Commodity Speculation and Middle East Turmoil

Here is an excerpt about the subject

The short answer with regard to the role of speculation in the Middle East turmoil (and the spike in gas prices) is that speculation is obviously playing a large role. Everyone I’ve spoken to seems to think this is a virtual replay of 2008, only the larger spike here is in food commodity prices. Wheat and corn are both up more than 75% over the last 12 months; cotton is up over 125%; coffee up 85%. Meanwhile oil prices are soaring and there’s talk again of futures maybe hitting $200 a barrel – oil futures are trading at about three times what they were in February 2009. The blame for all of this is going to be laid at disruptions in the Middle East and other factors, but the inescapable fact is that commodity index speculation was up $80 billion last year, meaning that there was $80 billion of new money coming on the market betting on the rise of commodity prices. The total amount of commodity index speculation approached $400 billion last year, meaning the amount of speculative money on the market was roughly twenty times pre-2003 levels – and again, this is all “long-only” speculation, i.e. money betting on prices to go up. Obviously disasters and political unrest and other factors (a very weak harvest in Russia last year was a factor in the wheat price spike, for instance) play a part in all of this, but I think in the end what we’re going to find out is that index speculation was a huge factor in both the skyrocketing food prices that led to the Middle East crisis and this current oil-price situation.

Pakistan Economy and Loopholes

A balance of payment crisis compelled Pakistan to seek $11.3 billion IMF loan in 2008. Strings attached with the loan invited harsh criticism from the political parties and business groups. The three-point reform agenda requires implementation of reformed sales tax, reduction in budget deficit and end to government subsidies. At present, Pakistan is in a peculiar situation today. Fiscal deficit is high, debt is increasing rapidly, growth is minimal and unemployment on the rise. The mounting debt and liabilities, approaching Rs11,000 billion, doubling in the last three years, is being used for non-productive expenditure. The budget deficit is set to hit 7.5 percent against the targeted 4.7 percent for fiscal 2010/11 (July-June). Pakistan badly needs to generate additional revenue to meet its budgetary deficit and conditions agreed to IMF. That is why the Govt. is doing all what it can to win favors for RGST but still it looks a far cry. While the IMF forecasts emerging economies, notably China and India, to drive the global growth, Pakistan’s economic sovereignty is facing serious challenges. The debt profile of the country is worsening day by day with fears of a looming debt trap. With over half a billion debt increase in the first quarter of FY11, shared equally by domestic and foreign components, the country’s total debt reached Rs10.7 trillion. With fiscal deficit threatening to reach Rs1.5 billion for FY11, according to the Finmin, a significant rise in the country’s debt is inevitable.

But on the other hand there are many loopholes that if plugged can generate all the necessary revenue without resorting to increase in power tariff and RGST. One such case is “ISAF Missing Containers”.

The International Security Assistance Force (ISAF) is a NATO-led security mission in Afghanistan established by the United Nations Security Council on 20 December 2001 by Resolution 1386 as envisaged by the Bonn Agreement. It is engaged in the War in Afghanistan (2001–present).

ISAF started importing goods through Karachi and established Forward Mounting Base (FMB) unit at Karachi in 2002 as part of co-ordination mechanism by designating one of the its officers at Karachi to regularly co-ordinate customs clearance matters with Additional Collector Customs Karachi Port. But this co-ordination system fizzled out when the FMB was shifted by ISAF to Kabul within a year of its establishment at Karachi. In June 2010, it was leaked to media that over 11,000 ISAF containers with equipment worth Rs220 billion went missing during the last two years or so.

The FBR data showed that during the period June 2005-2010, a total of 558,141 containers were transited to Afghanistan. Of these, 166,949 (30 percent) containers belonged to the US Military; 52,929 (9 percent) to ISAF/Nato and the remaining 338,263 (61 percent) were commercial ATT consignments. The biggest aspect of the ISAF Containers Scam is the non-availability of the data on the movement of ISAF containers. The FTO report on the scam shows that in response to data requisitioned from FBR for the period January 1, 2007 to October 15, 2010, Pakistan Revenue Automation Limited (PRAL) confirmed that Karachi Customs had handled a total of 306,267 transit containers during this period. For 71,202 containers, there is no information regarding either their departure from Karachi or their arrival at the border customs stations. In case of 27,871 containers, that did arrive at the destinations, their departure information from Karachi is not available. Another 55,140 containers are shown to have left Karachi but have no entries of arrival at the border stations. A total of 152,054 containers have records for departure from Karachi and arrival at the border customs station, but no record of crossing into Afghanistan. Finally, not a single container, out of 306,267, is recorded to have ever crossed over to Afghanistan during the almost four-year period under reference. According to one informed insider, the arrival or otherwise of the ‘missing containers’ could be verified from the ISAF Kabul officials. The containers that were meant to go missing after availing of ISAF duty-tax free clearance by Customs were never meant to reach ISAF warehouses in Kabul and therefore the ISAF headquarters could easily confirm whether they ever arrived in Kabul or not.

It is estimated very conservatively that the scandal involving the ISAF containers have caused a huge loss of over Rs 37 billion to the economy. Chief Justice Iftikhar Mohammad Chaudhary on Wednesday hearing the embezzlement of billions of rupees in International Security Assistance Force (ISAF) containers case observed that revelations made in the Federal Tax Ombudsman report is just the tip of the iceberg, as further investigations could divulge much more. He said because of smuggling the national exchequer faces a loss of $2 billion every year.  The Chief Justice further said that even the Islamabad markets are flooded with the smuggled goods. Justice Ramday said that the domestic barrowing have reached Rs4008 billion since 2008 to 2010. The court wondered that besides the smuggling of alcohol and arms, what else is being smuggled on the pretext of Afghan trade.

