Asia’s alternative path to economic growth

Review by DAVID TAN
davidtan@thestar.com.my

Nowhere to Hide: The Great Financial Crisis and Challenges for Asia
Authors: Dr Lim Mah Hui and Dr Lim Chin
Publisher: Institute of Southeast Asian Studies

ASIAN countries must not depend solely on being export-driven to generate growth but should instead focus on increasing domestic consumption.

Authors Dr Lim Mah Hui and Dr Lim Chin present a cogent argument why Asia should move away from being an export-oriented region in their book titled Nowhere to Hide: The Great Financial Crisis and Challenges for Asia. The authors say that the United States and Europe are no longer reliable markets for Asia.

“The US cannot go on accumulating international debt at the present rate without triggering another financial crisis. It has to narrow its chronic current deficit by either increasing its gross savings or reducing its gross investments,” the authors say.

The US is already buying less, as reflected by its improving savings rate, which rose from zero percent in April 2008 to 6.9% in May 2009. It is currently hovering around 4% at present.

Its current account deficit has also narrowed to about 3% of gross domestic product (GDP) in 2009 from 6.5% in 2006.

Neither can the European economy be relied upon as an export market for Asia, given the financial crisis in Greece, Spain, and Portugal.

This leaves the Asian domestic markets as the alternative for economic growth. But the authors point out that the ability of Asian economies to spend is capped by the people’s purchasing power.

In China, the population’s capacity to spend is restraint by the need to save for precautionary reasons.
“For instance, the poor are forced to save because of deterioration in access to health care, education, and social security,” the authors say.

Thus, if China wants to increase consumption as a driver of economic growth, it has to reduce income equality, improve social services, and provide social safety nets for the population.

Mah Hui and Chin argue that wages should increase to keep up with rising productivity to ensure adequate purchasing power.

Corporate savings in China can be taxed to help improve healthcare and social security services, reducing the need for excessive precautionary savings. This will also boost private and household consumption.

Asian economies with large foreign reserves should invest more in the region to raise growth, income, and consumption, and reduce dependency on the West.

To drive domestic consumption, Asian economies should not follow the Anglo-Saxon model, which is to turn to debt creation.

In Malaysia, there is reliance on increasing household debt to fuel consumption. About 55% of the country’s total bank loans are for private consumption and household such as residential and non-residential property loans (36%), passenger car loans (10%), credit cards and personal loans (7%).

In view that some 60% of the Malaysian population makes a monthly wage of about US$900, increasing consumption through debt creation could take it down the same path as the US, the authors say. “In fact, this is a policy challenge for most Asian countries, particularly China, which is attempting to turn to domestic consumption as an engine of growth,” they say.

Nowhere to Hide: The Great Financial Crisis and Challenges for Asia examines the origin of the crisis in the early eighties when US financial regulators were financially intoxicated.

This resulted in the removal of the Glass-Steagall Act, which separated commercial and investment activities in banks, prohibiting interstate banking so that banks do not become too big and take too much risks, and regulating the activities of commercial banks.

The deregulation led to the appearance of asset-backed securities (ABS) and collaterised debt obligations, which repacked and sold ABS with credit ratings, creating a category of subprime mortgages.

Subprime mortgages formed about 15%, or US$1.5 trillion, of total US housing loans from 2004 to 2006. These subprime loans, distributed worldwide, were fine as long as the US housing market continued to boom and interest rates did not rise.

When these conditions disappeared and the borrowers defaulted in 2007, the subprime crisis erupted in the US, leading inevitably to the global economic crisis.

The book also examines how long-term causes such as the imbalance between the financial sector and the real economy turned the US into the world’s largest debtor nation, with a current account deficit reaching more than US$800bil, or 6.5% of its 2006 GDP.

The US financial sector’s contribution to GDP from 1960 to 2006 rose from 14% to 20%, while the manufacturing sector more than halved from 27% to 11% of GDP.

From 1960 and 2007 the size of domestic debt grew 64 times from US$781bil in 1960 to US$49.9 trillion in 2007, while the GDP rose 27 times from US$526bil to US$14 trillion during the same period.

Mah Hui and Chin concludes the book with a call for capital controls to be reconsidered, as the free movement of capital results in the volatility of exchange rates, which in turn can undermine small economies and a country’s ability to pursue independent monetary policies.

The book also proposes that a Special Drawing Rights note, not pegged to any other sovereign state, be used as the international currency, which is one way of restoring global stability and equity.

