A primer on subprime (5 of 5): Who’s to blame?

Culprits as I see it:

1) Greed by everyone in the chain: The people who took out loans they really shouldn’t have, the bank officers helping to falsify loan information to meet their performance targets, the CEOs out to make their big bonuses, shareholders hungry for profit growth, ratings agencies focused on fee income, investors looking for a free lunch ….

Borrowers were encouraged to over-state their income to qualify for bigger loans; or even to qualify for loans in the first place as banks rushed to hand out credit. A senior officer at Washington Mutual, one of the failed US banks said, "At WaMu it wasn't about the quality of the loans; it was about the numbers … They didn't care if we were giving loans to people that didn't qualify. Instead, it was how many loans did you guys fund."

They were facilitated by a false sense of security after years of benign economic conditions. Over-optimistic assumptions were built into financial models. Bankers and ratings agencies conveniently assumed recent low default rates were sustainable in the long-term. Those who argued against were told, “This time it’s different”.

Some senior bankers knew it was a house of cards – remember former Citigroup boss Chuck Prince saying, “As long as the music is playing, you’ve got to get up and dance?” But bank bosses were under pressure to show profit growth. Banks competed fiercely to lend, and often dispensed with the usual covenants meant to secure such credits – ie the “cov-light” loan. Ratings agencies gave unwarranted AAA ratings.

2) The market failure was facilitated by regulatory failure. Alan Greenspan’s Federal Reserve refused to deflate the mortgage bubble. He argued that markets had efficiently found ways to diversify the risks. But regulators failed to look deeply enough into the institutions that had supposedly took on the risks. The risks appeared to have been off-loaded, but really weren’t as the insurers were not well capitalised. It turned out that even large AAA-rated firms like AIG were over-extended and could not pay up when defaults rose.

Quite frankly though, I don't think the soul-searching is worth much. History is useful if only we would learn from it. And yes, for a while, lending standards will be tighter, banks will focus on risks and regulators will be stricter.

But as the good times roll again, politicians and businessmen will push for relaxed standards. Risk managers don’t earn revenue. Loan salesmen do. We'll again hear “This time it's different. We've learnt our lessons.” We shall see.

Look deeper into IOI cancelling its Menara Citibank purchase …

At the last minute, IOI Corporation decided not to complete the RM587m acquisition of the Menara Citibank office tower in Kuala Lumpur. IOI forfeited its RM73m deposit - 12% of the purchase price. Here are 3 potential reasons:

1) It is an IOI problem. IOI cannot afford the deal because crude palm oil prices have collapsed. But a quick check with my analyst friends finds most of them forecasting about RM2bn pa of operating cashflows with CPO around RM2,000/ton. So, it doesn’t look like IOI itself has issues;

2) Which takes us to … IOI thinks the Malaysian economy will get a lot worse. And it thinks property prices will fall by at least another 20%. (Otherwise, why would it forgo the 12% deposit?);

3) Or, IOI thinks Citi is in serious trouble and will be forced to do a fire-sale later.

Any thoughts? Comments welcome.

A primer on subprime (4 of 5): What we can do

It's a given Malaysians will suffer too in this global slowdown. Anyone suggesting Malaysia will be unaffected is living in dreamland. All of us – government, businesses and employees – have to contribute to mitigate the pain:

1. Government in the next few months has to spend to cushion the local economy and protect society's poorest;
2. In the longer-term economic policy has to be reevaluated to attract investment, both local and foreign;
3. Businesses and employees must use the breathing space afforded by the government handouts to improve efficiency and productivity.
   

Like most things, these are easier said than done. Unfortunately, government fiscal options are limited. We had already been running Budget deficits for the past 12 years, through the good times. In fact, the deficit for this year, 2008, will hit 4.8%, higher than the 3.6% initially forecast, even with record high oil and crude palm oil prices. Next year, in 2009, there will be a lot less government revenue with oil prices down by more than half and lower corporate and income tax collections.

Fortunately, and ironically, there has been plenty of fat in the system. Most would agree that there is tremendous leakage when the Barisan government spends money. Cut out the fat, and spend what we have on projects with the maximum impact on the local economy – so small scale grassroots projects please. Mega projects with high foreign input costs should be carried out only if truly necessary.

