize the value of the holdings.
- Some of the folks from Bear Sterns and Lehman will form a Boutique. It will be a success.
- The debate over Glass-Steagall will linger. It will not happen. It is not practical at this point. This creates a dilemma for Goldman Sachs (GS). Can they go private and then just ignore all the noise?
- Fannie and Freddie will be merged. Their troubled assets will be transferred to a workout trust. There will be talk of returning the cleaned up entities to the private sector. The cost of these steps will bring the total losses to $500 billion.
FHA will receive a $40 billion equity infusion from Congress. This capital increase will be necessary as it will be determined that the FHA model is the best approach for Government involvement in the mortgage market. FHA will use the new capital and substantially increase its lending activities. This step will avoid the necessity of a bailout of FHA. These actions will marginalize Fannie and Freddie.
In 2010 over 90% of all new mortgages will come from or be supported by the government.
There will be spot shortages of all manner of things. Soy oil, diesel fuel, specialty steel, industrial chemicals, ball bearings, replacement parts etc. This is an inventory problem. It will result in price jumps for things. This will be a global story.
There will be several occasions when it will appear that we are about to fall off a cliff (or soar to the moon). Beware of these conditions. It is more than likely that the markets will be oversold and over-worried (or too enthusiastic). Take profits at these points. Do not stretch a bet too far. If you have some winnings in the jar consider counter trading big market moves on the day that the issue at hand gets front page coverage in the NY Times.
Japan will not get out of recession. They will have to confront the issue of deficit spending and their debt to GDP ratio. Their response will be to sell reserve holdings to fund the deficit. The amounts involved will be small but the change in direction will be perceived to be significant.
We will pay significantly more for virtually everything that we consume. The CPI and COLA numbers will be modest. We will be poorer as a result.
Americans' distrust of their financial institutions and our financial leadership will deepen. The whole notion of “I Promise to Pay” will come into question. As a result, the availability of consumer credit will continue to dry up.
There will be no curbs placed on Dark Pools or flash trading. The short sale rule will not be re-introduced. There will be no regulated futures market for CDS. The Securitized Market will not recover. Nothing will change.
The “Flight to Quality Trade” will be a dominant theme for the markets throughout the year. At some point this topic will drive the big capital flows. A month later they will have been reversed. This instability is driven by the conclusion that there really is no ‘Quality’ that the capital is Fleeing to. It is just the constant movement of the deckchairs. This creates good trading markets.
(from SeekingAlpha, December 29, 2009)
Ivanhoe Mines is at a two-year high, and the option action is looking for it to continue running higher.
The Canadian gold and copper mining company is up at $14.94, falling slightly from the open and trading just below the high of $15.19 set yesterday, the highest level since November 2007. IVN is up almost 50 percent since finding support at the beginning of November and more than 500 percent for 2009.
The average daily options volume is has been fewer than 3,000 contracts total in IVN, and despite the holiday slowness we see one block of 4,100 June 15 calls traded today. The calls were bought for $2.25 against open interest of 3,608 contracts.
This call buying is a bet that IVN will be above the all-time high for the stock set in July 2007. This is one way that traders have been trying to leverage the higher price of gold and other precious metals.
(Chart courtesy of tradeMONSTER)
We looked at this question from an open interest perspective in mid-December ("When Will The Gold Froth Dissipate?").
COMEX/NYMEX Gold (Feb. '10)
February gold is dawdling around the $1,100 mark now, seemingly ready to take a breather from its nearly monthlong swoon.
Some bulls, however, are waiting for a full 50 percent retracement of the contract's July-December rally as a buy-in point. That's $1,068 for the February contract. A number of traders, too, are selling puts struck at $1,070 as a way to capture a sale price on gold futures.
Here's the deal: Puts, as you may know, bestow the owner with the right, but not the obligation, to sell gold futures at the strike price. For this right, the put buyer pays cash to the option's seller. The seller, in consideration of the cash premium received, undertakes the obligation to buy futures at the strike price if, and when, the put buyer exercises his or her option.
Now, it's likely the put owner will only exercise the option if the underlying futures' price dips below the strike price. The economic advantage for "putting" gold futures to the option seller is equal to the difference between the strike price and the current market price of futures.
Think about those $1,070-struck puts. Put owners would only want to exercise (sell futures) if February gold's below $1,070. The farther below the strike February gold declines, the greater the economic gain upon exercise.
For the option grantor, it's pain, not gain, that increases with a decline in gold's price since he or she would be obliged to buy futures at the strike price.
But if you wanted to be a gold buyer on a dip to the 50 percent retracement level (near $1,070), that's exactly the kind of risk you'd be taking. The only difference between placing a buy limit order under the market at $1,068 and selling puts struck at $1,070 is the premium you receive for selling the option.
As gold closed out pre-holiday trading, the $1,070-struck put's premium was $14.30 an ounce. That means your effective gold futures purchase price would be $1,055.70 ($1,070 - $14.30) upon exercise.
Is that a good sale price for gold? It certainly is compared with $1,100.
What if February gold doesn't dip below $1,070 after selling the put? What then? Well, the same that would happen with a resting buy limit order at $1,070. Nothing.
It's not likely the put holder would want to exercise the option if February gold's trading above the strike price. There's only economic disadvantage in that since he or she would end up short futures.
The good news for the option grantor is that he/she gets to keep the premium. If February gold is at $1,100, for example, when the put expires, you can use the retained premium to lower the purchase price - or margin requirement - of the then-active gold futures by $1,430.
You can use this same approach with ETFs on gold bullion. The 50 percent retracement level for the SPDR Gold Trust Shares (NYSE Arca: GLD) is just above $104. With shares of the grantor trust trading around the $108 level now, the premium for a $104 put is about $2.06 a share.
The Market Vectors Gold Miners ETF (NYSE Arca: GDX), now trading with a $46 handle, has already rebounded from a test of its 50-retracement level around $44.80.(from SeekingAlpha, December 29, 2009)
Monday, December 28, 2009
Updated again: October 30, 2009 (added 2008-2009 chart to 2009 only chart)
This chart ran along with The Bernanke Market piece that ran in the Wall Street Journal back in July. I thought it was worth updating. The market seems to be following the Fed's money creation. I suspect the market will give out well before the Fed stops printing money.
The monetary base data is from this page at the St. Louis Fed. WSBASE is defined as the "Sum of currency in circulation, reserve balances with Federal Reserve Banks, and service-related adjustments to compensate for float."
(from Andy Kesler's blog, October 30, 2009)
Sunday, December 27, 2009
(from Zero Hedge, December 25, 2009)
1. Prices and Production
Oil prices stopped falling last week and climbed from circa $70 a barrel on Monday to close above $73 on Friday. The price jump came despite a stronger US dollar which kept downward pressure on prices. Colder weather and increased distillate demand in the US, coupled with trouble along the Iran-Iraq border, were primarily responsible for the jump. The market’s perceptions of the prospects for economic recovery, which vary daily, remain the key driver of prices.
The OPEC meeting in Luanda this week is expected to leave prices unchanged as they remain close to the Saudi’s favored “sweet spot” of $75 a barrel.
