Even the philanthropists are sending money overseas!

The University of St Andrews in Scotland has named its new GBP40m (RM210m) medical school the B.C. Sekhar School of Medicine, after Tan Sri Dr B.C. Sekhar, a former chairman of the Rubber Research Institute of Malaysia, reported the New Straits Times on 20 Nov.

Sekhar's youngest son Datuk Vinod Sekhar reportedly said his father loved creating solutions for problems that ailed the world. "This is what the School of Medicine and Science is about. It's a school that has a fully integrated scientific approach to research which will allow for faster solutions to be created," he said.

Here’s a point to ponder: Why did the Sekhars choose to spend their largesse in Scotland and not at home here in Malaysia? First, it was businessmen going overseas – the likes of Maybank, Telekom, Astro, Maxis, Genting, IOI and YTL Corp, for example. Remember Malaysia was the only ASEAN country to experience net capital outflows last year?Now even the philanthropists are taking their money out.

What’s wrong with Malaysia? We, the general public, know the answers – inept government, inefficient bureaucracy, out-dated policies …. Now if only the BN government would stop their internal party politicking and get on with preparing us better for the coming global recession.

A primer on subprime (3 of 5): Brace for tough times

Equity markets have generally risen from their year-lows as confidence returned that financial markets would not completely collapse, thanks to governments supporting the banks. The respite is welcome, but I believe the trend is still downwards.

I expect global economic growth to come in near zero, or even negative next year. The International Monetary Fund (IMF), which has been coming up with new, ever-lower forecasts, now projects 2.2% global GDP growth. It's hard to see how even that can be achieved with the United States, the the world’s largest consumer nation, in recession, Eurozone suffering and the Arab economies struggling to deal with oil prices well below levels they had come to think of as normal.

Economic growth will also be hurt by the credit being curtailed. A commercial banker friend tells me his bank is revoking credit lines, even of clients who are not showing any signs of distress. The bank is conserving capital in anticipation of tougher times ahead. Already Maybank has reported an increase in total NPLs.

Some ultra-pessimists are suggesting deflation and depression. With so much capacity, companies desperate for cash flow to stay afloat will slash prices and be happy with just covering variable costs. That is a possibility, but I am hopeful governments, central bankers and regulators have learnt from the Japanese lesson and will act to combat that scenario.

The base case is ugly enough. US banks are not out of the woods yet. The latest survey of syndicated debt (ie loans given out by three or more banks) found that US$373.4bn of such loans were “criticised” ie in actual or potential difficulties at the end of 2Q08 - this is nearly triple the US$114.1bn recorded in 2007. Even more worrying, the report said many of the loans could move to more severe status such as substandard, doubtful or loss-making. Such “classified” credits were also rising rapidly, soaring 128% to US$163bn.

Not surprisingly, potential capital-crimping bad loans has reduced banks' willingness to lend. The latest quarterly Fed survey in the first two weeks of Oct found a great majority of banks had “continued to tighten their lending standards and terms on all major loan categories over the previous three months.”. Prime (or good borrowers) were affected along with borrowers with poor credit histories.

1. 95% had tightened lending terms to large and medium-size businesses;
2. 20% had cut limits for existing credit card accounts held by prime, or strong credit, customers.
   

I see at least one more cycle of bank issues in the US. The contracting economy and tighter credit will hurt businesses and consumers, which in turn will lead to more loan defaults and another round of bank failures. In the meantime, the rest of us in Malaysia who didn't get to enjoy the party during the boom years will have to suffer along.

Part 3 on Wed: What we can do.

Cut your EPF to 8%; pay more taxes!

If your pay is about RM4,500/month, and you have no life insurance, you will actually pay more taxes if you decide to reduce your EPF contribution to 8%.

That's because up to RM6,000 of EPF contributions and life insurance premiums are tax-deductible. Here is the calculation:

1. You earn RM54,000 per year. 11% EPF = RM5,940, which is tax-deductible. There is also RM8,000 of personal relief. So your net taxable income is RM40,060. The tax on that will be RM2,183 (tax rate is RM1,525 on the first RM35k and 13% on the next RM15k).
2. The EPF contribution is reduced to 8% = RM4,320. That is equal to RM1,620 extra in your pocket every year. Very nice? Did you realise that's not all yours? That extra is now taxable income! So your net taxable income is RM41,680 and you will be paying RM2,393 of federal income tax.
   