The argument for government intervention in the economy, which the authors’ present in the book, occupy a middle-ground between two competing analyses of capitalism that were advanced in the first half of twentieth-century by two Austrian economists Friedrich Hayek and Karl Polanyi.

Hayek holds the view that depressions are cycles in a capitalist economy, which should be allowed to run its course without any intervention from the government, while Polanyi argues that the free market system needs to be regulated by a global governing financial authority, as it is prone to failure, which would lead to dystopia.
But how much government intervention should there be and in what areas should it intervene?

For example, should the Chinese government just play a role in improving healthcare and social security services to reduce precautionary savings and boost domestic spending?

Or should it also ensure that there is always full employment even during periods of depression to ensure that the working class have the power to consume?

Prior to the financial deregulation of the 1980s, government intervention in the UK’s economy to create jobs kept wages and inflation high, leading eventually to unemployment, deficits, and high interest rates. Should the government also intervene to create employment? These are some questions which the book leaves unanswered.

Nowhere to Hide: The Great Financial Crisis and Challenges for Asia is a reliable guide for the layman to understand the origins of the global economic crisis and how Asia should respond to the challenges.

Euro Company Spreads Rise to Record Versus U.S.: Credit Markets

By Bryan Keogh and John Detrixhe

 

June 11 (Bloomberg) -- The risk of owning Europe’s corporate bonds is the highest on record relative to U.S. company debt as investors lose confidence lawmakers and central bankers can tame the region’s worsening fiscal crisis.

Yields on investment-grade bonds in euros rose to a 10- month high of 239 basis points, or 2.39 percentage points, more than government debt, according to Barclays Capital index data. That’s 41 basis points more than the spread for U.S. company notes, near the record 44 basis points reached May 27. European bond spreads were below those on dollar debt as recently as February, the indexes show.

Yields suggest debt investors are concerned Europe’s sovereign debt crisis will stifle growth and curb profits even after European Union President Herman Van Rompuy said yesterday a 750 billion-euro ($908 billion) rescue package will be increased if it fails to quell volatility. About 75 percent of investors and analysts expect some governments in the region to default or the 16-nation euro area to break up, according to a quarterly poll of Bloomberg subscribers.

“It’s largely fear driven,” said John Milne, chief executive officer of JKMilne Asset Management, who oversees about $1.8 billion in Fort Myers, Florida, and favors U.S. corporate bonds. “People like ourselves are holding onto positions, watching the market like a hawk.”

Standard & Poor’s raised the ratings on 201 U.S. companies and cut 183 this quarter, a ratio of 1.1 to 1, according to data compiled by Bloomberg. That compares with 51 upgrades and 127 downgrades in Western Europe, a ratio of 0.4 to 1.

Selling Buyout Debt

“Deficits in Europe remain massive and are going to weigh down the economic recovery,” said Juan Esteban Valencia, a London-based credit strategist at Societe Generale SA. He predicts Europe’s corporate bonds will continue to underperform their U.S. counterparts.

Elsewhere in credit markets, Emerging-market bonds rallied the most in two weeks. JPMorgan Chase & Co. sold $716.3 million of bonds backed by commercial mortgages in the second offering of the debt this year, according to a person familiar with the transaction.

The largest top-rated portion, maturing in 4.53 years, yields 140 basis points more than the benchmark swap rate, said the person, who declined to be identified because the terms aren’t public. The AAA rated slice maturing in about 9.53 years yields 165 basis points over the benchmark, the person said. A basis point is 0.01 percentage point.

Bank of New York

Bank of New York Mellon Corp. is marketing $500 million of five-year notes, according to a person familiar with the offering. The debt may yield as much as 97 basis points more than similar-maturity Treasuries, said the person, who declined to be identified because terms aren’t set. A basis point is 0.01 percentage point.

Bank of New York Mellon may issue the notes as soon as today, the person said. Barclays Plc and UBS AG are managing the sale for the New York-based bank.

The extra yield investors demand to own corporate bonds instead of government debt rose 1 basis point to 200 basis points, the highest since Oct. 16, according to Bank of America Merrill Lynch’s Global Broad Market Corporate Index. Average yields were 4.158 percent.

An indicator of corporate credit risk in the U.S. fell for a second day. Credit-default swaps on the Markit CDX North America Investment Grade Index, which investors use to hedge against losses on corporate debt or to speculate on creditworthiness, declined 0.3 basis point to a mid-price of 125.3 basis points as of 1:46 p.m. in New York, according to Markit Group Ltd.