The Afghan Transit Trade Agreement (ATTA) scam is bleeding our beleaguered economy dry to the tune of up to Rs37 billion per year . The ATTA allows goods destined for Afghanistan to transit through Pakistan duty free but ATTA goods, amounting to an estimated $2 billion, either stay in Pakistan or are smuggled back in. Described as the “main source of smuggling” in Pakistan, the ATTA scam is hemorrhaging our economy on several fronts. The ATTA has become an unmitigated source of customs duty evasion. When the Federal Board of Revenue (FBR) enhances duties on any product, official imports to Pakistan decline as people shift to import the same product, fraudulently, under the ATTA. Such was the case with stainless steel imports, which doubled under ATTA within six months, immediately after duties were increased on it. So the ATTA has dented the FBR authorities’ ability to accrue revenue via customs duties which, when combined with the stranglehold of the feudal and political classes on preventing income tax collection, has stymied Pakistan’s tax-to-GDP ratio to an eye-watering nine per cent. This is a critical issue for the nation’s economic future. The extent of the problem with ATTA is borne out by the fact that Afghanistan’s per capita imports are 72 per cent higher than Pakistan, even though its GDP per capita is almost 300 per cent lower. The statistics reveal the extent of smuggling into Pakistan. The Afghan economy cannot sustain such high imports. In fact, 80 per cent of these goods are smuggled into Pakistan, damaging local industry and destroying legal businesses here. Worse still, Pakistan’s high-value edibles are smuggled into Afghanistan, bleeding our exchequer further, as both fertilizers and flour are heavily subsidized by the government. The resultant shortage in Pakistan drives up prices — another body blow for the Pakistani people, already bludgeoned by food inflation.

Revenue loss on account of smuggling of Afghan transit trade alone, as estimated by the World Bank, amounted to US$ 35 billion during nine years from 2001 to 2009. It is no secret that Pakistani tax evaders have been transferring to Swiss banks huge amounts of money generated through illegal activities by some politicians, bureaucrats, terrorist networks and businessmen to Swiss banks. White-collar crimes are also responsible for facilitating transfer of capital towards informal economy either from the black market or the formal economy with the connivance of FRB’s officials. Due to Pakistan’s low productivity resulting from massive exemptions, poor administration, low threshold, and lack of transparency and enforcement, the country faces a massive challenge of balancing low revenues and the avaricious politicians, corrupt bureaucrats, and greedy businessmen, who are mostly crook, corrupt and tax evaders, succeed to remit this black money to their hidden accounts in Switzerland and other European countries. On the one hand parallel economy in Pakistan is growing at an alarming rate of 20 percent per annum and on the other hand, according to an estimate, the money lying in Swiss banks of Pakistanis has reached to the tune of US $200 billion. The volume of black money generated in the year 2008-09 alone has been measured by the independent sources which is not less than $ 40 billion. The rent-seekers and beneficiaries of loan write-offs in Pakistan have also shifted funds worth billions of dollars to Switzerland.

What caused food inflation?

In 2008, the government pushed the procurement price of wheat up from Rs. 625 per 40 kg to Rs. 950 per 40 kg. This action immediately triggered inflationary pressures that have continued to persist as food accounts for just over 40% of Pakistan's consumer price index. According to State Bank of Pakistan (SBP) analysis, cumulative price of wheat surged by 120 per cent since 2008, far higher than the 40 per cent between 2003 and 2007. it is also many times greater than the international market price increase of 22 per cent for wheat in the same period. Similarly,sugar prices have surged 184 per cent higher since 2008, compared with 46 per cent increase during 2003-07.

Some have attributed this rise in prices to recent flood and global food crisis. Yet some relate this price increase to poor harvest and strong demand from emerging economies.

This food inflation is a cause of concern for the policy makers and it is suggested that underlying the sudden, volatile uprising in Egypt and Tunisia is a growing global crisis sparked by soaring food prices.

Here is an excerpt from an article that throws flood light on to the causes of food price escalation.

The cause of the recent jump in global food prices remains a matter of debate. Some analysts blame the Federal Reserve’s “quantitative easing” program (increasing the money supply with credit created with accounting entries), which they warn is sparking hyperinflation. Too much money chasing too few goods is the classic explanation for rising prices.

The problem with that theory is that the global money supply has actually shrunk since 2006, when food prices began their dramatic rise. Virtually all money today is created on the books of banks as “credit” or “debt,” and overall lending has shrunk. This has occurred in an accelerating process of deleveraging (paying down or writing off loans and not making new ones), as the subprime housing market has collapsed and bank capital requirements have been raised. Although it seems counterintuitive, the more debt there is, the more money there is in the system. As debt shrinks, the money supply shrinks in tandem.

That is why government debt today is not actually the bugaboo it is being made out to be by the deficit terrorists. The flipside of debt is credit, and businesses run on it. When credit collapses, trade collapses. When private debt shrinks, public debt must therefore step in to replace it. The “good” credit or debt is the kind used for building infrastructure and other productive capacity, increasing the Gross Domestic Product and wages; and this is the kind governments are in a position to employ. The parasitic forms of credit or debt are the gamblers’ money-making-money schemes, which add nothing to GDP.

Prices have been driven up by too much money chasing too few goods, but the money is chasing only certain selected goods. Food and fuel prices are up, but housing prices are down. The net result is that overall price inflation remains low.

While quantitative easing may not be the culprit, Fed action has driven the rush into commodities. In response to the banking crisis of 2008, the Federal Reserve dropped the Fed funds rate (the rate at which banks borrow from each other) nearly to zero. This has allowed banks and their customers to borrow in the U.S. at very low rates and invest abroad for higher returns, creating a dollar “carry trade.”

Meanwhile, interest rates on federal securities were also driven to very low levels, leaving investors without that safe, stable option for funding their retirements. “Hot money” – investment seeking higher returns – fled from the collapsed housing market into anything but the dollar, which generally meant fleeing into commodities.