The conventional wisdom that the demand for oil will grow in 2010 continues, with OPEC joining the IEA and EIA in forecasting an increase in demand next year. OPEC, however, only sees an increase of 30,000 b/d, most of which will come in the second half. There are still many unknowns ranging from China’s economic growth to the fate of the dollar in face of growing US deficits.
Natural gas prices in the US surged last week as colder weather led to a record drop in supply. Gas in storage still remains 14 percent above normal for this time of year.
In Nigeria, the Movement for the Emancipation of the Niger Delta says it bombed an oil pipeline last week, the first such attack in five months. Although Nigeria’s oil production has been increasing in recent months due to the ceasefire, a report in the London Times says Shell is about to throw in the towel in Nigeria and is putting its on-shore oil production up for sale.
One of the major developments affecting the availability of oil in 2010 could well be the Iranian situation. Faced with internal unrest following its controversial presidential election, Tehran is adhering to a provocative foreign policy in order to garner domestic support. Last week saw Tehran test a long range missile capable of striking Israel and parts of Europe, then temporarily seize an Iraqi oil well within a disputed sector of the Iran-Iraq border.
The major issue still remains Iranian efforts to enrich uranium in defiance of UN demands that such activity be subjected to adequate safeguards. The Israelis, of course, realizing that their micro-state could be destroyed in minutes by a small number of nuclear weapons, remain adamant that Iranians shall never have such devices.
Despite incessant protests that all they seek is nuclear power plants, years of foot-dragging by Tehran, coupled with rejections of various offers to provide them with power plant-grade uranium in a safeguarded manner, has raised deep international suspicions about their intentions. Last week a document surfaced which purports to contain information on Iranian plans to develop a device only useful for nuclear weapons. In today’s world, long-range missiles, such as the ones Tehran continues to test, are useless as deterrents unless they carry a nuclear warhead.
The issue seems likely to come to a head in 2010 as the US and the EU step up efforts to sanction Tehran for its intransigence. While Beijing is starting to realize that it is the odd-man out in its continued support for Tehran on this issue, the conventional wisdom is that China would still supply whatever the Iranians need should the effects of sanctions on Iran become too severe. The Chinese continue to call for negotiations.
While the West cites a possible embargo on the roughly 50 percent of Iran’s daily gasoline consumption that must be imported as the most effective sanction, Tehran talks of cutting oil exports to the world. The Saudis and their Gulf allies do have some spare capacity to offset a cut in Iranian exports; much of this would otherwise go to expected increases in demand next year.
The lessons derived from the failure of the UN climate change meeting in Copenhagen to conclude a formal treaty will likely be discussed for years to come. Many believe the major development at the conference was the emergence of the US and China as the only two nations that count on an issue as important as global warming and the future of world energy consumption and economic development. While the current administrations in Washington and Beijing realize that they are dealing with an issue of highest importance to the survival of their societies, both are hampered by their histories, domestic politics, national goals and perceptions of sovereignty.
The idea of UN mega-conferences to set emissions standards at which 193 nations are supposed to debate and approve the text of any agreement will likely go by the board in favor of smaller regional meetings of the 30 or so nations that produce 90 percent of the emissions.
The final accord reached at the meeting was a 12 paragraph document, a non-binding statement of intentions to keep the average world temperature from climbing beyond another 2 degrees Centigrade above pre-industrial levels and to continue work to achieve this goal. Although this document does nothing itself, some progress was made at the meeting in that China tentatively accepted some form of emissions verifications for the first time and the US promised to raise $100 billion to help poorer nations convert to non-polluting energy.
The accord reached at Copenhagen will do little or nothing to control emissions. Frankly, to expect that one meeting could reach agreement on changes that will have a major impact on the global economy was unrealistic. Progress on reducing emissions will come slowly, perhaps as the major world nations start to feel directly the consequences of global warming or perhaps energy shortages.
With much higher oil and other fossil fuel prices just a few years away, it is likely that economic pressures will bring about greater progress on reducing emissions than treaties. Whether these economic pressures will come soon enough to significantly reduce the ongoing climate threat will take many years to be seen.
4. Exxon and XTO
Exxon Mobil’s $30 billion purchase last week of XTO is being hailed as a paradigm shift in the US energy industry. The move puts an oil major stamp-of-approval on the potential for shale gas and may presage a round of takeovers of independent gas producers by the major international oil companies.
The better-financed oil companies are generally able to continue wide scale drilling programs even in difficult economic times. Analysts are talking of all sorts of benefits from the involvement of the majors in natural gas production, including long-term fixed-price contracts, stabilization of the natural gas market at higher levels, and more work for the oil service companies. Others talk of a major expansion of the natural gas market to include more gas-heated homes, more gas-fired power plants and more natural gas-powered vehicles.
Lost in all the enthusiasm are environmental concerns which range from potential contamination of ground water to the amount of water required to drill and frac the lengthy horizontal wells. There is also the issue of increased costs of drilling and fracing long horizontal wells in shale formations vs. the value of the gas that will be recovered from each well.
Quote of the Week
- “To me it looks like the economics of many of these [Iraqi oil] deals don't work at all. They're profitable, mind you, but they don't offer a rate of return that justifies the investment. In other cases, the rate of return is high enough to justify the deal, but only if initial estimates of costs and production volumes turn out to be correct. In other words, nothing can go wrong.”