European Credit Risk

The index, which typically falls when investor confidence improves and rises when it deteriorates, is down 6.8 basis points since reaching an 11-month high on June 9.

The cost of protecting European corporate bonds from default plunged the most in more than two weeks, with credit- default swaps on the Markit iTraxx Crossover Index of 50 mostly junk-rated companies dropping as much as 21.3 basis points to 581, according to Markit Group Ltd. The index was at 597.8 basis points as of 1:53 p.m. New York time, up 8.6 basis points for the week.

The Markit iTraxx Asia index of 50 investment-grade borrowers outside Japan fell 9 to 142 in Singapore, its biggest daily decline since May 27, according to Royal Bank of Scotland Group Plc and CMA DataVision.

BP Credit Swaps

The cost of insuring BP Plc’s bonds using credit-default swaps fell from a record, with contracts on the company declining 34.5 basis points to 443.5, according to CMA. Credit swaps on the company have surged since the April 20 explosion of the Deepwater Horizon rig that killed 11 people and triggered an oil spill.

BP’s $3 billion of 5.25 percent notes due in 2013 rose 3.125 cents to 95.375 cents on the dollar yesterday, after declining to as little as 89.94 cents the day before, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. The yield declined to 6.8 percent, a premium of 534 basis points over similar-maturity Treasuries, down from 655 basis points.

Credit-default swaps tied to Spain’s two largest banks fell today, with Banco Santander SA dropping 18.5 basis points to 195.5 and Banco Bilbao Vizcaya Argentaria SA declining 24 basis points to 362, CMA prices show.

Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

Emerging-Market Bonds

In emerging markets, yield spreads widened 9 basis points to 327 basis points, the biggest jump in a week, according to a JPMorgan index. The spread has ranged from this year’s low of 230 on April 15 to a high of 346 on May 20.

Spreads on European company bonds traded at an average of 64 basis points tighter than the yield premiums on U.S. debt before this year, according to Barclays Capital’s U.S. and euro aggregate corporate bond indexes dating back to 1998.

The debt in Europe has traded at or above U.S. bonds since Feb. 23, the data show. European notes, which carry an average maturity of five years, half that in the U.S., traded wider for the first time in December.

Banks in the U.S. are better bets than those in Europe because of their deposit bases, plenty of near-term liquidity and improving balance sheets, said Mark Kiesel, global head of corporate bond portfolio management at Pacific Investment Management Co. in Newport Beach, California.

“The U.S. banks look very compelling on a global basis relative to other banks,” said Kiesel, who oversees about $300 billion of credit investments for the firm, which also manages the world’s biggest bond fund. “In contrast, Europe looks like the sick patient.”

Companies sold 14 billion euros of bonds in Europe last month, an 89 percent decline compared with the same month last year, according to data compiled by Bloomberg. U.S. issuance totaled $35 billion last month, a 75 percent drop from the same period in 2009, Bloomberg data show.

Europe’s rescue fund for nations struggling with spiraling budget deficits, which is backed by 440 billion euros-worth of national guarantees, has had a “muted impact,” according to Jamie Stuttard, head of European and U.K. fixed income at Schroders Plc in London.

Stuttard, who oversees the equivalent of about 25 billion pounds ($37 billion), cited rising European government bond yields, led by Greece and including so-called Club Med nations such as Italy and Spain.

‘No Meaningful Impact’

“If the bailout was formed to prevent contagion to larger and more serious peripheral economies such as Spain, then the package seems to have had no meaningful impact,” Stuttard said. Lenders are being affected and “the market perceives that European banks are riskier than at any point in 2008,” he said.

Van Rompuy, a former Belgian prime minister who became the EU’s first full-time president in January, was the first European official to say the rescue fund may be expanded. He voiced confidence Greece won’t default and that no country will be forced to quit the euro.

Sovereign bond spreads have surged. The 10-year Greek bond yield reached 12.46 percent on May 7, the highest since the common currency was introduced in 1999. The yield plunged to 6.3 percent on May 10 after the rescue program was announced, before rising to 7.68 percent. It was 8.14 percent today.

‘Incomprehensible’

Skepticism about euro-area rescue funds is “incomprehensible” and they are “significant programs,” European Central Bank Governing Council member Axel Weber said at a conference this week in Berlin. The Frankfurt-based ECB kept its main refinancing rate at a record-low 1 percent at yesterday’s monthly policy meeting to avoid stamping out the fragile economic recovery.

Spreads on company bonds in Europe and the U.S. are widening even as the World Bank raised its forecast for global economic growth this year and next, while acknowledging the risks posed by strained government budgets.

