Investors Pull Out of Mutual Funds

If this trend continues, and US corporations continue to scale back on their stock buybacks, look for another slump in US stock prices this quarter. Right now the stock market is likely being sustained by hedge fund buying from resurgence in the carry trade. Once that let's up, the thinness in the equity market will be set up for an event driven plunge.

Investors pull out of mutual funds
By Deborah Brewster in New York
Financial Times
Published: April 27 2008 22:26

All but one of the 25 largest US mutual fund managers saw their long-term assets fall in the first quarter, as returns dived and investors pulled out of funds.

In the worst start to a year for more than a decade, most money managers had retail outflows, and even stalwarts such as American Funds and Vanguard suffered a drop in assets, of 6.6 per cent and 4.3 per cent respectively.

Pimco, the bond manager, was the only one to show a rise in retail assets, according to Financial Research Corporation and industry estimates. Pimco’s Total Return fund had an inflow of $9bn in the three months to March.

The trend is likely to worry economists, because it suggests the credit turmoil is hurting the confidence of mainstream investors. That, in turn, could dampen activity among consumers in the months ahead, since falling investment sentiment is often associated with muted household spending levels.

However, the fall also marks a fresh blow for the financial industry, because mutual fund managers typically make money by charging a percentage of assets – meaning that profits in the industry fall when assets decline.

Last week, a group of publicly traded asset managers announced bleak quarterly results. Affiliated Managers Group, which holds stakes in 26 mutual and hedge fund companies, reported a quarterly profit fall for the first time in five years, with outflows of $8.4bn in the quarter.

Big institutional fund groups – such as AllianceBernstein, a unit of French insurance group Axa – likewise showed asset falls.

One senior industry executive said: “This is the worst I have seen for a long time, the industry-wide outflows, and unfortunately I don’t think it is a short-term situation. The days of domestic [US] equity funds driving profits for us, that could be gone.”

Retail and institutional investors pulled $100bn from US, European and Japanese equity funds during the quarter, according to Strategic Insight.

The trend is accelerating a shift in the money management industry, as investors move away from equity funds, which have been the industry’s profit mainstay, towards either low-margin options such as short-term cash and indexed funds, or high- margin alternative investments such as hedge funds, private equity and hard assets.

Long-term assets do not include money market funds, which have seen big inflows. Several money managers, such as Fidelity, have large money market funds which are offsetting their outflows, although money market funds are low-margin products and do not provide long-term investor loyalty. Fidelity had a drop of long-term assets of close to 10 per cent for the quarter, as investors continued to pull funds from the former market leader despite a lift in performance in its funds.

How the SEC Enabled the Wall Street Credit Crisis

The bailout of Bear Stearns by the Fed was a travesty of the public trust. To say that no public money was put at risk is a misstatement of the facts.

The investment bank should have been allowed to fail in a managed liquidation, and the Fed should have opened the discount window for the commercial banks to keep them solvent on an arranged borrowing plan that minimized their profits and cut the bonuses and dividends severely. The so-called purchase of Bear by JPM is a farce.

That these banks are still paying dividends and bonuses is a crime against the public trust. Unless we reform the banking system, reinstate Glass-Steagall, and tighten capital requirements on commercial banks the looting of the US Dollar by the banks will continue.

April 27, 2008
Everybody’s Business
Wall Street, Run Amok
By BEN STEIN

YOU may well be asking yourself, as I have asked myself, how on earth did the credit crisis on Wall Street become such a catastrophe?

How did all of the mechanisms operated by the mind-bogglingly well-paid men and women of the Street go so wrong that we saw a major investment bank, Bear Stearns, essentially disappear? How did Wall Street firms of ancient lineage take such immense losses that they made banks clam up on lending — at great risk to the economy?

Weren’t fail-safe devices in place to guard against risk? Weren’t government watchdogs there to make sure that catastrophes could not happen? Weren’t ratings agencies on the job to police what was going on in the canyons of Lower Manhattan?

To paraphrase Dr. Evil in the “Austin Powers” movies: “How about ‘no,’ Scott?”

Anyone who cares about this disaster would be extremely well advised — and I’d underline “extremely” as often as possible — to read a speech on the matter that was given on April 8 by a genius investor named David Einhorn at a Grant’s Interest Rate Observer event.

Mr. Einhorn runs Greenlight Capital, a successful hedge fund. He also isn’t an infallible observer of human lapses and regulatory failures — he invested in and briefly served on the board of New Century, a subprime mortgage lender that later went bust amid accounting problems. (When I sought his response, Mr. Einhorn said he did not want to comment on New Century or on his essay.)