3. The BN federal government will be taking an RM210 (RM2,393 vs RM2,183) of taxes from you ie 13% of that extra which you thought was all yours.

Of course, the better-paid employees with hefty life insurance premiums are already well over the RM6,000 ceiling for tax-deductibility, so they won't be affected. But aren't these measures supposed to help the poorer?

Is that why the BN government made the 8% option automatic? Perhaps you'd better head over to EPF and insist you want to keep paying 11%.

The End of Wall Street's Boom

Here's an excerpt from an article on www.portfolio.com, by Michael Lewis, whose Liar's Poker was one of my inspirations:

When a Wall Street firm helped him get into a trade that seemed perfect in every way, he said to the salesman, “I appreciate this, but I just want to know one thing: How are you going to screw me?”

Heh heh heh, c’mon. We’d never do that, the trader started to say, but Moses was politely insistent: We both know that unadulterated good things like this trade don’t just happen between little hedge funds and big Wall Street firms. I’ll do it, but only after you explain to me how you are going to screw me. And the salesman explained how he was going to screw him. And Moses did the trade.

Read more.

A primer on subprime (2 of 5): Why governments had to bail out the banks

The virtuous cycle was trundling along. The economy was doing well (thanks to consumers spending on borrowed money), asset (house) prices kept increasing which meant default rates hit all-time lows as even the sub-prime borrowers were able to either flip their houses or service their loans at the low rates. The low default rates made financial institutions even more confident and they offered increasingly attractive loans to consumers.

At the peak, banks offered “No money down” mortgages and arrangements such as ARMs (Adjustable Rate Mortgages). ARMs allowed borrowers to pay very low interest rates for periods of two to three years. After that, market rates would be charged and principal repayments also started, but borrowers were convinced that by that time property prices would be higher. They would just sell their property, repay what was necessary and still reap a healthy profit.

Some alarm bells were raised. Some pundits suggested mortgages were increasingly being offered to people who couldn’t afford them. But regulators, lead by Alan Greenspan, said markets had found new ways of dealing with and pricing risks and there was no systemic problem (ie individual institutions that took on too much risk may go under, but the entire financial system was robust)

With hindsight, Greenspan was proven hugely wrong at enormous cost to the taxpayer. All good things must come to an end, eventually.

There are only so many people and so many potential housebuyers. After years of scraping the bottom-of-the barrel for the marginal borrower, to the point where lenders closed one eye as borrowers over-stated their incomes so they could go for bigger mortgages, there were no more new borrowers to be found. No new borrowers meant reduced demand for properties, which meant asset prices started to fall.

The house of cards started unravelling. Default rates on the CDOs turned out to be higher than expected. Even AAA-rated CDOs turned sour. Not surprising – considering the mortgages on which these CDOs were based were given to consumers with poor credit histories or to consumers who could not afford them.

Wait! Weren’t some CDOs backed by credit default swaps (CDS)? The CDSs turned out to be not worth the paper they were printed on. The institutions that were supposed to pay-up were woefully under-capitalised!

The problem was made even worse by the absence of open markets for these CDOs. These were traded over-the-counter with valuations based on complex mathematical models. But investors had lost faith in the assumptions going into the models so values could not be determined with certainty.

Also, it turned out that the banks were also liable for some of these CDOs. To entice investors to take the CDOs, the banks had agreed to buy back at least some of these if default rates turned out to be higher than expected. No-one expected the default rates to be that high, but when they hit that level, the banks had to buy back, incurring losses.

This lead to inter-bank credit markets freezing. Any bank, on any particular day, could be a net borrower in the inter-bank market. It is not bad management, it is just a matter of cash flow. For example, a company the bank had already approved a huge loan to draws down that day. The bank knows another borrower is due to repay tomorrow, but in the meantime, it has to borrow today to cover the gap. Tomorrow, when a loan is repaid, it may become a net lender in the inter-bank market.