The world economy will expand 3.3 percent this year and by the same amount in 2011, up from January predictions of 2.7 percent for 2010 and 3.2 percent next year, the Washington-based World Bank said in a June 9 report. The bank said it saw a “high probability” of a “more muted recovery” because of accelerated efforts to trim deficits.

Risks to the global economic outlook have “risen significantly” and policy makers have limited room to provide support to growth, International Monetary Fund Deputy Managing Director Naoyuki Shinohara said.

--With assistance from Sonja Cheung, Caroline Hyde, Abigail Moses, John Glover in London, Sandrine Rastello and Timothy R. Homan in Washington and Margaret Brennan, Sarah Mulholland, Craig Trudell, Emre Peker and Shannon D. Harrington in New York, Drew Benson in Buenos Aires and Ed Johnson and Sarah McDonald in Sydney. Editors: Paul Armstrong, Charles W. Stevens

The global regulatory reforms

THINK ASIAN
BY ANDREW SHENG

JUST as the US appears to have reached an agreement on their banking financial sector reforms, the Euro-Greek crisis broke out.

In April, two important consultations on the Basel Committee on Banking Supervision’s proposals for the reform of bank capital and liquidity requirements ended, just as the banking lobby around the world furiously pushed back the suggested reforms in different ways.

After having carefully read the proposals, I have formed two conclusions. Firstly, I am not sure that the global proposals will prevent the next crisis. Secondly, I do not think that all the proposals fit the needs of the emerging markets.

Everyone is waiting for the World Cup Football matches in South Africa. What you are seeing in the rule changes can be likened to a football referee, who after witnessing a collapse of the game where everyone has broken the rules, asks that the goalpost be shifted.

Insufficient enforcement

This crisis did not happen because the rules were defective (some were), but because there was insufficient enforcement of the existing rules.

If you say that Basel II rules were good enough to prevent a major crisis in Japan, which had implemented the rules, then why didn’t it also prevent the crisis in the US, UK and Europe?

The answer is that no one there enforced Basel II. The whole basis for Basel II was capital efficiency, not capital adequacy.

After the crisis, people were shocked that all the complex rules boiled down to was 2% core capital against markets that moved more than 5% a day and a liquidity of 1% of total assets.

When the crisis came, the central bankers became lenders of first resort, not lenders of last resort. The emperor had no clothes and the banking system, as Alan Greenspan reminded Asia in 1999, had no spare tire.

Why is the banking industry in the West so much against such rules? The answer is that the low capital adequacy (in fact high leverage) was exactly the reason why bankers were getting such large salaries – the more short-term profits they appeared to get, the higher the bonuses and the larger the bailout that the taxpayers have to fork out.

We now agree that banks should not be too large to fail. But the Greek rescue means that for countries that are members of larger unions are also “too small to fail”.

So we have a situation that under the present system, no one is allowed to fail. The issue is very simple. Everyone who eats a pound of delicious French fries knows that it is “short-term gain, long-term pain.” If you become overweight, you will pay through weak health and more hospital bills.

Anyone who tries to diet will understand that it is all about “short-term pain, long-term gain.”
Financial regulation and supervision means that you prevent crisis by taking small steps all the time by enforcing the rules. Small and immediate enforcement can help to prevent big crisis.

Big problems have small origins. If the football referee does not enforce the rules, are we surprised that the game becomes totally uncontrollable?

The second issue is moral hazard. The first basis of financial regulation is that it must be easy to understand, learn, use and enforce. This is why we have principles–based regulation.
However, those who are regulated prefer to have rules-based regulation. This means that rules are made more and more complex, as the market demands that this and that are exempted from the rule or the calculation.
For example, the 8% capital adequacy rule is diluted through many gimmicks. First, the capital adequacy ratio is calculated as the numerator (capital) divided by the denominator (the asset or liability).

The numerator can be changed or diluted in many ways, such as Tier 2 capital, using subordinated debt or unrealised profit from unsold stocks held by the bank.

The core capital (paid-in capital plus retained earnings) is weakened from 8% to less than 2% by these classifications.

The second gimmick is to change the denominator. Instead of strict and simple calculation like total assets or liabilities (including contingent liabilities or those below the line), banks were permitted to use risk-weighted assets.
 
For example, sovereign bonds were given zero weighting if they had investment grade rating by the rating agencies. Look what has happened with Greek bonds, which can be downgraded overnight to junk bond status. Even mortgages were given very low risk ratings.