At one time food was considered a poor speculative investment, because it was too perishable to be stored until market conditions were right for resale. But that changed with the development of ETFs (exchange-traded funds) and other financial innovations.

As first devised, speculation in food futures was fairly innocuous, since when the contract expired, somebody actually had to buy the product at the “spot” or cash price. This forced the fanciful futures price and the more realistic spot price into alignment. But that changed in 1991. In a revealing July 2010 report in Harper’s Magazine titled “The Food Bubble: How Wall Street Starved Millions and Got Away with It,” Frederick Kaufman wrote:

The history of food took an ominous turn in 1991, at a time when no one was paying much attention. That was the year Goldman Sachs decided our daily bread might make an excellent investment. . . .

Robber barons, gold bugs, and financiers of every stripe had long dreamed of controlling all of something everybody needed or desired, then holding back the supply as demand drove up prices.

MM Theorem and Reality

MM proposition 1 says that value of a firm is independent from its financial structure. If this is the case then the ideal financial structure is 100% debt.
But fortunately this is not the case otherwise everything on the earth might be held by banks as collateral. The reasons for the current scenario is different than advocated by MM are
1. Arbitrage mechanism has its limits.
2. Interest rate on personal debt is different from corporate debt because of underlying collateral, size of debt and remaining borrowing capacity.
3. Borrowing capacity of corporations as well as its shareholders is limited because there is a real cost of bankruptcy.
4. Capital markets are not perfect, there is asymmetry of information between corporations and its capital providers.
5. Interest rate varies with the leverage because of risk of default.
6. There is no “equivalent return” class because the underlying risk is different from firm to firm, which is accumulation of numbers of factors.
7. Firms within the same industry post very different operating income because of difference in strategy pursued.
8. Securities of all firms in the world are not traded on capital markets.

Sure Win Turnaround Formula

One of the reason for a turnaround of Ford Motors is slashing of debt and reducing interest cost. This is another evidence that debt exert unbearable pressure on companies and bring them down. Here is an excerpt from an article from Economist

That turnaround is impressive (see chart 1). Despite the sluggish recovery in the North American market, in the third quarter Ford’s automotive businesses made an operating profit of $2.1 billion, twice as much as a year before and the fifth quarterly surplus in a row, on revenue of $29 billion. Its net income was a quarterly record of $1.7 billion. Analysts at Morgan Stanley, an investment bank, expect the company to make a profit of $10.5 billion in 2010. In 2009 it made one third of that. Ford has also slashed $12.8 billion off the automotive debt of $33 billion it had at the start of the year. By late November the company reckoned it had lowered its annualised interest costs by nearly $1 billion.

Deficit Terrorist at work again

Here is a reproduction of a news item from DAWN

ISLAMABAD, July 12: While the rest of the country was fixated on the face-off between the media and the PML-N, Prime Minister Yousuf Raza Gilani was provided a reality check last week about the precarious economic situation in the country. He was warned by the finance ministry that with the fiscal deficit touching 6.2 per cent of GDP (Rs925 billion) last year, the government ran the risk of IMF backing out unless it earned Rs500 billion through additional revenue or reduce its expenditures drastically during the current fiscal year. More serious still, he was informed that the only way of controlling expenditures was to ask the provinces not to exercise their powers to raise additional funds under the new NFC award. This was the gist of the message hammered home during a presentation by Finance Minister Dr Abdul Hafeez Shaikh and his team to the prime minister during his visit to the ministry. A major headache in this regard, Dawn has learnt, is the overall fiscal situation which can deteriorate because of inter-corporation circular debt. This, according to the finance ministry’s estimates, will take a 25-30 per cent hike in electricity tariff during the current financial year to breakeven on this count. However, what makes this crisis unpredictable is that an increase in international oil prices or Pakistan’s failure to produce estimated amount of gas and hydel energy (which would mean more thermal energy and hence more oil) can push these numbers higher. No wonder then that the World Bank and the IMF, sources told Dawn, had estimated a 49 per cent increase in electricity rates. As a result, the government has no choice but to check its spending and improve revenue collection. The prime minister was informed that the government had exhibited little fiscal responsibility and failed to limit debt for the third year running because of financial indiscipline by the provincial governments. Hafeez Sheikh and his team pointed out that the provincial governments, which were expected to provide a surplus of about 0.6 per cent of GDP during the last financial year, ended up with deficits. The Punjab government closed its accounts with a Rs38 billion deficit, followed by Sindh at Rs27 billion and Balochistan Rs7 billion. As a result, the provincial governments together contributed about one per cent to the overall fiscal deficit of 6.2 per cent instead of helping to meet the 5.1 per cent target agreed with the IMF. The prime minister was also informed that Federal Board of Revenue had missed the revenue collection target by about Rs70 billion, excluding over Rs50 billion of refunds. The total revenue shortfall, therefore, remained in excess of Rs120 billion. If the refunds were also excluded, the fiscal deficit could be close to Rs1,000 billion. MORE BAD NEWS: The bad news for the prime minis ter did not end here. He was informed that the economic situation could further worsen because of the strong parliamentary opposition to the value-added tax (VAT). The reformed general sales tax could also face practical and administrative hiccups in case the Sindh government did not drop it insistence on collecting the tax on services. And if the government fails to introduce the uniform reformed GST across the country, it should stop counting on the IMF programme under which more than $2 billion is still to be transferred to Pakistan. As a consequence, the country will not be able to get bilateral and multilateral financial support, increasing the chances of a default. Mr Gilani was told that if the government wanted to avoid this situation it would have to persuade the provincial governments to check expenditures and prepare themselves for additional revenue generation. The problem the government may face is that the finance ministry cannot rein in the provinces and force them to spend less or to reduce their federal transfers in view of a consensus NFC award. Therefore, the prime minister had been requested to persuade the provinces to limit their spending to the last year’s level, notwithstanding additional shares they had thanks to the new NFC award to generate a surplus of at least 1.5 per cent of GDP (which translates to about Rs170 billion), the sources said. According to the sources, the prime minister assured the finance ministry officials that he would raise the matter with chief ministers on Tuesday.