Yet his speech so well explains what went wrong in the financial debacle that it’s frightening. Here is my CliffsNotes version of it.

First, Maestro Einhorn points out that the fellows who run big investment banks have a strong incentive to maximize their assets and leverage themselves into deep trouble because their pay is a function of how much debt they can pile on. If they can use relatively low-interest debt to generate slightly higher returns, the firm earns more revenue and executive pay increases. Often, an astonishing 50 percent of total revenue goes to employee compensation at Wall Street firms.

NOW, you may ask, what kind of assets were they acquiring with that debt? Well, sometimes, as with Bear Stearns, the leveraged assets are mostly government agency debt, which used to be regarded as fairly safe.

Sometimes, as Mr. Einhorn notes, those portfolios also hold stocks, bonds, loans awaiting securitization, and pieces of structured finance deals. They also hold heavy exposure to derivatives that have stunning risk profiles and can produce astounding losses in bad circumstances. They might also contain real estate assets and have exposure to private equity deals.

In other words, they can hold some scary “assets.” What do they hold as capital against such risks? You would think it would be cash or Treasury bonds, wouldn’t you? But no.

Under an interesting set of rules promulgated by the Securities and Exchange Commission in 2004, called “Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities,” the amount of capital that had to underlie assets was reduced substantially. (Mr. Einhorn rightly says that this set of rules should have been called the “Bear Stearns Future Insolvency Act of 2004.”)

Through the act, the S.E.C. — acting as one of Wall Street’s chief regulators, mind you — also allowed such things as “hybrid capital instruments” (much riskier than cash or Treasuries), subordinated debt (ditto) and even deferred return of taxes, to be counted as capital. The S.E.C. even allowed the banks to hold securities “for which there is no ready market” as capital.

“These adjustments reduced the amount of required capital to engage in increasingly risky activities,” Mr. Einhorn says.

In response to Mr. Einhorn’s critique, an S.E.C. spokesman told me that these changes could theoretically lower capital, but that the agency has seen no evidence that that has, in fact, occurred.

But Mr. Einhorn has even more troubling observations. He says the S.E.C. also allowed broker-dealers to set their own valuations on assets and liabilities that were hard to value. And broker-dealers could assign their own creditworthiness ratings to counterparties in complex derivatives transactions when those counterparties were otherwise unrated.

In a word, Mr. Einhorn says, the S.E.C. told Wall Street to police itself to save on regulatory costs, while not bothering to “discuss the cost to society of increasing the probability that a large broker-dealer could go bust.”

A result of all this, he says, was as follows:

“The owners, employees and creditors of these institutions are rewarded when they succeed, but it is all of us, the taxpayers, who are left on the hook if they fail. This is called private profits and socialized risk. Heads, I win. Tails you lose. It is a reverse-Robin Hood system.”

And when it all went kaput during the Bear Stearns debacle, the likable chairman of the S.E.C., Christopher Cox, said that the system was fine and needed no immediate repairs. Of course, Henry M. Paulson Jr., the Treasury secretary, is calling for merging the S.E.C. with the easygoing Commodity Futures Trading Commission, in the financial equivalent of setting off a Doomsday Device.

The S.E.C. told me that all of its actions were helpful to investors and that no one could have prevented the Bear Stearns collapse because it was caused by liquidity issues, not capital issues. My respectful response is that if Bear were thoroughly well capitalized, why would liquidity issues come up at all?

There is much more in Mr. Einhorn’s speech about how dramatically understaffed the ratings agencies are in assessing risk on Wall Street and how even the biggest ratings agencies largely allowed the Street to rate itself.

The big ratings firms, according to Mr. Einhorn, do not even bother to assess the major investment banks’ portfolios because they change so often.

It looks to me as if the inmates are running the asylum. One truth, that deregulation is sometimes a good thing, has been followed down so long and winding a road that it has led to an immense lie: that deregulation carried to an extreme will not lead to calamity.

To think that people of this mind-set are in charge of the finances of the nation that is the cornerstone of world freedom is terrifying. Mr. Einhorn may well have done us a service of great value.

Ben Stein is a lawyer, writer, actor and economist. E-mail: ebiz@nytimes.com.

Wave of Coming Bankruptcies Likely to Devastate Corporate Bondholders

Bondholders Lucky to Get 10 Cents in Looming Defaults
By Caroline Salas

April 23 (Bloomberg) -- The looming wave of bankruptcies is unlikely to be kind to bondholders. And they have only themselves to blame.

Rather than receiving the historical average recovery of 42 cents on the dollar in a default, owners of a third of high- yield, high-risk bonds rated B+ or lower may get no more than 10 cents, according to New York-based Fitch Ratings. About 22 percent are likely to get 11 cents to 30 cents.