-- Jim Jubak, Editor and Founder, JubakPicks.com
- OPEC, which produces about 40 percent of the world’s oil, predicts members will need to produce 28.6 million barrels a day to satisfy demand in 2010. That’s about 100,000 b/d more than last month’s projection and represents an increase in 30,000 b/d from 2009, the first annual rise in three years. (12/16, #8)
- OPEC, together with two major non-cartel oil exporters, Russia and Mexico, consumes 14.5 million barrels of oil per day. That’s nearly twice as much as China. Oil demand among OPEC members has been growing at well over double the world average. And the more these countries consume their own oil, the less they have to export. (12/17, #17)
- Brazil’s oil production could pass that of Mexico and Venezuela by 2011, as its ultra-deep offshore fields start producing. Mexico and Venezuela have seen crude-oil output drop dramatically in recent years. Petrobras has targeted domestic output of 2.25 million barrels a day for 2010, growing to 2.43 million in 2011. (12/19, #11)
- Venezuela has been in a deep recession this year, despite pocketing many billions of dollars. Some analysts, such as PFC Energy, estimate that Venezuela needs an oil price of around $100 a barrel to keep its spending commitments. (12/19, #6)
- During the recent Iraqi auction of oil development rights, there are two reasons that national oil companies dominated the list and international majors were absent. First, the Iraqi auction continues the shift of power in the global oil industry to national oil companies. Second, the terms of the Iraqi auctions made them, by and large, unattractive to international majors, but not to national oil companies. The auction results show how different the motives are that are driving these two parts of the global oil industry. (12/19, #7)
- Pemex estimated that losses from oil theft were $730 million in 2008. Gasoline, diesel, jet fuel and condensates from gas fields were the most common targets. (12/19, #10)
- Russia launched an oil tanker capable of slicing through a meter of ice, bringing Russia a step closer to its ambition of launching its first offshore oilfield in the Arctic. (12/19, #18)
- Anadarko said that it struck oil for a second time in the subsalt region of Brazil's Campos Basin. The Itaipu prospect encountered more than 90 net feet of oil in a high-quality carbonate reservoir. The well was drilled to a total depth of 16,300 feet in 4,400 feet of water, Anadarko said. (12/18, #9)
- India’s oil imports averaged 2.57 million b/d in November, up 6.3% from the same month of last year. (12/17, #15)
- Venezuela, site of the biggest refinery complex in the Americas, may process less oil as a drought reduces power generation, said the chief executive officer of Curim Capital Advisors LLC. The global market could lose 200,000 barrels a day, which would most likely affect heating oil, and China in particular. (12/17, #11)
- China’s crude stockpiles at the end of November are forecast to have fallen 1.3 percent from a month earlier, according to China Oil, Gas & Petrochemicals. (12/17, #12)
- Russian Energy Minister Sergei Shmatko said on Tuesday he expects no problems with Ukraine over gas supplies at New Year. (12/15, #20)
- Chinese President Hu and his counterparts from Turkmenistan, Kazakhstan and Uzbekistan jointly put into operation a natural gas pipeline linking the four nations. The 1,833-kilometer gas pipeline starts at the gas plant near a border town in Turkmenistan and runs through central Uzbekistan and southern Kazakhstan before entering China at the border pass of Horgos in the northwest region of Xinjiang. (12/14, #17)
- Range Resources Corp. said its net production from the Marcellus shale gas has reached a net 100 MMcfd of gas equivalent from the formation and forecast that to rise to 360-400 MMcfd of gas equivalent by yearend 2011. The current output figure is a fourfold increase since late 2008. (12/17, #16)
- The global edifice of cheap food rests on the volatility of a single input; the exponentially depleting supply of easy, cheap oil. (12/17, #18)
- The world's airlines are set to lose $5.6 billion next year, far more than previously estimated, with a rebound in passenger and air cargo demand only partly compensating for rising fuel costs. In its latest outlook, the International Air Transport Association reaffirmed its projection for an $11 billion loss in 2009. (12/15, #7)
- The Arab states have agreed to launch a single currency modeled on the euro, hoping to blaze a trail towards a pan-Arab monetary union. Saudi Arabia, Kuwait, Bahrain, and Qatar are to launch the first phase next year, creating a Gulf Monetary Council that will evolve quickly into a full-fledged central bank. (12/17, #9)
- In Ecuador, President Rafael Correa, already frowned upon by some investors for his 2008 bond default and the tough stance he has taken with international oil companies, faces a growing domestic challenge posed by power outages caused by droughts that are spreading across this Andean country. (12/15, #10)
- Nuclear Power Corp. of India, the nation’s monopoly atomic generator, plans to borrow as much as $6.5 billion to fund six new reactors as the second fastest- growing major economy grapples with power shortages. (12/17, #14)
- China is preparing to build three times as many nuclear power plants by 2020 as the rest of the world combined. China’s civilian nuclear power industry includes11 reactors operating and construction starting on as many as an additional 10 each year. (12/16, #11)
- Geothermal energy: the company in charge of a California project to extract vast amounts of renewable energy from deep, hot bedrock has removed its drill rig and informed federal officials that the government project will be abandoned. (12/14, #22)
(from energybulletin.net, December 21, 2009)
Saturday, December 26, 2009
"The insurance industry gets the biggest bonanza imaginable in the form of tens of millions of coerced new customers without any competition or other price controls."
Of all the posts I wrote this year, the one that produced the most vociferous email backlash -- easily -- was this one from August, which examined substantial evidence showing that, contrary to Obama's occasional public statements in support of a public option, the White House clearly intended from the start that the final health care reform bill would contain no such provision and was actively and privately participating in efforts to shape a final bill without it. From the start, assuaging the health insurance and pharmaceutical industries was a central preoccupation of the White House -- hence the deal negotiated in strict secrecy with Pharma to ban bulk price negotiations and drug reimportation, a blatant violation of both Obama's campaign positions on those issues and his promise to conduct all negotiations out in the open (on C-SPAN). Indeed, Democrats led the way yesterday in killing drug re-importation, which they endlessly claimed to support back when they couldn't pass it. The administration wants not only to prevent industry money from funding an anti-health-care-reform campaign, but also wants to ensure that the Democratic Party -- rather than the GOP -- will continue to be the prime recipient of industry largesse.
As was painfully predictable all along, the final bill will not have any form of public option, nor will it include the wildly popular expansion of Medicare coverage. Obama supporters are eager to depict the White House as nothing more than a helpless victim in all of this -- the President so deeply wanted a more progressive bill but was sadly thwarted in his noble efforts by those inhumane, corrupt Congressional "centrists." Right. The evidence was overwhelming from the start that the White House was not only indifferent, but opposed, to the provisions most important to progressives. The administration is getting the bill which they, more or less, wanted from the start -- the one that is a huge boon to the health insurance and pharmaceutical industry. And kudos to Russ Feingold for saying so:
Sen. Russ Feingold (D-Wis.), among the most vocal supporters of the public option, said it would be unfair to blame Lieberman for its apparent demise. Feingold said that responsibility ultimately rests with President Barack Obama and he could have insisted on a higher standard for the legislation.
"This bill appears to be legislation that the president wanted in the first place, so I don’t think focusing it on Lieberman really hits the truth," said Feingold. "I think they could have been higher. I certainly think a stronger bill would have been better in every respect."
Let's repeat that: "This bill appears to be legislation that the president wanted in the first place." Indeed it does. There are rational, practical reasons why that might be so. If you're interested in preserving and expanding political power, then, all other things being equal, it's better to have the pharmaceutical and health insurance industry on your side than opposed to you. Or perhaps they calculated from the start that this was the best bill they could get. The wisdom of that rationale can be debated, but depicting Obama as the impotent progressive victim here of recalcitrant, corrupt centrists is really too much to bear.
Yet numerous Obama defenders -- such as Matt Yglesias, Ezra Klein and Steve Benen -- have been insisting that there is just nothing the White House could have done and all of this shows that our political system is tragically "ungovernable." After all, Congress is a separate branch of government, Obama doesn't have a vote, and 60 votes are needed to do anything. How is it his fault if centrist Senators won't support what he wants to do? Apparently, this is the type of conversation we're to believe takes place in the Oval Office:
The President: I really want a public option and Medicare buy-in. What can we do to get it?
Rahm Emanuel: Unfortunately, nothing. We can just sit by and hope, but you're not in Congress any more and you don't have a vote. They're a separate branch of government and we have to respect that.
The President: So we have no role to play in what the Democratic Congress does?
Emanuel: No. Members of Congress make up their own minds and there's just nothing we can do to influence or pressure them.
The President: Gosh, that's too bad. Let's just keep our fingers crossed and see what happens then.
In an ideal world, Congress would be -- and should be -- an autonomous branch of government, exercising judgment independent of the White House's influence, but that's not the world we live in. Does anyone actually believe that Rahm Emanuel (who built his career on industry support for the Party and jamming "centrist" bills through Congress with the support of Blue Dogs) and Barack Obama (who attached himself to Joe Lieberman when arriving in the Senate, repeatedly proved himself receptive to "centrist" compromises, had a campaign funded by corporate interests, and is now the leader of a vast funding and political infrastructure) were the helpless victims of those same forces? Engineering these sorts of "centrist," industry-serving compromises has been the modus operandi of both Obama and, especially, Emanuel.