TOP

It seems that these terrorists are developing their arguments for the total surrender of our autonomy, whatsoever is left, to IMF. To me this deficit and its consequences can be taken as a blessing in disguise as we, the masses, shall not be taking another burden of $2 billion that the IMF has yet to disburse. We all including the so called Servants of the country have to face the stark reality of living within our means so there would be automatic cut in expenditures, no need to worry about increasing trend in expenditures. As the saying goes " Necessity is the mother of invention", when there will be acute shortage of electricity on numbers of accounts, people will find a way to out of this seemingly impossible obstacle. And this necessity shall not be only in electricity but shall be everywhere and when you put the brains of some 200 million people on innovation, then everything and anything is possible. Moreover, we, the masses, shall be relieved of the rampant corruption as Muslims we have faith in Allah (SWT) that He is the One who has all answers to our miseries and as we have shown time and again that in adversity we turn toward Him for help and we then behave or try to behave as closely as possible as Allah (SWT) has ordained.

So, default and save the country from the plunderers.

Capital Structure and Its Determinants

Harris, M. and A. Raviv (1991) in their paper "The Theory of Capital Structure" identified four categories of factors that are responsible for determination of capital structure of a firm. These factors or as they put it "desires" are

• ameliorate conflicts of interest among various groups with claims to  the firm's resources,  including managers (the agency approach), 
• convey private  information  to capital markets or mitigate adverse selection effects  (the asymmetric  information approach), 
• influence  the  nature  of  products  or  competition  in  the  product/input market, or 
• affect the outcome of corporate control contests. 

The theories that it is to "ameliorate conflict of interest" and "affect the outcome of corporate control contests" have nothing to do with the basic purpose of the firm - to create value for stakeholders - and in all probability, these are satanic designs that ruin the firm in the end. If all the stakeholders are working according to the well defined norms of justice and fair play than why there is conflict of interest? The theory of Capital Structure to avoid agency costs that Jensen and Meckling identified lead the managers on the path of destruction since the managers are given incentives such as based on EVA etc. and managers when faced with -ve results try to manipulate the earnings in order to achieve the target and earn incentives, the examples are "Enron", "Worldcom", etc. Debt provides incentive to engage in suboptimal investment because  in debt  contract  there is an implicit provision  that  if  an  investment  yields  large returns, well  above  the face value of the debt, equityholders capture most of the  gain.  If,  however,  the  investment  fails,  because  of  limited  liability, debtholders  bear  the  consequences in case liquidation is insufficient to cover the entire amount of debt. So clever managers who would like to hold on to power would go for the higher debt equity ratio and this is the strategy that comes to mind immediately there is any threat of take over. But that is a dangerous path to move on because debt has to be paid at some fixed time in future and that future is highly uncertain. Uncertainty coupled with fixed nature of debt commitment puts the managers under pressure for results and that is where the best laid out plans fall apart and lead the managers to play games.

The theory that capital structure decison is to convey inside / private information to market means it is used / can be used as a deception. Why can't we convey inside information in a straight forward manner without taking any steps that can lead the firm on the road to destruction? If the answer is no, then something is wrong that is being dragged under the rug. Information asymmetry between insiders and outsiders cause different value for the firms' assets and that may result in financing a new project / investment opportunity by existing owners / managers with debt if internal fund are insufficient - pecking order theory of capital structure. This pecking order begins when outsiders have some serious doubts about the information not available to them and that makes them suspicious. The question is why such asymmetry of information in the first place? Market, it seems always thinks of the information asymmetry that is why  "Noe shows that the average quality of  firms  issuing  debt  is  higher  in  equilibrium  than  that  of  firms  issuing equity.  Therefore,  like Myers-Majluf,  Noe's model  predicts  a  negative  stock market response to an announcement of an equity issue. Noe  also predicts a positive  market  response  to  an  announcement  of  a  debt  issue." There is always mistrust of managers by the market about firm's inside information. Why can't insiders speak the truth? Or why can't market take the words of insiders to be true on its face value unless otherwise proved? Is there lack of trust or lack of reputation? Because of lack of trust and distortion of communication between management and market, the market tends to heavily tilted towards the debt, which promises a fixed return irrespective of any reference to profit / (loss) - a figure that is highly questionable from the point of view of the outsiders for numbers of reasons but mainly on account of asymmetry of information. 

Leverage changes the behavior of the firm and its strategy because a levered firm assumes a sure commitment of periodic fixed payment to debtholders to remain in business. In the face of debt, it is very difficult to sustain high quality. Because quality can only be achieved through truth - speaking truth about its systems, products, people and speaking truth to its suppliers, customers, but when a firm has a debt to pay its ability to speak truth is highly undermined. This is even more true in case of an adverse forecast or less than expected results then the deviations from the straight path take start. All information asymmetries, conflicts of interests, contests for control of firm and competitive strategies move in different directions than the relevant theoretical models predict. 

Capital Structure Decision and Firm Value

According to famous MM proposition I, value of the firm is independent of its capital structure - firm value is invariant to its financial structure. They proved this proposition mathematically. Intuitively this proposition hold value. Valuation of a firm is a function of its expected earnings over time capitalized at an appropriate rate for its given risk class. Critics, however, are ready to point out that value of the firm can be increased by taking tax advantage of debt, which has been rejected by the MM by going over the investors' side and taking help from personal Income Tax. The value maximization criticism can't be overruled as a firm's net after tax cash inflow to firm increase with the addition of debt in the capital structure. 