Bond investors from Pacific Investment Management Co. to Capital Research & Management Co. may pay the price for allowing themselves to be subordinated by junk-rated companies that borrowed a record $2.2 trillion of bank loans in the past three years. Unsecured creditors of Fedders Corp. and Buffets Inc. have lost almost all their money as lenders lay claim to the companies' assets. Standard & Poor's says Burlington Coat Factory Warehouse Corp. and Univision Communications Inc. bondholders may meet a similar fate in a default.

''There've been some disappointments,'' Paul Scanlon, team leader for U.S. high yield and bank debt at Putnam Investments, said in a telephone interview from his Boston office. Putnam manages $66 billion in fixed-income, including bonds of Univision. ''As people look back over the last 24 months, there are many transactions in portfolios that people have hoped the outcome might have proceeded differently than it has.''

More Crucial

Bondholder recovery rates are becoming more crucial as the U.S. economy slows. Chapter 11 business bankruptcies rose 16 percent in the first quarter, according to court records compiled by Jupiter eSources LLC, and Moody's Investors Service said last week that the number of companies at risk of running out of cash is the highest since at least October 2002.

''When leverage was so ample, private equity firms were able to buy companies at multiples that didn't make sense,'' said James Keenan, who oversees $20 billion of high-yield debt as co- head of leveraged finance at BlackRock Inc. in New York. ''Most people use the assumption senior unsecured bonds are going to recover 40 percent. I don't think you're going to see that.''

The amount of debt in Merrill Lynch & Co.'s U.S. High Yield Distressed Index has swelled to $206 billion from $4.8 billion a year ago. The index contains non-defaulted bonds with yields of 10 percentage points or more above Treasuries.

Defaults to Rise

Moody's anticipates defaults will quadruple to 5.9 percent in 12 months. That assumes a ''mild'' recession. Judging by the amount of distressed debt, investors expect an 8 percent default rate, said Martin Fridson, head of high-yield research firm FridsonVision LLC in New York.

''I'm inclined to take the market at its word,'' said Fridson, who previously led a research group at Merrill that won first place for high-yield strategy in Institutional Investor's survey nine years in a row.

Junk bonds lost 3 percent in the first quarter, the worst start to a year on record, according to Merrill's U.S. High Yield Master II Index. The extra yield, or spread, investors demand to own the debt instead of Treasuries has risen to 7.07 percentage points from 5.92 percentage points at year-end, Merrill data show. High-yield, or junk, debt is rated below Baa3 by Moody's and lower than BBB- by S&P and Fitch.

Of about 100 issuers rated B+ and lower by Fitch, 24 percent may recover 51 cents on the dollar or more. B+ is the fourth- highest of 12 junk bond levels. Asset-rich companies such as Dallas-based Energy Future Holdings Corp., the former TXU Corp., which is the largest electricity producer in Texas, may be among those that would generate above-average recoveries, Keenan said.

Covenant-Lite

Along with the surge in bank loans came covenant-lite loans, which typically don't limit the amount of debt a company can have relative to earnings. A record $141 billion of covenant-lite loans was made last year, according to S&P.

The value of companies with those loans is likely to be 25 percent less when they ultimately default than if they'd been forced to restructure earlier, Fitch estimates.

Univision, the largest U.S. Spanish-language broadcaster, received $7.45 billion of covenant-lite loans last year to finance the New York-based company's $12.3 billion takeover by a buyout group including Chicago-based Madison Dearborn Partners LLC and billionaire Haim Saban.

S&P, which cut Univision's credit rating to B- in March and may downgrade it further, predicts investors in its first-lien bank loans will get from 70 percent to 90 percent of their money back in a default while owners of Univision's $1.5 billion of 9.75 percent notes due in 2015 may get nothing.

Capital Research owns the Univision notes, which have lost about 31 percent in the past year, filings and data compiled by Bloomberg show. Abner Goldstine, fund manager at Los Angeles- based Capital Research, didn't return calls seeking comment.

Hawaiian, Burlington

As of Dec. 31, Goldstine's $12.2 billion American High- Income Trust also owns bonds of Burlington, New Jersey-based retailer Burlington Coat Factory, phone company Hawaiian Telcom Communications Inc. of Honolulu and mobile-phone chipmaker Freescale Semiconductor Inc. notes, based in Austin, Texas.

Pimco, the manager of the world's biggest bond fund, owns Hawaiian Telcom and Freescale. Putnam owns Freescale.

Bonds of all those companies are trading at distressed yields and noteholders will get no more than 10 cents on the dollar back in defaults, S&P predicts.