Indeed, we've seen before what the White House can do -- and does do -- when they actually care about pressuring members of Congress to support something they genuinely want passed. When FDL and other liberal blogs led an effort to defeat Obama's war funding bill back in June, the White House became desperate for votes, and here is what they apparently did (though they deny it):
The White House is playing hardball with Democrats who intend to vote against the supplemental war spending bill, threatening freshmen who oppose it that they won't get help with reelection and will be cut off from the White House, Rep. Lynn Woolsey (D-Calif.) said Friday. "We're not going to help you. You'll never hear from us again," Woolsey said the White House is telling freshmen.
That's what the White House can do when they actually care about pressuring someone to vote the way they want. Why didn't they do any of that to the "centrists" who were supposedly obstructing what they wanted on health care? Why didn't they tell Blanche Lincoln -- in a desperate fight for her political life -- that she would "never hear from them again," and would lose DNC and other Democratic institutional support, if she filibustered the public option? Why haven't they threatened to remove Joe Lieberman's cherished Homeland Security Chairmanship if he's been sabotaging the President's agenda? Why hasn't the President been rhetorically pressuring Senators to support the public option and Medicare buy-in, or taking any of the other steps outlined here by Adam Green? There's no guarantee that it would have worked -- Obama is not omnipotent and he can't always control Congressional outcomes -- but the lack of any such efforts is extremely telling about what the White House really wanted here.
Independent of the reasonable debate over whether this bill is a marginal improvement over the status quo, there are truly horrible elements to it. Two of the most popular provisions (both of which, not coincidentally, were highly adverse to industry interests) -- the public option and Medicare expansion -- are stripped out (a new Washington Post/ABC poll out today shows that the public favors expansion of Medicare to age 55 by a 30-point margin). What remains is a politically disastrous and highly coercive "mandate" gift to the health insurance industry, described perfectly by Digby:
Obama can say that you're getting a lot, but also saying that it "covers everyone," as if there's a big new benefit is a big stretch. Nothing will have changed on that count except changing the law to force people to buy private insurance if they don't get it from their employer. I guess you can call that progressive, but that doesn't make it so. In fact, mandating that all people pay money to a private interest isn't even conservative, free market or otherwise. It's some kind of weird corporatism that's very hard to square with the common good philosophy that Democrats supposedly espouse.
Nobody's "getting covered" here. After all, people are already "free" to buy private insurance and one must assume they have reasons for not doing it already. Whether those reasons are good or bad won't make a difference when they are suddenly forced to write big checks to Aetna or Blue Cross that they previously had decided they couldn't or didn't want to write. Indeed, it actually looks like the worst caricature of liberals: taking people's money against their will, saying it's for their own good --- and doing it without even the cover that FDR wisely insisted upon with social security, by having it withdrawn from paychecks. People don't miss the money as much when they never see it.
In essence, this reinforces all of the worst dynamics of Washington. The insurance industry gets the biggest bonanza imaginable in the form of tens of millions of coerced new customers without any competition or other price controls. Progressive opinion-makers, as always, signaled that they can and should be ignored (don't worry about us -- we're announcing in advance that we'll support whatever you feed us no matter how little it contains of what we want and will never exercise raw political power to get what we want; make sure those other people are happy but ignore us). Most of this was negotiated and effectuated in complete secrecy, in the sleazy sewers populated by lobbyists, industry insiders, and their wholly-owned pawns in the Congress. And highly unpopular, industry-serving legislation is passed off as "centrist," the noblest Beltway value.
Looked at from the narrow lens of health care policy, there is a reasonable debate to be had among reform advocates over whether this bill is a net benefit or a net harm. But the idea that the White House did what it could to ensure the inclusion of progressive provisions -- or that they were powerless to do anything about it -- is absurd on its face. Whatever else is true, the overwhelming evidence points to exactly what Sen. Feingold said yesterday: "This bill appears to be legislation that the president wanted in the first place."
UPDATE: It's also worth noting how completely antithetical claims are advanced to defend and excuse Obama. We've long heard -- from the most blindly loyal cheerleaders and from Emanuel himself -- that progressives should place their trust in the Obama White House to get this done the right way, that he's playing 11-dimensional chess when everyone else is playing checkers, that Obama is the Long Game Master who will always win. Then, when a bad bill is produced, the exact opposite claim is hauled out: it's not his fault because he's totally powerless, has nothing to do with this, and couldn't possibly have altered the outcome. From his defenders, he's instantaneously transformed from 11-dimensional chess Master to impotent, victimized bystander.
The supreme goal is to shield him from all blame. What gets said to accomplish that goal can -- and does -- radically change from day to day.
UPDATE II: I'll be on MSNBC this afternoon at 3:00 p.m. EST with David Shuster/Tamron Hall discussing this post.
UPDATE III: Over at Politico, Jane Hamsher documents how Joe Lieberman's conduct on the health care bill provides the perfect vehicle to advance the agenda of the White House and Harry Reid. Consistent with that, she independently notes media reports that White House officials are privately expressing extreme irritation with Howard Dean for opposing the Senate bill as insufficient, but have nothing bad to say about Lieberman, who supposedly single-handedly sabotaged what the White House was hoping for in this bill.
UPDATE IV: Immediately prior to the MSNBC segment I just did -- video for which I will post when it's available -- an NBC reporter explained how Robert Gibbs used his Press Briefing today to harshly criticize Howard Dean for opposing the health care bill. Why did Gibbs never publicly criticize people like Blanche Lincoln, Ben Nelson, Joe Lieberman and the like if they were supposedly obstructing and impeding the White House's agenda on health care reform (this is a point Yglesias acknowledges as a "fair" one)? Having a Democratic White House publicly criticize a Democratic Senator can be a much more effective pressure tactic than doing so against a former Governor who no longer holds office.
Meanwhile, as one would expect, health insurance stocks are soaring today in response to the industry-serving "health care reform" bill backed by the Democratic Senate and White House -- the same people who began advocating for "health care reform" based on the need to restrain on an out-of-control and profit-inflated health insurance industry (h/t Markos).
UPDATE V: Here's the roughly 4-minute segment I did with David Shuster today:
(from salon.com, December 16, 2009)
How to Stop Iran. The West has reached a defining moment in its bid to prevent the rogue state from going nuclear.
The lack of progress in negotiations with Iran, together with the latest report from the International Atomic Energy Agency and Iran's announcement that it would develop new enrichment facilities, all point toward an inconvenient truth: Iran is not only not serious about negotiating in good faith. It is also very likely that it has, for more than a decade now, concealed a significant part of what appears to be a major nuclear military effort. This week's revelations about Iran's recent work on warhead design underscore the point. No country has ever gone so far along the road toward the acquisition of a nuclear military capability without actually developing one.
Iran could well stop at the threshold of such capability, letting it be known to all specialists that it has a military capability without openly deploying it. This would still leave it uncertain, in the eyes of the public, whether it really has an effective nuclear arsenal. But this would not change much in practical terms. Western decision makers are now at a defining moment.
Politically, no Israeli prime minister could survive the fact that Iran became a nuclear-armed state, officially or unofficially, on his watch. The pressure on the Israeli government to do something to counter Iran's acquisition of nuclear weapons would be so strong that it could well be tempted to play a desperate gamble, regardless of any security guaranties that the U.S. might offer.