Inherent in the discussion on capital structure decision is that EBIT of a firm is independent of its financing structure. Expected earnings are a function of assets' earning capacity and its productivity and this has nothing to do with how the assets are financed. But "DEBT is as powerful a drug as alcohol and nicotine. In boom times Western consumers used it to enhance their lifestyles,companies borrowed to expand their businesses and investors employed debt to enhance their returns." Can we say that inclusion of debt in capital structure is synonymous to introduction to a healthy person "drug and alcohol"? In the words of Hyman Minsky, an American economist "these debt crises were both inherent in the capitalist system and cyclical. Prosperous times encourage individuals and companies to take on more risk, meaning more debt. Initially such speculation is successful and encourages others to follow suit; eventually credit is extended to those who will be able to repay the debt only if asset prices keep rising (a succinct description of the subprime-lending boom). In the end the pyramid collapses." 

The problem with debt is that it needs to repay it. That is where the problem starts. The need to repay something in future and future is a t the very best is a mere guess - uncertain. This compulsory payment in future coupled with uncertainty about future is the root cause of the problem that needs to be probed into and analysed thoroughly. A firm which has future obligations for payment must meet the minimum necessary to honor its commitments. In the words of Merton H. Miller "The firm pays  its debts not just  because the  law says it must, but because the value of  the stock to  its shareholders is  greater  to  them  if  the  firm  pays  the  debts  than  if  it  doesn't." So  to remain on the same level of value before inclusion of debt in the capital structure, a firm has to honor its commitment to pay the debt obligation and has to earn a minimum to honor that commitment. This compulsory or mandatory nature of target puts some kind of an extra pressure on the levered firm as compared to unlevered firm. Because of that extra pressure, the EBIT of a levered firm may be different than an unlevered firm keeping everything else same.

Deficit Terrorists

The financial sector, which controls the money supply and can easily capture the media, cajoles the populace into compliance by selling its agenda as a “balanced budget,” “fiscal responsibility,” and saving future generations from a massive debt burden by suffering austerity measures now. Bill Mitchell, Professor of Economics at the University of New Castle in Australia, calls this “deficit terrorism.” Bank-created debt becomes more important than schools, medical care or infrastructure. Rather than “providing for the general welfare,” the purpose of government becomes to maintain the value of the investments of the government’s creditors.

England’s new coalition government has just bought into this agenda, imposing on itself the sort of fiscal austerity that the International Monetary Fund (IMF) has long imposed on Third World countries, and has more recently imposed on European countries, including Latvia, Iceland, Ireland and Greece. Where those countries were forced into compliance by their creditors, however, England has tightened the screws voluntarily, having succumbed to the argument that it must pay down its debts to maintain the market for its bonds.

Deficit hawks point ominously to Greece, which has been virtually squeezed out of the private bond market because nobody wants its bonds. Greece has been forced to borrow from the IMF and the European Monetary Union (EMU), which have imposed draconian austerity measures as conditions for the loans.

DEFICIT TERRORISTS STRIKE IN THE UK - USA NEXT?

The Great American Bubble Machine - Goldman Sachs

Here is an excerpt from an article by Matt Taibbi

The First thing you need to know about Goldman Sachs is that it's every-
where. The world's most powerful investment bank is a great vampire squid
wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money. In fact, the history of the recent financial crisis, which doubles as a history of the rapid decline and fall of the suddenly swindled-dry American empire, reads like a Who'sWho of Goldman Sachs graduates.


By now, most of us know the major players. As George Bush's last Treasury secretary, former Goldman CEO Henry Paulson was the architect ofthe bailout, a suspiciously self serving plan to funnel trillions of Your Dollars to a handful of his old friends on Wall Street. Robert Rubin, Bill Clinton's former Treasury secretary, spent 26 years at Goldman before becoming chairman of Citigroup - which in turn got a $300 billion taxpayer bailout from Paulson. There's John Thain, the asshole chief of Merrill Lynch who bought an $87,000 area rug for his office as his company was imploding; a former GoIdman banker, Thain enjoyed a multibillion dollar handout from Paulson, who used billions in taxpayer funds to help Bank of America rescue Thain's sorry company. And Robert Steel, the former Goldmanite head of Wachovia,
scored himself and his fellow executives $225 million in golden parachute payments as his bank was self-destructing. There's Joshua Bolten, Bush's chief of staff during the bailout, and Mark Patterson, the current Treasury chief of staff, who was a Goldman lobbyist just a year ago, and Ed Liddy, the former Goldman director whom Paulson put in charge of bailed-out insurance giant AIG, wbich forked over $13 billion to Goldman after Liddy
came on board. The heads ofthe Canadian and Italian national banks are Goldman alums, as is the head of the World Bank, the head of the New York Stock Exchange, the last two heads of the Federal Reserve Bank of NewYork - which, incidentally, is now in charge of overseeing Goldman - not to mention ...


But then, any attempt to construct a narrative around all the former Goldmanites in influential positions quickly becomes an absurd and pointless exercise, like trying to make a list of everything. What you need to know is the big picture: If America is circling the drain, Goldman Sachs has found a way to be that drain - an extremely unfortunate loophole in the system of
Western democratic capitalism, which never foresaw that in a Society governed passively by free markets and free elections,organized greed always defeats disorganized democracy.

The bank's unprecedented reach and power have enabled it to turn all of America into a giant pump-and-dump scam, manipulating whole economic sectors for years at a time, moving the dice game as this or that market collapses, and all the time gorging itself on the unseen costs that are breaking families everywhere - high gas prices, rising consumer credit rates, half eaten pension funds, mass layoffs, future taxes to payoff bailouts. All that money that you're losing, it's going somewhere, and in both a literal and a figurative sense. Goldman Sachs is where it's going: The bank is a huge, highly sophisticated engine for converting the useful, deployed wealth of society into the least useful, most wasteful and insoluble substance on Earth - pure profit for rich individuals.