The third gimmick is the shifting of liabilities off-balance sheet so that they do not require capital. This is the main effect of creating derivatives so that liabilities become contingent.
Now we know that in a systemic crisis, contingent liabilities have a habit of getting back into the balance sheet.

The fourth gimmick is to persuade regulators that sophisticated investment bankers can rely on their internal risk models to measure risks.

The fifth gimmick is to move liabilities offshore completely beyond the regulation of the home regulator.
This was the creation of the shadow banking system, where one is lightly or not regulated at all. These gimmicks mean that for every rule, there are at least five ways of going around the rules.

Moral hazard

However, the more complex the rule, the easier it is to escape them and the greater the moral hazard that the state would have to end up paying for.

When people do not understand the rules, they blame the rule maker, not the rule breaker.
The Basel Committee has decided that there are five major areas of reform:

·The quality, consistency and transparency of the capital base will be raised;

·The risk coverage of the capital will be strengthened, avoiding the arbitrage which I had earlier mentioned;

·An overall leverage ratio will be used as a supplementary measure to the minimum risk-based framework. This is a limit to the leverage that became also infinite just before the crisis;

·There should be an element of anti-cyclical or dynamic provisioning, in the sense that the higher the risks, the higher the provisions or capital; and

·A global minimum liquidity standard for internationally active banks will be introduced.
All the rule changes look very sensible, but will they stop banks making more mistakes? I shall discuss this in the next article.

Datuk Seri Panglima Andrew Sheng is adjunct professor at Universiti Malaya, Kuala Lumpur, and Tsinghua University, Beijing. He has served in key positions at Bank Negara, the Hong Kong Monetary Authority and the Hong Kong Securities and Futures Commission, and is currently a member of Malaysia’s National Economic Advisory Council. He is the author of the book From Asian to Global Financial Crisis

Bondholders: Don't Fear Rising Rates

Many advisors and their bondholder clients are fretting about rate hikes. Here's why they should relax.

Beginning in June 2004 the Federal Reserve raised interest rates a record 17 times in a row, from 1% to 5.25%, over a two-year period ended June 2006. How badly did bond investors do in this period of time? The answer will be disclosed near the end of this article--don't cheat and jump ahead, read the article first, for your own investing good!

Perhaps the question most often presented to us today is, "How will you manage portfolios if interest rates rise?" Of course the fear is that interest rates will not only rise, but rise considerably. Here is what I think:


--An old Wall Street adage says that most of the people are wrong most of the time when it comes to predicting the investment future. Be wary of the investor's epidemic! When just about everyone fears rates will spike tomorrow, our adage tells us that such a dramatic change is highly unlikely to occur.

--Did you know that the 300-year average inflation rate in the United States is less than 1.9% per year? Low inflation is common, not uncommon. We are in a period of low inflation.

--Inflation and interest rates historically move together. With the current lower-than-low interest rates, and without forecasted rises in inflation, we have a long way to go before seeing higher inflation (and therefore higher interest rates).

--Unemployment has a negative correlation with inflation; high unemployment is associated with low inflation. This is because wages contribute such a large amount of overall product and service costs. Unemployment is high and will remain high for a long time to come. Result: continued low inflation and low interest rates.

--The period 1970 through 1990 saw uncommonly high interest rates. Even the 1990s had high rates by long-term comparison. Many of today's investors have grown up in this high interest rate environment. Many homeowners in the 1980s had mortgage rates as high as 16% (yes, 16%, not a typo). Think about that experience and their lifelong perspective on the fear of rising interest rates.

--Safety should keep investors hungry for U.S. Treasuries and help keep interest rates low.

--When interest rates do rise, there is no indication they will rise considerably.

--When interest rates do rise, they usually do not rise in a straight line; they go up a little, down a little less, up a little more, down a little less. To state another Wall Street adage, "there are no straight lines on Wall Street," which applies to the direction and flight of interest rates as much as anything.

--Rising interest rates is not necessarily a bad thing. On the contrary, rising rates would potentially be an indication that sustained economic growth is back. There is also the benefit for fixed income investors to consider--they will be receiving a greater yield!

--Many portfolio managers "ladder" portfolios, which can provide them with a steady stream of maturing bonds to re-invest at the higher interest rates.

Now that I have made the case for a continued low inflation rate, and therefore low interest rate environment, let's ignore that and look at a rising interest rate environment that occurred from June 2004 to June 2006. This is not to say that the past experience will be replicated precisely, but instead for this review is for discussion purposes only.