Similarly, no U.S. president (especially one endowed with a Nobel Prize) could escape blame for having let Iran become a nuclear-weapon state by consistently underestimating its ability to conceal its preparations. The intelligence community's credibility would be devastated, and the indecision by successive administrations (Clinton, Bush and now Obama) to quash a program that has been suspected for 15 years and openly known for seven would be seen as a failure of major proportions.
What's more, the message sent to all U.S. and Western allies in the Gulf region would be dire. For all the promises made to these allies, the West has been unable to prevent a rogue state—one intent on destabilizing their societies, the strategic balance in the Middle East and beyond, and the oil market—from acquiring nuclear weapons that will make it much more difficult to compel it to behave prudently.
Last but not least, the nuclear non-proliferation regime, which has been significantly weakened by the North Korean antics and the Iranian finessing, would be close to collapse: If Iran has nukes, the temptation for countries such as Saudi Arabia, the United Arab Emirates, and Turkey, among others, to equip themselves with such weapons would be almost irresistible. The 2010 review conference of the Nuclear Non-Proliferation Treaty would be rendered a feckless pantomime, with almost as little effect as those aimed, between the two world wars, at preventing armed conflict.
It is now necessary, therefore, to plan for the worst—some form of military constraint upon Iran. It is urgent that the U.S., Great Britain and France, together with Israel if possible (in a discreet and deniable way, of course), gather and try to reach agreement on how to terminate the Iranian nuclear program militarily. Those three permanent members of the U.N. Security Council should not be cowed by the argument—which has already been deployed repeatedly by Iranian advocates and idiots utiles—that such an endeavor would be akin to pitching "the West against the rest." They would actually be exercising an implicit mandate on behalf of all the states that have renounced nuclear weapons and do not accept being threatened and bullied by rogues.
How could this be done? The experience of the 1962 Cuban crisis provides an interesting precedent. Applying pressure on the Iranians by interdicting any imports or exports to and from Iran by sea and by air would send a message that would undoubtedly be perceived as demonstrative by Tehran. Additionally, reinforcing the Western naval presence inside or immediately outside the Gulf would make it clear to the Iranians, without infringing on their territorial waters, that they (and all states dealing with them) are entering a danger zone. In parallel to this slow strangulation, measures should be taken to deter Gulf states (such as Dubai) from engaging in any trade or financial transactions with Iran and to encourage them to freeze Iranian assets in their banks. This should not be too difficult, as the threat of disconnecting any renegade from the Swift system would be sufficiently persuasive in the current circumstances, in which Dubai sorely needs international financial assistance.
It might be necessary to go beyond that and actually resort to force to prevent the Iranians from achieving nuclear military capabilities. Planning for a massive air and missile attack on Iran's nuclear facilities (known and suspected) should be considered seriously, and this planning made public (at least partially) to convince Iran that the West can not only talk the talk, but also walk the walk. Such planning should also, to the extent possible, involve NATO, against the territory of which there is little doubt that the majority of Iranian missiles and nuclear weapons would be targeted (if only because they cannot yet reach the U.S.). The U.S., U.K., French and Israeli intelligence services should better co-ordinate what they know, and contributions from others should also be welcome, as well as any information that could be provided by internal opposition movements in Iran.
The idea here is simple, and has been expressed many times by theoreticians of deterrence: When one plans for war, when one deploys forces and rehearses military options, one actually conveys a message. Deterrence is about dialogue. Whether the Iranian government would listen to it is uncertain. But at least it would have been properly warned.
The time for diplomacy has passed. Iran must cave in, and quickly. If the West is not prepared to force it to comply with its commitments under the Nuclear Non-Proliferation Treaty, this in effect means that the treaty is dead and that the Gulf countries are being abandoned—stealthily, but nonetheless very definitely. It also means that the non-proliferation regime is, for all practical purposes, dead. Is this really what we want?
Mr. Debouzy is a lawyer and a former specialist in nuclear military affairs and intelligence for the French government. He writes here in a strictly personal capacity.
(from WSJ, December 16, 2009)
(From TheAlexJonesChannel, December 3, 2009)
Dec. 18 (Bloomberg) -- Anne Phillips Ogilby, a bond attorney at one of Boston’s oldest law firms, on Oct. 31 last year relayed an urgent message from Harvard University, her client and alma mater, to the head of a Massachusetts state agency that sells bonds. The oldest and richest academic institution in America needed help getting a loan right away.
As vanishing credit spurred the government-led rescue of dozens of financial institutions, Harvard was so strapped for cash that it asked Massachusetts for fast-track approval to borrow $2.5 billion. Almost $500 million was used within days to exit agreements known as interest-rate swaps that Harvard had entered to finance expansion in Allston, across the Charles River from its main campus in Cambridge, Massachusetts.
The swaps, which assumed that interest rates would rise, proved so toxic that the 373-year-old institution agreed to pay banks a total of almost $1 billion to terminate them. Most of the wrong-way bets were made in 2004, when Lawrence Summers, now President Barack Obama’s economic adviser, led the university. Cranes were recently removed from the construction site of a $1 billion science center that was to be the expansion’s centerpiece, a reminder of Summers’s ambition. The school said last week they will suspend work on the building early next year.
“For nonprofits, this is going to be written up as a case study of what not to do,” said Mark Williams, a finance professor at Boston University, who specializes in risk management and has studied Harvard’s finances. “Harvard throws itself out as a beacon of what to do in higher learning. Clearly, there have been major missteps.”
Harvard panicked, paying a penalty to get out of the swaps at the worst possible time. While the university’s misfortunes were repeated across the country last year, with nonprofits, municipalities and school districts spending billions of dollars on money-losing swaps, Harvard’s losses dwarfed those of other borrowers because of the size of its bet and the length of time before all its bonds would be sold.
In December 2004, Harvard completed agreements that locked in interest rates on $2.3 billion of bonds for future construction in Allston, with plans to borrow $1.8 billion in 2008 after they broke ground and the remaining $500 million through 2020. At the time, the benchmark overnight interest rate set by the U.S. Federal Reserve was 2.25 percent. The agreements backfired last year after central banks slashed lending rates to zero and the value of the contracts plunged, forcing the school to set aside cash.
Borrowers use swaps to match the type of interest rates on their debt with the rates on their income, which can help reduce borrowing costs. Lenders and speculators use swaps to profit from changes in the direction of interest rates. A bet on higher rates, for example, means paying fixed rates and receiving variable. At Harvard, nobody anticipated some interest rates going to zero, making the university’s financing a speculative disaster.
Harvard’s woes stemmed from misunderstanding its role, said Leon Botstein, president of Bard College in Annandale-on-Hudson, New York.
“We shouldn’t be in the banking business, we should be in the education business,” Botstein said in a telephone interview.
The financing plan using the swaps was developed by the university’s financial team and discussed with the Debt Asset Management Committee, an oversight group, according to James Rothenberg, a member of the President and Fellows of Harvard College, or Harvard Corp., and the school’s treasurer, a board position.
The swaps plan was then approved by Harvard Corp. and implemented and monitored by the financial team, Rothenberg said in an e-mail.
Summers, who left Harvard in 2006, declined to comment. As president and as a member of the Harvard Corp., the university’s seven-member ruling body, Summers approved the decision to use the swaps.