They achieve this using the same playbook over and over again. The formula is relatively simple: Goldman positions itself in the middle of a speculative bubble, selling investments they know are crap. Then they hoover up vast sums from the middle and lower floors of society with the aid of a crippled and corrupt state that allows it to rewrite the rules in exchange for the relative pennies the bank throws at political patronage. Finally, when it all goes bust, leaving millions of ordinary citizens broke and starving, they begin the entire process over again, riding in to rescue us all by lending us back our own money at interest, selling themselves as men above greed, just a bunch of really smart guys keeping the wheels greased. They've been pulling this same stunt over and over since the 1920s - and now they're preparing to do it again, creating what may be the biggest and most audacious bubble yet.


If you want to understand how we got into this financial crisis, you have to first understand where all the money went - and in order to understand that, you need to understand what Goldman has already gotten away with. It is a history exactly five bubbles long - including last year's strange and seemingly inexplicable spike in the price of oil. There were a lot of losers in each of those bubbles, and in the bailout that followed. But Goldman wasn't one of them.

High tech Financial Modeling

One of the many theories that are being put forward in relation to financial crisis of 2007 - 10 is high tech financial modeling. Here is an excerpt from an article from The Economist.

Thanks to Black-Scholes, options pricing no longer had to rely on educated guesses. Derivatives trading got a huge boost and quants poured into the industry. By 2005 they accounted for 5% of all finance jobs, against 1.2% in 1980, says Thomas Philippon of New York University—and probably a much higher proportion of pay. By 2007 finance was attracting a quarter of all graduates from the California Institute of Technology.

These eggheads are now in the dock, along with their probabilistic models. In America a congressional panel is investigating the models’ role in the crash. Wired, a publication that can hardly be accused of technophobia, has described default-probability models as “the formula that killed Wall Street”. Long-standing critics of risk-modelling, such as Nassim Nicholas Taleb, author of “The Black Swan”, and Paul Wilmott, a mathematician turned financial educator, are now hailed as seers. Models “increased risk exposure instead of limiting it”, says Mr Taleb. “They can be worse than nothing, the equivalent of a dangerous operation on a patient who would stand a better chance if left untreated.”

Modelling is not going away; indeed, number-crunchers who are devising new ways to protect investors from outlying fat-tail risks are gaining influence. Pimco, for instance, offers fat-tail hedging programmes for mutual-fund clients, using cocktails of options and other instruments. These are built on specific risk factors rather than on the broader and increasingly fluid division of assets between equities, currencies, commodities and so on. The relationships between asset classes “have become less stable”, says Mohamed El-Erian, Pimco’s chief executive. “Asset-class diversification remains desirable but is not sufficient.”


In some areas the need may be for more computing power, not less. Financial firms already spend more than any other industry on information technology (IT): some $500 billion in 2009, according to Gartner, a consultancy. Yet the quality of information filtering through to senior managers is often inadequate.

The way forward is not to reject high-tech finance but to be honest about its limitations, says Emanuel Derman, a professor at New York’s Columbia University and a former quant at Goldman Sachs. Models should be seen as metaphors that can enlighten but do not describe the world perfectly. Messrs Derman and Wilmott have drawn up a modeller’s Hippocratic oath which pledges, among other things: “I will remember that I didn’t make the world, and it doesn’t satisfy my equations,” and “I will never sacrifice reality for elegance without explaining why I have done so.” Often the problem is not complex finance but the people who practise it, says Mr Wilmott. Because of their love of puzzles, quants lean towards technically brilliant rather than sensible solutions and tend to over-engineer: “You may need a plumber but you get a professor of fluid dynamics.”

One way to deal with that problem is to self-insure. JPMorgan Chase holds $3 billion of “model-uncertainty reserves” to cover mishaps caused by quants who have been too clever by half. If you can make provisions for bad loans, why not bad maths too?

http://www.economist.com/specialreports/displaystory.cfm?story_id=15474075

All about current financial mess

In my search for the answer (s) regarding the current financial melt down, I stumbled upon a blog from Tompeters. Here is his suggestion as a starting point to see through the fog that surround the mess.

"My favorite came from the Financial Times' prize-winning reporter–editorialist Gillian Tett. Namely: Fool's Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe. (Hats off to the FT in general for reporting on the crisis—my FT "take" beats my Wall Street Journal take 4 days out of every 5.) (Ms. Tett notwithstanding, I believe the best way to get your reading head around the current mess is to readMichael Lewis's 1989 classic, Liar's Poker.)

As to best book by a "finance guy," it's no contest! The gold to Vanguard Mutual Fund Group founder John Bogle for Enough. The chapter titles tell the story. Here's a sample:

"Too Much Cost, Not Enough Value"
"Too Much Speculation, Not Enough Investment"
"Too Much Complexity, Not Enough Simplicity"
"Too Much Counting, Not Enough Trust"
"Too Much Business Conduct, Not Enough Professional Conduct"
"Too Much Salesmanship, Not Enough Stewardship"
"Too Much Focus on Things, Not Enough Focus on Commitment"
"Too Many Twenty-first Century Values, Not Enough Eighteenth-Century Values"
"Too Much 'Success,' Not Enough Character"

As to the overarching theme of the book, Mr. Bogle begins with this vignette: "At a party given by a billionaire on Shelter Island, Kurt Vonnegut informs his pal, Joseph Heller, that their host, a hedge fund manager, had made more money in a single day than Heller had earned from his wildly popular novel Catch-22 over its whole history. Heller responds, 'Yes, but I have something he will never have ...
enough.'"

tompeters! management consulting leadership training development project management

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Why companies manage their earnings?