But the inter-bank market froze. Banks became reluctant to lend to each other as they could not tell if the other bank would still exist tomorrow. Imagine if you were the bank lending to Bear Stearns or Lehman the day before they went under!

Initially the US Federal Reserve and the European Central Bank tried to restore the inter-bank market by making funds available for banks to borrow on more favourable terms and cutting interest rates. This did not help: 1) Banks were unwilling to take Federal funds because it would indicate weakness; and 2) cutting interest rates did not help because it did not address the core issue – banks were unwilling to lend to each other at any price.

The financial problem was turning into a real economy problem. Because banks could not tap the inter-bank market to cover short-term cash shortfalls, every bank wanted to be net cash. They started cutting back on loans to companies and individuals. In turn, companies and individuals would also want to hoard cash. The curtailing of credit facilities threatened the foundations of the economy – business activity would slow leading to job losses, bankruptcies and recession.

British Prime Minister Gordon Brown in the end got it right. Contrary to his long-held views, he extended government backing to the banks. This led to a flood of central banks around the world, including Malaysia, to guarantee deposits. With government guarantees, banks became willing to lend to each other again and credit markets were restored.

Next on Saturday: Brace for tough times

Open forum on global financial crisis and Malaysia

On Wednesday evening I participated in an open forum on The Global Financial Crisis and its Implications on Malaysia, organised at Universiti Malaya by the Centre of Public Policy Studies. The 5 member panel of Datuks, Drs and one Encik (me :-) had a very good 2 hour dialogue with members of the public, very ably moderated by Tan Sri Ramon Navaratnam. The Nut Graph was there …

A primer on subprime (1 of 5): On CDOs, SPVs and CDSs

I prepared this in anticipation of a forum that ultimately did not materialise. It’s not so topical now, but better late than never ….

The roots of our current crisis are in the US housing and consumer-credit boom. This was fuelled by the Wall Street innovation called CDOs – Collateralised Debt Obligations.

The amount that any financial institution can lend is constrained by the capital it has. Historically, banks kept the mortgages on their balance sheets – these are their assets on which they earn interest income. Against these mortgages, they had to keep a certain level of capital aside to insulate against defaults.

Then, Wall Street invented special purpose vehicles (SPVs) just to buy and pool thousands and thousands of mortgages together. These SPVs raised the money to buy the mortgages by issuing their own securities – the CDOs. Banks were happy to sell their mortgages to the SPVs because it freed up their capital to make new loans.

Basic financial/statistical theory is that it is hard or impossible to predict if any single mortgage will default. But if you have a pool of, say 10,000 separate mortgages, you can be reasonably sure that, say, 98% will be fine and 2% will default. So the SPVs issued CDOs with varying risk levels. If you had a senior CDO, you got paid before everyone else. Of course you also received a lower interest rate than another investor buying a junior CDO, which would suffer first if the default rates were higher than expected, but that interest rate was still more compelling than other alternatives.

Wall Street and the SPVs managed to convince the credit ratings agencies (like Moody’s and Standard and Poors) that the more senior of these CDOs deserved AAA credit-ratings, suggesting they were very safe for pension funds and insurance companies to invest in. And on top of that, a new market in credit derivatives (CDS – credit default swaps) allowed buyers of CDOs to purchase insurance against default.

Markets were working like a dream. Banks rushed to give as many mortgages as possible. Millions of poor Americans who were hitherto considered poor credit risks (sub-prime) became new homeowners, millions of existing homeowners got to upgrade and others were able to “unlock home equity” ie take a mortgage on the rising value of their houses to spend as they wished.

Banks’ profits went up from the mortgages they generated. They didn’t care about the risks because these mortgages would quickly be sold to SPVs. The SPVs had no problems selling the CDOs to investors. Investors were happy because they got higher interest rates on the CDOs, at apparently little incremental risk. Even the junior CDOs did well. Everyone was happy. Investors made high returns and financial institutions and CEOs reaped billions in profits and millions in bonuses.

Then the gears jammed ….

Next (on Wed): Why governments had to bail out the banks