Mark Porterfield, spokesman for Pimco in Newport Beach, California, declined to comment. Putnam's Scanlon declined to comment on specific companies.

''Over the past few years you had a large growth of aggressive deals coming to market,'' said William May, senior director in credit market research at Fitch. ''The unsecured creditors are the ones who are most at risk.''

Limited Recoveries

Bondholders already face limited recoveries from companies that filed for bankruptcy.

Unsecured creditors of Liberty Corner, New Jersey-based air conditioner maker Fedders are suing lenders including Goldman Sachs Group Inc. and Highland Capital Management LP in addition to executives and directors. A $90 million loan taken out by the company in March 2007 wiped out the value of the stakes of creditors, they allege. Fedders filed for bankruptcy in August.

''They were saddling the company with secured debt that could never be repaid and the end game for them was prolongation of job security for upper management and putting off the inevitable,'' Jeremy Coffey, partner at Brown Rudnick Berlack Israels LLP in Boston, who represents unsecured creditors, said.

Goldman spokesman Michael Duvally declined to comment. Jack Yang, a partner at Highland, declined to comment.

Fedders Prelude

The Fedders fight may be a prelude to more battles between loan and bond investors as defaults rise. Typically, those spats have been reserved for subordinated bondholders, who rank behind bank lenders and the owners of senior notes.

''Whereas in the last recession it was more common perhaps to see the inter-creditor fights between subordinated unsecured creditors and the senior unsecured creditors, it may very well be that in this cycle that will have moved up a level in the priority chain,'' Andrew Rahl, a partner in commercial restructuring and bankruptcy at Reed Smith LLP in New York, said.

Stiglitz: Greenspan and Bush to Blame for the US Crisis

Its difficult to react to an excerpt from an unpublished interview.

Although we strongly agree with what he has said here, we are dumbfounded that there is no mention of the big US banks and Wall Street, who were engaging in serial fraud and corruption of the system going back to Enron and beyond, encouraging accounting fraud and reckless speculation. Greenspan and Bush were obvious figureheads and enablers, having accomplished little or nothing in their private lives before their moment on the stage.

Are we at the point we predicted when the real perpetrators start looking for scapegoats and patsies to toss over the back of the sled to hold off the oncoming pack of wolves?

If so, Greenspan and Bush make a likely pair of shallow boobs to take the fall. But it won't fix anything. And where were all the professors and pundits during the period in which this was all happening? Playing dumb for the most part, or putting out weighty sounding defenses of these offenses for a few pieces of silver.

The scapegoat phase is predictable but fruitless overall. The system must be reformed; the banks must be restrained again. The theft of the public good will continue until this occurs. They will distort every program, pollute every dollar of aid, to their continuing looting of the public trust.

There is a growing call in the US to pull one's money out of the big Wall Street banks. We're not sure about the effective of this, since it keeps the stock and bond markets intact, but its a start. Petitions for redress have been ignored. We've elected the Democrats and they have done far too little, waiting for the safety of a likely Democratic president. So now the time for boycotts has begun it appears.

The system must be reformed. Glass-Steagall must be reinstated. The Wall Street Banks must be restrained from using the public money to finance their private speculations. We must stop privatizing gains and socializing their losses.

Greenspan, Bush to blame for U.S. crisis: Stiglitz
Reuters
Sun Apr 27, 6:48 AM ET

Former Federal Reserve Chairman Alan Greenspan and the government of President George W. Bush were to blame for the U.S. financial crisis, Nobel laureate economist Joseph Stiglitz said in a magazine interview.

"This man (Greenspan) has unfortunately made a lot of mistakes," said former World Bank chief economist Stiglitz, according to a preview of the interview to be published on Monday in profil magazine.

"His first one was to support all the tax cuts which were introduced under Bush -- they didn't stimulate the economy very much ... This task was then transferred more towards monetary policy, though then (Greenspan) created a flood of credits with low interest rates," Stiglitz was quoted as saying.

Earlier in April, Greenspan said in an interview with CNBC television that the U.S. economy was in recession and defended his chairmanship of the U.S. central bank against charges that his policy missteps had laid the groundwork for the crisis.

He said decisions during his charge had been rationally constructed based on evidence at the time.

Stiglitz said Bush's government was also to blame.

"I reproach them, that the economy was not as resilient as it could have been due to the ongoing tax cuts and the huge costs incurred by the war in Iraq," he was quoted as saying.

He said it was a myth that Europe could decouple itself from the United States.

"Especially the weak dollar will continue to hit the European economy hard, because it will make it much harder to export," he said.

(Reporting by Karin Strohecker; Editing by David Holmes)