The strategy made sense in the economic climate of the time, Rothenberg said in another e-mail. Rothenberg is chairman of Capital Research & Management Co., the investment advisory unit of Capital Group Cos. in Los Angeles.
“Rates were at then-historic lows, and the university was contemplating a major, multibillion-dollar campus expansion,” Rothenberg said. “In that context, locking in our financing costs so that we would achieve some budgetary certainty had definite advantages.”
Harvard’s failed bet helped plunge the school into a liquidity crisis in late 2008. Concerned that its losses might worsen, the school borrowed money to terminate the swaps at the nadir of their value, only to see the market for such agreements begin to recover weeks later.
Harvard would have avoided paying the costs of its swap obligations by waiting. Its banks, including JPMorgan Chase & Co., headed by James Dimon, were demanding cash collateral payments -- ultimately totaling almost $1 billion -- that Harvard in 2004 had agreed to pay if the value of the swaps fell. At least $1.8 billion of the swaps the school held were with JPMorgan, said a person familiar with the agreements. Dimon, a 1982 Harvard Business School alumnus, declined to comment on the agreements through a spokeswoman, Jennifer Zuccarelli.
Drew Faust, Harvard’s president since 2007, said in an interview about the financial crisis she experienced some of her darkest days as she watched the collapse of U.S. markets that deepened the school’s losses.
“Someone would say that this happened, that had happened, they were going to bail out AIG or Lehman is failing,” Faust recalled in an interview, referring to the September 2008 bankruptcy of Lehman Brothers Holdings Inc. in New York and the subsequent government bailout of American International Group Inc. in New York. “We were wondering what was going to happen tomorrow.”
Harvard speculated in the swap market as early as 1994, according to rating companies’ reports. Under Jack Meyer, former chief executive of Harvard Management Co., the school’s endowment used swaps to profit from interest-rate changes. The university also used them to fix borrowing costs for capital projects.
Summers became president in July 2001, after serving as U.S. Treasury Secretary. He earned a Ph.D. in economics from Harvard, and became a tenured professor there at age 28. He served from 1991 to 1993 as chief economist at the World Bank, which initiated the first interest-rate swap with International Business Machines Corp. in 1981.
In the 1990s, Harvard began amassing 220 acres (89 hectares) for construction near Harvard Business School and its football stadium, located in Allston. In June 2005, Summers unveiled his vision for a campus expansion replete with new laboratories, dormitories and classrooms, renovated bridges and a pedestrian tunnel beneath the water. The Allston project was to transform an industrial and working-class neighborhood of two-family wood homes and small shops by building two 500,000- square-foot (46,000-square-meter) science complexes and a redrawn street grid.
Harvard was flush at the time, with an endowment of $22.6 billion that had returned an average of 16 percent during the previous 10 fiscal years. Summers told Faculty of Arts & Sciences professors in May 2004 that he hoped they wouldn’t be “preoccupied with the constraints imposed by resources, for Harvard was fortunate to have many deeply loyal friends,” according to minutes of a faculty meeting.
“Harvard would be able to generate adequate resources,” according to the minutes. “The only real limitation faced by the Faculty was the limit of its imagination.”
When the plan was made public in 2005, Harvard’s financial team had been busy for more than a year behind the scenes, devising a financing strategy for the project using interest- rate swaps. These derivatives enable borrowers to exchange their periodic interest payments. They typically involve the exchange of variable-rate payments on a set amount of money for another borrower’s fixed-rate payments.
In 2004, Harvard used swaps for $2.3 billion it planned to start borrowing four years later. The AAA-rated school would have paid an annual average rate of 4.72 percent if it had borrowed all the money for 30 years in December 2004, according to data from Municipal Market Advisors. The swaps let it secure a similar rate for bonds it planned to sell as it constructed the campus expansion during the next two decades.
The agreements were so-called forward swaps, providing a fixed rate before the bonds were actually sold. Harvard was betting in 2004 that interest rates would rise by the time it needed to borrow. The school was also assuming the expansion would proceed on the schedule set by Summers and his advisers.
While the university could have paid banks for options on the borrowing rates, the swaps required no money up front.
That time frame, along with the size of the position, was unusual, said Peter Shapiro, an adviser at Swap Financial Group Inc. in South Orange, New Jersey.
“There have been lots of forward swaps, but out longer than three years is relatively rare,” Shapiro said in a telephone interview. That duration increases the risk, because the longer the term of the contract, the more volatile the value of the swap, he said.
Columbia University is breaking ground on a $6.5 billion expansion in New York City, and last year used an interest-rate swap for its borrowing of $113 million of bonds sold seven months later. Yale University in New Haven, Connecticut, is also AAA-rated. It had 32 separate swap agreements totaling $975 million as of Oct. 31, hedging the school’s $1.4 billion variable rate debt and commercial paper, according to Moody’s Investors Service Inc.
Corporations might use derivatives to lower their borrowing costs as many as four years before a bond sale, according to bankers who sell derivatives. Anadarko Petroleum Corp. used the swap market in December 2008 and January 2009 to secure rates for $3 billion it plans to refinance in October 2011 and October 2012, according to the Houston, Texas-based company’s third- quarter report from Nov. 3. Matt Carmichael, a company spokesman, declined to comment.
Rothenberg, a Harvard College and Harvard Business School graduate, said he was among the key players involved in developing the financing strategy. His Los Angeles-based company, Capital Group, operates American Funds, the second- biggest family of stock and bond mutual funds in the U.S. He had been Harvard’s treasurer for six months when the school arranged the Allston swaps in December 2004.
Ann Berman, Harvard’s chief financial officer at the time, also played a role in developing the plan, Rothenberg said. Berman declined to be interviewed. She stepped down in 2006 when she was named an adviser to the president, according to the school’s Web site. A certified public accountant, Berman got her master’s in business administration at the University of Pennsylvania’s Wharton School of Business in Philadelphia and had earlier served as a financial planner and adviser for Harvard’s dean of the Faculty of Arts & Sciences.
Other members of Harvard Corp. in 2004 and 2005, who served with Summers and Rothenberg, were former U.S. Treasury Secretary Robert Rubin, Summers’s previous boss and predecessor at the U.S. Treasury, who was an instrumental supporter of his bid for the Harvard presidency; Robert D. Reischauer, former director of the Congressional Budget Office, who was a colleague of Summers and Rubin’s in Washington; Conrad K. Harper, a lawyer at Simpson Thacher & Bartlett LLP in New York; Hanna Gray, former president of the University of Chicago; and James R. Houghton, chairman of Corning Inc., the world’s biggest maker of glass for flat-panel televisions, in Corning, New York.
All except Rothenberg declined to comment or didn’t return telephone calls.
Harvard University’s finance staff worked with JPMorgan to develop the size and the length of the forward-swap agreements, said a person familiar with the contracts. Final negotiations to set the rates were left to Harvard Management, which oversees the endowment, because it had swap contracts in place with JPMorgan dating back to 1996 that set terms for the agreements, according to a copy of the agreement obtained by Bloomberg News.
The original swap contract between Harvard Management and JPMorgan was approved by Michael Pradko, the endowment’s risk manager, the copy shows. Pradko left Harvard Management in 2005, along with Jack Meyer, the endowment’s head, to join Convexity Capital Management LP in Boston, the hedge fund Meyer started. Pradko declined to comment.