Besides the short-term spending, the Barisan Nasional government must reconsider its economic policies. The government has been increasing its role in the economy over the years. The federal budget has increased 57% over the last three years! That is not healthy. Sustainable economic growth is always private sector-led.

The amount of capital investments in Malaysia is very low poor. We were the only Asean nation to record net capital outflows last year . And if foreign exchange rates are any indicator, we are considered a worse risk than Thailand, where quite literally there was blood in the streets. The ringgit has depreciated against the baht in the past year.

Now is the time to ask the hard questions and implement the solutions. Why is investment lagging in Malaysia? Why has the perception of our country deteriorated so much? We were once seen as close to Singapore in terms of stability and prospects; we are now compared with lesser peers.

Create a conducive environment for private sector investment. And don't just focus on the foreigners. Remember the locals too. There are many Malaysian millionaires and billionaires with cash to spare. What will it take to get them to put it back into the Malaysian economy?

As for what businesses and individuals can do, Tan Sri Ramon Navaratnam said, “Be lean and mean.” Time was short and he was closing the discussion at the open forum on The Global Financial Crisis and its Implications on Malaysia. Elaborating on his behalf, we should all be looking at ourselves and asking how we earn our income. No-one owes us a living, and in my working life, my guiding philosophy was “My employer must consider me good value.” That's the only way to job security, no matter what you do. If you're a businessman, it's “My customer must find me good value.” I'm not saying cut prices – there is a difference in price and value, which can be the subject of another blog – I'm suggesting there's also substantial room for customer service, productivity and efficiency improvement in Malaysia.

For those lucky enough to have spare cash, I personally believe this is a buying opportunity . Traditional financial theory says markets are efficient. My experience is that markets are made up of people. These people may be smart, may be very highly qualified, may be very intelligent but they are humans with very human emotions. There will be periods of euphoria and periods of pessimism.

We are entering a period of pessimism. I had drinks with a friend recently. He used to be a happy punter in the stock market. Conversation turned to personal portfolios and I recommended a stock at 1.5x P/E. His first reaction – what will earnings be next year? I said, even if earnings go down by half, the stock would be at 3x P/E. But still he wasn’t convinced – and this was a guy happily buying in the bull market when P/Es were well in the teens or 20s.

It won't be an easy ride. Warren Buffet last month said, "…. the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary … ..…… Let me be clear on one point: I can’t predict the short-term movements of the stock market.”

But he added, “…fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now..”

The plunge in share prices has been indiscriminate. Prices of shares in good, and bad, companies are cheap. Hunker down for tough times, do your homework, find companies you’re comfortable with and put your spare cash in the stock market. “Be fearful when others are greedy, and be greedy when others are fearful.”

It will be hard to maintain equanimity in the coming months. News flow will be more negative than positive. Tan Sri Ramon at the forum reminded us that economic cycles come and go. He's seen 6 in his lifetime. We will survive this; the good times will roll again, and I’m sure we’ll see another crisis after that.

Finally, on Sunday: Who's to blame?

Malaysians subsidising foreigners …

Picking up on the likes of Maybank, Telekom, Astro, Genting, Maxis and YTL investing chunks of money overseas ….

It can be argued they have grown too big for Malaysian markets and this is part of normal corporate development. Some would say we should be proud that Malaysia has been able to grow such large companies.

I see no reason to be proud - all these companies are either monopolies or operate in cosy oligopolies with limited competition in Malaysia. All the extra funds they have are from the supernormal profits they reaped from you and me, the average Malaysian, thanks to the government protecting them from competition.

Take Astro, which has a government-granted monopoly on satellite tv. While it was operating in highly competitive Indonesia, it was charging Indonesians less than Malaysians. And consider Telekom, spending huge sums overseas while giving us atrocious Streamyx service, charging us RM25/month minimum fixed line charges and crying to the government that it cannot afford to spend on broadband in Malaysia (and successfully getting a subsidy!).

Investments overseas don’t generate that many jobs for Malaysians. But the investments are paid for by Malaysians through inflated prices and poor service in Malaysia due to the lack of competition. Government policies need rethinking. If our companies are big enough to go overseas, they are big enough to face competition here in the local market. Local consumers will then benefit from lower prices and better services.

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%.