 Joseph Grundfest and Nadya Malenko analyzed almost half a million earnings reports from 1980-2006. They discovered that when companies want to appear more successful than they are, they often massage their per-share earnings numbers upward by a tenth of one cent. 


Why earnings management?


Consistent with analyst coverage being a determinant of earnings management, quadrophobia increases (declines) when companies gain (lose) analyst coverage, and is more frequent when earnings are close to analyst forecasts."


Why analysts' coverage is required? In my opinion asymmetry of information about business between outsiders and insiders.


Quran says: Ayat 8 - 16 of Sura Al-Baqara


First the characteristics of people who lie.

1. Of the people there are some who say: "We believe in Allah and the Last Day" but they do not (really) believe.
2. Fain would they deceive Allah and those who believe but they only deceive themselves and realize (it) not!

Then the reasons why people lie.

1. In their hearts is a disease; and Allah has increased their disease and grievous is the penalty they (incur) because they are false (to themselves).

Then the symptoms of people who lie.

1. When it is said to them: "Make not mischief on the earth" they say: "Why we only want to make peace!"
2. Of a surety they are the ones who make mischief but they realize (it) not.
3. When it is said to them: "Believe as the others believe" they say: "Shall we believe as the fools believe?" nay of a surety they are the fools buy they do not know.
4. When they meet those who believe they say: "We believe" but when they are alone with their evil ones they say: "We are really with you we (were) only jesting."

Then the benefit cost analysis of lying.

1. Allah will throw back their mockery on them and give them rope in their trespasses; so they will wander like blind ones (to and fro).
2. These are they who have bartered guidance for error: but their traffic is profitless and they have lost true direction. 

Predicting the Next Enron - Freakonomics Blog - NYTimes.com

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Deleveraging: Now the hard part

Every research into finding the causes of recent financial crisis leads to one point that debt is the cause, yet there is blindness and deafness. What could be said about this phenomenon other than that 


"As to those who reject Faith, it is the same to them whether thou warn them or do not warn them; they will not believe."
"Allah hath set a seal on their hearts and on their hearing, and on their eyes is a veil; great is the penalty they (incur)."
(Aya 6 & 7 of Sura Al-Baqara)


Here is an excerpt from Mackinsey Global Institute research report.


"Even as signals multiply that a global economic recovery is underway, government and business leaders face uncertainty over its durability and how to manage the lengthy process of debt reduction—or deleveraging—that will weigh on growth after the bursting of the great global credit bubble.

New McKinsey research shows that the challenge of reducing total debt levels relative to GDP is a global problem that is only just getting started. Leverage is still very high in some sectors of several countries, including the United States. History also shows that deleveraging episodes are painful—on average lasting six to seven years—and exert a significant drag on GDP growth in the early stages." 

Facebook | McKinsey Quarterly: Deleveraging: Now the hard part

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How the tax code encourages debt: newyorker.com

How the tax code encourages debt: newyorker.com

John Kenneth Galbraith wrote that all financial crises are the result of “debt that, in one fashion or another, has become dangerously out of scale.” The recent financial crisis was no exception, with everyone—homeowners, private-equity investors, our biggest banks—taking on enormous amounts of debt. If it’s frustrating that the government is footing the bill to clean up the mess, it’s even worse that the government helped pay for the debt binge that created the mess in the first place, thanks to a tax system that actually subsidizes borrowing. Debt didn’t get dangerously out of scale because the system was broken. It got out of scale, in part, because the system worked

Read more: http://www.newyorker.com/talk/financial/2009/11/23/091123ta_talk_surowiecki#ixzz0XfTASpak

Economic Sense

The cause of indebtedness most of the time is the "Economic Sense" that is being inculcated through marketing tactics and promoting theories of finance. The "Economic Sense" is future projections show that it is feasible to finance the project through loan, our inflows are good enough to meet our interest plus installment obligations. It also makes "Economic Sense" to buy a car on lease finance for commuting to a higher paying job than presntly a less attractive. It is also an "Economic Sense" to buy a home on mortgage by calculating and equating interest plus installment to present rent.

Paul Krugman says best " the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations. The renewed romance with the idealized market was, to be sure, partly a response to shifting political winds, partly a response to financial incentives. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess."

The economic sense is all mathematical equation devoid of reality. It assumes that nothing can go wrong. This false assumption leads us to disaster. It is synonymous to "Lead to destruction those whom thou canst among them with thy (seductive) voice; make assaults on them with thy cavalry and thy infantry; mutually share with them wealth and children; and make promises to them. But Satan promises them nothing but deceit." Aya 64 Sura Al-Isra

Beware of debt financing. It is just a mathematics, an illusion, a trap.

"the belief in efficient financial markets blinded many if not most economists to the emergence of the biggest financial bubble in history. And efficient-market theory also played a significant role in inflating that bubble in the first place.

Now that the undiagnosed bubble has burst, the true riskiness of supposedly safe assets has been revealed and the financial system has demonstrated its fragility. U.S. households have seen $13 trillion in wealth evaporate. More than six million jobs have been lost, and the unemployment rate appears headed for its highest level since 1940."

The assumption was "nothing can go wrong", here is the projection, risk analysis, sensitivity analysis etc. etc.