Special Offer: Richard Lehmann's 2009 total return on his medium-risk fixed-income portfolio was 58%--triple the Dow's return--and it still yields 8%. Click here for new buys and sells in Forbes/Lehmann Income Securities Investor.
 
Below is a chart of the Federal Reserve Fed Funds Target Rate for the period June 2004 through July 2006. As you can see, the Federal Reserve increased interest rates seventeen times during this period, starting at a Fed Funds rate of 1% and ending at a Fed Funds rate of 5.25%.

Now the answer to the quiz. Below is a listing of various Morningstar U.S. open-ended bond mutual fund categories and their respective annualized rates of return for the period June 30, 2004, to June 30, 2006. Clearly you can see that during this unprecedented rising interest rate time period, bond investors held their own quite nicely.

High Yield Bonds: +6.89%
Intermediate-Term Bond: +2.54%
Short Government: +1.68%
Intermediate Government: +2.05%
Long Government: +3.55%

Are the above outstanding rates of return? No. But investors should never take epidemic, sky-is-falling paranoia as an investment strategy. Interest rates are not going to the moon anytime soon, and if they do rise, investment success is still quite possible--even if your portfolio is brimming with bonds.

By Sean Hanlon, CFP, is the founder, chairman, CEO and chief investment officer of Hanlon Investment Management, a registered investment advisory with $1.8 billion that employs tactical active allocation strategies.

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Google testing Google News tweaks

Google is testing a couple of new features on the Google News page, revamping the way users see stories presented on the page and adding content selected by actual human beings.

Perhaps the most striking change (see below) is one observed by Search Engine Land, in which Google is experimenting with a blog-like design that lists news stories by category in a single column, rather than the two side-by-side columns currently used on the page. Within that column, users can set preferences as to which stories they'd like to see the most and Google will also display a "Spotlight" on certain stories across a variety of topics.

But Google News--which debuted with the promise that all stories on the page were selected by algorithms--is also trying out a section called "Editor's Picks," where editors from a small group of publications can display five stories they've chosen to highlight. The publication highlighted in that section will change with each visit to the page, with companies such as Reuters, US Magazine, and The Atlantic among the initial partners according to The New York Times.

It's just the latest move in Google's continual dance with the news industry. There's no shortage of news executives who think Google is a pox on their industry, "stealing" their headlines and content in Google News. But Google is sensitive to those concerns, having pointed out several times that it drives an awful lot of traffic to news sites and is working with news publishers to help them get their content online in a way that makes sense for editors and readers.

Not all visitors to the page will see either or both of the tests, as Google follows its usual practice of "bucket testing" new features with small audiences to get a sense of whether the changes make sense.

(Credit: Search Engine Land)

By Tom Krazit writes about the ever-expanding world of Internet search, including Google, Yahoo, and portals, as well as the evolution of mobile computing. He has written about traditional PC companies, chip manufacturers, and mobile computers, spending the last three years covering Apple. E-mail Tom.

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Why Corporate Fraud Is On The Rise

Lax boards, equity-linked pay lead to rise in financial wrongdoing.

Newspaper headlines aside, only a fraction of corporate executives who manipulate or misrepresent their companies' performances get exposed by regulators for such misdeeds. My company, Audit Integrity, is in the business of uncovering such wrongdoing because it represents a substantial risk to stakeholders.

A subset of such manipulation and misrepresentation is securities fraud, which itself is so egregious that the Securities and Exchange Commission does prosecute some offenders civilly. An indication of just how common such behavior is appears in a study analyzing fraudulent financial reporting in the decade through 2007 that was recently released by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission.

It is important to note that, while auditors actively support fraud-detection research, they do not guarantee in their audited statements that they will uncover it. That's because auditors believe they too can be misled by clever fraudsters. I understand the auditors' reluctance; material manipulation and misrepresentation are difficult actions to uncover. Turning to the COSO report, the interesting conclusions include these:
--The number of fraud cases increased between 1998 and 2007 in comparison with the level in the prior 10-years studies.

--The dollar value of fraudulent financial reporting soared in the last decade, despite the implementation of the Sarbanes-Oxley Act of 2002.

The Risk List

--Companies involved in fraud were much larger than those observed in a 1988-1997 study.
--Fraud occurred most frequently in the computer hardware and software industries.

--The SEC cited a company's chief executive officer and/or chief financial officer for some level of involvement in 89% of fraud cases studied.

--The most common fraud techniques involved improper revenue recognition, followed by overstatement of assets and bogus expense recognition.