When Harvard Management completed its swap contracts for the school, the timing was encouraging. U.S. Federal Reserve Chairman Alan Greenspan had just begun raising the overnight target rate as the economy rebounded from the bursting of the technology bubble. In the second half of 2004, he lifted it to 2.25 percent from 1 percent.
For more than 20 years, investment banks such as Goldman Sachs Group Inc., JPMorgan, and Citigroup Inc., all based in New York, have been selling swaps as a way for schools, towns and nonprofits to reduce interest costs and protect against rising interest payments on variable-rate debt. The swap agreements can be terminated if either the bank or the issuer is willing to pay a fee, which varies with interest rates.
“Swaps have become widely accepted by the rating agencies as an appropriate financial tool,” according to a slide entitled “Swaps Can Be Beneficial” that was used in a 2007 Citigroup presentation to the Florida Government Finance Officers Association. Debt issuers can “easily unwind the swap for a market-based termination payment/receipt,” the slide said.
Rothenberg said officials throughout Harvard were monitoring the school’s swap position, including members of the financial office, the budget office, the controller’s office and Harvard Management. Although the contracts required Harvard to post collateral, or set aside cash when the values reached certain thresholds, such provisions weren’t unusual, Rothenberg said.
“I think there are lots of swaps with collateral postings,” Rothenberg said in an interview. “From fiscal years 2005 through 2008, these swaps were in place and there were collateral postings. It was not a pressing concern for the University, even though you can look at the financial statements and see that there was at least an unrealized loss in certain years.”
“I think the unusual nature of these swaps were two things,” Rothenberg said. “One, they were large, but the anticipated capital spending program was large; and two, they were longer-dated than most people are used to thinking about, because the capital spending program was expected to last over a number of years. The problem resulted from the rapid meltdown in the markets, which culminated in November when short-term interest rates and swaps rates collapsed.”
After credit markets seized up in 2007, central banks worldwide pushed some bank lending rates to zero in their effort to rescue the financial system.
While Harvard Corp. is ultimately responsible for the school’s financial decisions, the losses sustained by the school in almost every financial domain -- the endowment, cash account and swaps -- suggest that oversight was lax, said Harry Lewis, a Harvard alumnus, computer science professor and former dean of Harvard College.
Harvard not only lost money on the swaps last year. The value of its endowment tumbled a record 30 percent to $26 billion from its peak of $36.9 billion in June 2008, and its cash account lost $1.8 billion, according to Harvard’s most recent annual report.
“They have a structural problem,” Lewis said in a telephone interview. “There’s something systemically wrong with Harvard Corp. It’s too small, too secretive, too closed and not supported by enough eyeballs looking at the risks they are taking.”
Summers’s departure as president came in 2006, after he questioned women’s innate aptitude for math and science. Summers apologized formally and repeatedly for the remarks made in a speech, which he said were misconstrued, and the school said it would spend $50 million to help women succeed in science and engineering. He resigned after the faculty passed a no- confidence motion against him.
That left Faust, the Civil War historian and prize-winning author who succeeded Summers as president in July 2007, to manage the Allston plans. Faust committed to its first phase: beginning construction of a $1 billion science center that would house researchers from the Harvard Stem Cell Institute, the Harvard School of Public Health and the Wyss Institute for Biologically Inspired Engineering.
By June 2005, the value of the swaps tied to Harvard’s debt was negative $460.8 million, meaning that’s how much it would have to pay the banks to terminate the agreements, according to the school’s annual report that year.
By 2008, Harvard had 19 swap contracts on $3.5 billion of debt with JPMorgan, Goldman Sachs, New York-based Morgan Stanley, and Charlotte, North Carolina-based Bank of America Corp., including the swaps for Allston, according to a bond- ratings report by Standard & Poor’s released on Jan. 18, 2008.
The swaps became a financial burden last year as their value fell and collateral postings rose. In a contract with Goldman Sachs, the school agreed to post cash if the swaps’ value fell below $5 million, according to a copy obtained by Bloomberg News. The collateral postings with the banks approached $1 billion late last year as central banks slashed their target rates, according to people familiar with the situation.
Harvard wasn’t alone in being forced to set aside cash last year to meet such margin calls. The difference was the scale.
Cornell University in Ithaca, New York, posted $38 million of collateral on $1.5 billion of swaps, according to a Moody’s report on the Ivy League School. Hanover, New Hampshire-based Dartmouth College, also in the Ivy League, didn’t post collateral on their swaps because their investment banks agreed to waive the requirement to win the business, according to a person familiar with the contracts. The Ivy League is a group of eight elite schools in the northeast U.S., including Harvard.
After a year during which central banks provided an unprecedented amount of money to rescue financial institutions, the credit markets unraveled along with the stock market in September 2008. Lehman Brothers filed the largest bankruptcy in history on Sept. 15. Two weeks later, the House of Representatives rejected a $700 billion bailout plan, sending the Dow Jones Industrial Average down 778 points, its biggest point drop ever.
The value of Harvard’s swaps plunged and its need for cash soared. Under contracts signed in 2004, Harvard had to post larger and larger amounts of collateral to cover the negative value of the swaps; the total amount would approach $1 billion.
At the same time, the usual sources the university relied on to generate cash -- the endowment and its operating cash account -- were hemorrhaging. The school’s endowment tumbled, losing 22 percent from July 2008 through October 2008.
The Harvard endowment had more than 50 percent of its assets allocated to private equity, hedge funds and other hard- to-sell assets. The university already had borrowed to amplify gains, with leverage targeted at 3 percent of assets as of last year. When Jane Mendillo took over as chief executive officer of Harvard Management on July 1 last year, one of her top priorities was to raise cash. The school couldn’t get acceptable prices from the $1.5 billion of private equity stakes Mendillo tried to sell.
Outside managers investing Harvard’s endowment were either performing poorly or preventing Harvard from withdrawing cash. Citigroup CEO Vikram Pandit shut down Old Lane Partners in June 2008. Ospraie Management, in New York, closed its biggest hedge fund in September and Farallon Capital Management, in San Francisco, put up a so-called gate, prohibiting clients from taking out cash.
Making matters worse, Harvard disclosed Oct. 16 that its checkbook fund, the general operating account, lost $1.8 billion in the year ended June 30. Lumping the cash account with the endowment was risky, said Louis Morrell, who managed the endowment for Radcliffe College, which is part of Harvard, until 1990.
“They put the operating funds in the endowment --it’s like the guy who has his retirement income in company stock,” said Morrell, who is also the former treasurer of Wake Forest University in Winston-Salem, North Carolina.
Rothenberg, Mendillo and Daniel Shore, Harvard’s chief financial officer, decided last year as the credit crisis deepened that the school needed to borrow money. Shore became acting CFO last year after Elizabeth Mora, who was Berman’s successor, stepped down in May 2008. Shore was named to the position permanently in October 2008.
It was at this point, in October, that Harvard officials contacted Ogilby, their bond lawyer at Ropes & Gray LLP in Boston. A 1980 Harvard College graduate, Ogilby is head of the firm’s Public Finance Group. E-mails show that Craig McCurley, the director of Harvard’s treasury management office, and his associate director, Tom Balish, contacted Ogilby, who in turn reached out to the Massachusetts Health & Educational Facilities Authority, which sells bonds for the state’s nonprofits. Ogilby declined to comment.