Poverty Alleviation through Charity

I am surprised to find that there is an alternative to poverty reduction through micro finance / micro lending. The program is run by The BOMA fund in Africa. Through three programs, the Rural Entrepreneur Access Project (REAP), Agents of Change, and Cows For Kids, BOMA helps groups in northern Kenya learn how to run businesses, become leaders, and start on the road to self-sufficiency. Executive Director of the BOMA fund, Kathleen Colson says that we focus on economic empowerment, primarily with women, through the Rural Entrepreneur Access Project, or REAP. That's our signature program of micro-enterprise development.We identify and train people within villages to work as business mentors. They must have strong community roots, work well with women, and have a sustainable income through some kind of business. They then organize small businesses around groups of five women and provide them with business skills training and a small grant of 150 dollars. The groups are mentored for two years. She says that I think that grants are the right way to go for an effective poverty alleviation program when you're dealing in areas where you have the truly ultra-poor who don't have experience or skills with business. It's not so much about the 150 dollar grant as it is about the business skills training program and helping people identify the discipline that's required in starting these very small businesses. Her theory of helping the poors is very much in line with Quranic injunctions. "They ask thee what they should spend (in charity). Say: Whatever ye spend that is good is for parents and kindred and orphans and those in want and for wayfarers. And whatever ye do that is good Allah knoweth it well". Aya 215 Sura Al-Baqara

Debt Based Business - 1

Reading and thinking about debt / loan, I come to the conclusion so far that it is highly dangerous for one's wealth as well as for ethics to deal in it either as a lender or as a borrower as far as Muslim and Islam is concerned and this is best for the mankind as a whole as Allah (SWT) says that "And this was the legacy that Abraham left to his sons and so did Jacob; "O my sons! Allah hath chosen the faith for you; then die not except in the faith of Islam." Aya 132 Sura Al-Baqara

Let us discuss, first, why and how the debt is harmful for one's wealth. First, it is not possible to lend someone without any benefit whether pecuniary or else, Islamic or non-Islamic. So the discussion of usury / interest / mark-up / profit is irrelevant. It will be present in any transaction involving debt; pure loan transaction, credit based trading transaction, Islamic debt "Murabaha", "Ijara" etc. Second, in lending business there shall always be risk of default because future is an unknown entity, anything can go wrong beyond our most sophisticated analysis or our wildest dreams. As a Muslim, we have complete faith that what is said in Quran, is absolutely true.

"O ye who believe! devour not usury doubled and multiplied; but fear Allah; that ye may (really) prosper. " Aya 130 Sura Al-i'Imran

"That which ye lay out for increase through the property of (other) people will have no increase with Allah: but that which ye lay out for charity seeking the Countenance of Allah (will increase): it is these who will get a recompense multiplied." Aya 39 Sura Ar-Rum

"Allah will deprive usury of all blessing but will give increase for deeds of charity: for He loveth not creatures ungrateful and wicked." Aya 276 Sura Al-Baqara

"O ye who believe! fear Allah and give up what remains of your demand for usury if ye are indeed believers." Aya 278 Sura Al-Baqara

"If ye do it not take notice of war from Allah and his Apostle: but if ye turn back ye shall have your capital sums; deal not unjustly and ye shall not be dealt with unjustly." Aya 279 Sura Al-Baqara

"That they took usury (interest) though they were forbidden; and that they devoured men's substance wrongfully; We have prepared for those among them who reject faith a grievous punishment." Aya 161 Sura An-Nisa

"If the debtor is in a difficulty grant him time till it is easy for him to repay. But if ye remit if by way of charity that is best for you if ye only knew." Aya 280 Sura Al-Baqara

Two commandments from Allah (SWT) are very clear from above referred verses from Quran. First, usury/ interest/ mark-up/ profit on loan is forbidden, stay away from it otherwise take notice of war from Him and His Messenger (PBUH). Second, grant time to debtor in distress till he is able to pay or write off debt by way of charity. Both the orders are very difficult to obey if not impossible. How can one lend to someone without any benefit explicit or implicit? How can one give unlimited time to debtor, even in distress, for payment of his debt?

Debt Based Business Transactions

While thinking about this Aya 280 of Al-Baqara. I am not able to determine whether the first part of the Aya "If the debtor is in a difficulty grant him time till it is easy for him to repay" is mandatory up on Muslims. If so then it is not for everyone to do business on 'Murabahah", one must have enough capital, if one has to wait for sometime that some of his debtors are able to pay, he is not out of business. This Aya is part of Ruku 38 that starts from Aya 274 and ends at Aya 281. While reading of these Ayat, I understood these Ayat as follows:

1. Give charity. Those who give charity, they shall be in no fear and grief whatsoever - decrease in their wealth is one of these.
2. Trade is permitted but usury is forbidden. Usury is something different from trade.
3. Usury will not increase anything including wealth but deeds of charity will increase all things including wealth. Allah(SWT) does not love ungrateful and wicked. People shall be ungrateful and wicked also - ungrateful to Allah(SWT) on His blessings on them and wicked as to use some mischievous ways to defeat the forbidding of usury.
4. Those who have firm belief in everything that is said above and do good deeds and establish Salah and pay Zakah, their reward is with Allah(SWT) and they shall be in no fear and grief whatsoever - That reward, they may not perceive it.
5. Those who claim to be Muslims should be conscious of Allah(SWT) and should give up their demand of usury if they claim to be Muslims.
6. If you (those who claim to be Muslims) don't do this, then there is a notice of war from Allah(SWT) and His Messenger (PBUH) and if you agree to give up your demand of usury then you are entitled to your original amount.
7. If the debtor is unable to pay the original amount that is promised above then give him time to such an extent that he is able to pay the amount but it is much better to give up entire amount as charity. Don't write off this amount in your books as bad debt but as giving a charity. This act is best of the things in debt based transactions but one may not perceive it.
8. Remain conscious of the day of judgment when all human beings shall be accounted for their deeds and each shall have his account statement of good deeds and sinful deeds that shall be prepared with enough proof that no one shall be able to deny it.

All of the above leads to one conclusion that there is an element of usury in debt based transactions and these types of transactions are not to be taken as a routine matter as in business no one has enough capital to give time to debtor till they are able to pay the original amount - meaning cost or cash basis price and nor can everyone write them off as charity even if it is the best and it is the best because Allah(SWT) has said so.