--Among firms involved in fraud, 26% changed auditors between the filing of their final clean financial statement and their final fraudulent financial statement. Sixty percent of the firms involved in fraud that changed auditors did so during the period the wrongful reporting was taking place; the remaining 40% changed auditors in the fiscal period just before the fraud began.

--Press reports of an alleged fraud resulted in an average 17% abnormal stock price decline in the two days surrounding the announcement. News of an SEC or Department of Justice investigation resulted in an average 7% abnormal stock price decline.

--Long-term negative consequences of fraud included bankruptcy, de-listing from a stock exchange or material asset sales.

--The most commonly cited motives for fraud included the desire to: meet earnings expectations; conceal the company's deteriorating financial condition; bolster performance for pending equity or debt financing; or to increase management compensation.

–The average period during which fraud occurred was 31 months.

The Risk List

--There appears to be no difference between the number or character of frauds since the passage of Sarbanes-Oxley. (Note: the sample periods after 2002 are shorter than those prior to 2002.)

--Fraudulent firms disclosed significantly more related-party transactions than non-fraudulent firms.
--All 347 firms prosecuted by the SEC for financial fraud during the decade studied received unqualified opinions from their auditors for their final set of misstated financial filings.

--Financial statement fraud sometimes implicated the external auditor.

--The consequences associated with financial statement fraud were severe for the individuals allegedly involved. However, the severity of the penalties may not be a sufficient deterrent, the COSO believes.

--There were few differences in the boards overseeing companies involved in fraud and those that weren't.
Audit Integrity's independent findings largely mirror the COSO's conclusions. From our perspective, four important issues stand out:

1. Fraud continues to increase, despite Sarbanes-Oxley.
2. The motivations continue unabated.

The Risk List

3. The methods of committing financial fraud have not materially changed.
4. Traditional measures of corporate governance have no impact on predicting fraud.

While the COSO study does not categorically state that fraud has increased (or, at least, has not diminished) since the implementation of the Sarbanes-Oxley Act, it does confirm that there is no evidence Sarbanes-Oxley has had any impact on the commission of fraud.

We are highly doubtful that additional analysis would show any decline in the fraud rate. As mentioned in the COSO report, 89% of the fraud cases implicate the CEO and/or CFO. Sarbanes-Oxley's primary focus is on establishing more rigorous internal controls (Reg. 404); those controls are targeted at multiple levels of management but only indirectly at the C-suite. The board of directors is responsible for protecting stakeholders; it is our opinion that until corporate directors are held to a higher standard, fraud will continue regardless of the rigor of internal controls.

As the economy has faced mounting stress, many companies have been feeling pressure merely to survive. This pressure may lead to fraudulent behavior to mask decaying operations, the COSO points out.

The COSO and our analysis concur that the methods of committing fraud remain unchanged: The majority of the fraud metrics included in Audit Integrity's Accounting and Governance Risk (AGR) model have remained relatively stable over the past decade.




Revenue recognition, asset/liability valuation and expense recognition are the keystones of the AGR model.
It is interesting to note that insider trading was involved in 24% of the cases; insider trading is a key high-risk metric in assessing potential fraud.

In contrast, board composition resulted in no significant difference in the prevalence of fraud, the COSO found. Audit Integrity's research likewise indicates that board composition plays a very small part in predicting fraud.

We do, however, believe certain governance metrics that are independent of accounting metrics do have an impact. These include frequent amendments to financial filings; boards chaired by the CEO; prevalence of incentive pay vs. annual pay for the CEO and CFO; a high ratio of CEO to CFO total pay; large volumes of stock sales by top executives, relative to market capitalization; frequent legal and regulatory issues; and frequent officer changes.

The Risk List

• The Risk List

• Comprehensive Rankings

• Why Corporate Fraud Is On The Rise

• In Pictures

• Retailers Flashing Financial Danger Signs

Among the important conclusions that could be used to curb future fraudulent activity are the following:

--Fraud will persist until boards of directors are held more accountable for their actions.

--If the economy remains under pressure, fraud will continue to increase.

--The 347 cases of fraud prosecuted by the SEC between 1998 and 2007 represent a small number and a nadir during which a blind eye was often turned to fraudulent activity. Under Chairman Mary Shapiro, the SEC appears to have "found its legs." We believe the number of enforcement actions will increase substantially in the coming years.