Harvard needed cash to pay bills, refinance outstanding debt and break its money-losing swap agreements, according to a series of e-mails beginning on Oct. 31 last year between Ogilby and staff members of the state authority that were obtained by Bloomberg News. School officials asked whether the agency could omit from a public hearing that some of the bonds would finance swap termination payments.
“There is some sensitivity at Harvard about not specifically flagging the swap interest unwind payments,” Ogilby wrote on Nov. 12 to Deborah Boyce, an analyst at the authority. “They still would like the ability to finance them, but would prefer to delete those references if they can do so.”
Benson Caswell, the bond authority’s executive director responded Nov. 13 that the swap agreements would have to be identified and that the authority needed “timely, accurate and unfiltered information, including a balanced presentation,” from issuers. Harvard disclosed the use of the bond proceeds, and only wanted to avoid telegraphing potential activity in the swap market, said Christine Heenan, a school spokeswoman.
“The spirit of our inquiry was whether prematurely disclosing plans for what are inherently market transactions would in any way jeopardize the execution of those transactions,” she said in an e-mail.
At its Nov. 13 monthly meeting in Boston’s financial district, the agency’s seven-member board approved a Harvard bond issue of up to $2.5 billion, about the amount of debt it sells for all schools and borrowers in a typical year. The board usually takes two meetings to approve a bond sale. In Harvard’s case it took just one meeting.
“I can assure you that Harvard doesn’t get any special treatment,” Caswell said. “Other borrowers have received the same service.”
Caswell said one board member, Marvin Gordon, is a Harvard graduate and that as long as there is no conflict of interest between his business and the use of the bond proceeds, a board member may vote on approval of a bond sale.
Gordon said while he didn’t have a conflict in voting to approve Harvard’s bond issue, “they never should have been in the position where they had to get out” of the swaps.
Harvard unwound the swaps at possibly the worst moment in the history of financial markets, said Shapiro, the municipal swap adviser. Just as Harvard’s request for approval to sell tax-exempt bonds arrived in the state offices, the swap market began sliding, according to Bloomberg data. While the school waited for permission to raise money, the price to break the swap agreements escalated.
On Nov. 13, the index used to value the agreements, the U.S. dollar 30-year swap rate, closed at 4.247 percent. By the time Harvard held its bond sale Dec. 8, the swap index had tumbled to 2.7575 percent. Harvard exited three of its swaps tied to $431 million debt on Dec. 9, when the benchmark fell again to 2.6885 percent. The interest-rate swap market reached a record low of 2.363 percent on Dec. 18.
Harvard’s decision to borrow money came at a time when the difference, or spread, between yields on corporate and U.S. Treasury securities was the widest since at least 1990, according to data from Barclays Plc. That meant AAA-rated Harvard was selling bonds when the market was demanding the biggest premium in at least 18 years.
“December 2008 was, by an enormous amount, the worst time in history” to terminate the swaps by borrowing money, said Shapiro.
Harvard sold $1.5 billion of taxable and $1 billion of tax- exempt bonds, using $497.6 million of the proceeds to pay investment banks to extract itself from $1.1 billion of interest-rate swaps, according to its annual report released Oct. 16. Separately, the school agreed to pay another $425 million over 30 years to 40 years to the banks to terminate an additional $764 million of the swaps, Harvard’s Shore said.
The school on Dec. 12 paid JPMorgan $34.5 million from the tax-exempt bond proceeds to unwind a swap tied to $205.9 million of variable-rate bonds it sold for capital projects, according to documents obtained from the Massachusetts financing authority. It also paid Goldman Sachs $41.6 million on Dec. 9 and $23.2 million on Dec. 11 to end agreements on another $226.8 million of existing debt. Harvard didn’t disclose recipients of the other termination payments because it paid them from the taxable bonds.
The timing was “less than ideal, but the surrounding context was less than ideal as well,” said Shore.
Harvard and JPMorgan celebrated the bond issue by hosting a cocktails-and-dinner party at the French restaurant Mistral, in Boston’s South End neighborhood, where appetizers start at $15 and entrees cost about $40, according to e-mails obtained from the state finance agency. JPMorgan invoiced the agency $388.78 for three employees who attended: Caswell, Marietta Joseph and Danielle Manning.
Since then, some of the values in the swap market have recovered to their levels of December 2004 when Harvard signed the forward contracts.
“If Harvard had waited, the cost of terminating may well have been lower, but they weren’t willing to take that risk,” said Matt Fabian, managing director at Municipal Market Advisors in Westport, Connecticut.
Shore said that he, Mendillo and “a lot of us in senior management” contributed to the decision to break the swap agreements. That group included Ed Forst, the former executive vice president, who returned to Goldman Sachs after less than a year at Harvard, Shore said. Shore also cited Harvard Corp.’s role as bearing the school’s ultimate fiduciary responsibility. Forst didn’t return calls seeking comment.
Waiting didn’t appear to be an option at the time, Shore said.
“In evaluating our liquidity position, we wanted to get ourselves some stability and some safety,” he said in an Oct. 16 interview this year at Harvard. “It was to take the losses now rather than run the risk of having further losses if we continued to hold on to the positions.”
No one expected the indexes used for valuing swaps to fall as fast and as much as they did, said Chris Cowen, managing director of Prager, Sealy & Co. in San Francisco.
“What we ended up with was an outlier event,” said Cowen, who advised Harvard as it unwound its position last year. “I was taken by surprise by the falling rates.”
Harvard, in the meantime, has cut its capital spending estimate for the next four years in half to about $2 billion. Before the credit crisis, it planned on spending $10 billion over a decade on capital projects, including Allston. Faust is building a team to study “financially and structurally” how Harvard can expand, she said in an e-mail announcing the planned work stoppage in Allston.
Summers, along with Rubin and Greenspan opposed the U.S. Commodity Futures Trading Commission’s attempt in 1998 to regulate so-called over-the-counter derivatives, which included agreements like interest rate swaps. At the time, Summers was Rubin’s deputy secretary.
Now Summers is leading the Obama administration’s effort to write stricter rules for the derivatives market “to protect the American people,” he said in October at a conference in New York sponsored by The Economist magazine.
Universities would have been better served if they had stayed away from the more complicated financial instruments being sold by Wall Street, said David Kaiser, a Harvard class of 1969 alumnus who has been critical of the high salaries paid to managers of the school’s endowment.
“They used many of the investment strategies of the big banks and hedge funds, and when things went badly they could not get a bailout,” said Kaiser, a history professor at the U.S. Naval War College in Newport, Rhode Island. “It would clearly be better for any nonprofit on whom many people depend to pursue safer, more stable strategies.”
Pennsylvania State Auditor General Jack Wagner said Nov. 18 that the state should ban local governments from entering into derivative contracts tied to bond issues, a practice he termed “gambling” with taxpayer funds.
Harvard might have considered it a conservative step to lock in rates when they were low, said Shapiro, the New Jersey- based swap adviser.
“You can be very big and very rich and very smart and still get things wrong,” Shapiro said.
(from Bloomberg, December 18, 2009)