--The 347 companies prosecuted in the decade through 2007 represent a small fraction of the number of financial fraud cases that occurred. Very few frauds result in SEC enforcement action; many more are adjudicated by class actions. Most are recorded only in stakeholder disappointment, large price drops, bond defaults and insolvency.

James Kaplan is cofounder and chairman of Audit Integrity, a financial research firm based in Los Angeles.

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‘Shameful’ suicides

THE differences between Western and Eastern, particularly Confucian and Buddhist-based, cultures and attitudes towards crisis, hardship and austerity are great, like day and night.

As debtmocratic Greece has shown in the current debt crisis, the ordinary Greeks have resorted to violent demonstrations, strikes and public anger over the various austerity measures being tied to the proposed eurozone and International Monetary Fund rescue package.

While the public outburst over the corrupted Greek government is somewhat justified, their reaction is grossly different from the Confucius and Buddhist-influenced Asians.

The ordinary Greeks should take a very hard look at themselves, and ask honestly whether they should bear a big part of the blame for the serious debt crisis that Greece is in now instead of only violently pointing their fingers at the government for all the blame.

The way the Confucius and Buddhist-influenced Asians would have reacted in such situations would have been totally different. They would have taken the blame mostly on themselves.

We all know that the Japanese economy has not been performing well for the last 20-odd years but do we know the social costs of this slump?

The number of Japanese who committed suicide in Japan in 2009 stayed above 30,000 for the 12th straight year, with suicides due to hardships of life and job losses rising sharply, states a Japanese police survey.
More significantly, suicides traced to job losses surged 65.3% to 1,071 while those due to hardships in life jumped 34.3% to 1,731.

More worrying, depression continued to top the list of reasons for the suicides.
Perhaps even more worryingly, the number of suicides per 100,000 people came to 24.1 among those in their twenties, an all-time high for that age category, and 26.2 among those in their thirties, a record for the third year in a row.

Not surprisingly, the number of suicides jumped in October 2008 – a month after Lehman Brothers collapsed.
This taking-all-the-blame on oneself instead of looking for easy scapegoats can also be seen at another level.
In 2009, monthly suicides increased year-on-year from January to August.

They were especially rampant from March to May as fiscal year-end fund demands picked up during the period.

From 1990 onwards, even as the ordinary Japanese increasingly suffered under the grossly inept Liberal Democratic Party, one has not seen the violent demonstrations, strikes and public anger that is being seen in Greece, at present.

Instead they take their own lives, probably in shame.
As the ordinary Japanese suffers in silence, the economy stumbles from one recession to another. The cycle repeats.

Now, with the global economic recovery in full swing, the ordinary Japanese gets another cyclical and temporary respite from the rising economic hardship.

How to Prevent Deepwater Spills

Safety upgrades are critical but could mean higher prices for oil and gas

A culture of tighter safety and more experienced regulators might have prevented the BP Deepwater Horizon leak. But equipment modifications and new technology will be needed to minimize the risk of such deepwater oil leaks. According to some petroleum engineers, recommended technology upgrades could price some deepwater resources out of the global energy market.

A mess: Workers clean up oil from a beach on Grand Isle, LA, earlier this week.  Credit: U.S. Coast Guard/PA2 Gary Rives

This could help extend the six-month moratorium on deepwater drilling instituted by President Obama last month. "I tend to be kind of a glass half empty guy, but I think there's a 50/50 chance that the current six-month moratorium will stretch out," says Paul Bommer, a senior lecturer in petroleum engineering at the University of Texas at Austin.

Documents and statements released by various federal investigators point to several decisions and at least one faulty piece of equipment that allowed uncontrolled gas and crude to blow out and destroy the Deepwater Horizon rig in April, initiating the worst oil spill in U.S. history.

Engineers contacted by Technology Review insist that conclusive answers will come with completion of the investigations, but criticize, for example, BP's decision to install a continuous set of threaded casing pipes from the wellhead down to the bottom of its well. "The only thing I can figure is they must have thought it was a cost-cutting deal," says Bommer of BP's well design.

This can be problematic in deep, high-pressure wells for two reasons. First, it seals off the space between the casing and the bore hole, leaving one blind to leaks that sneak up around the casing pipe (as the BP Deepwater blowout is suspected to have done). Second, the long string gives gas more time to percolate into the well. A preferred alternative in high-pressure deepwater is a "liner" design in which drillers install and then cement in place a short string of casing in the lower reaches of the well before casing the rest of the well. This design enables the driller to watch for leaks while the cement is setting. "It takes a more time and costs a little more but it's a much safer way to do it," says Geoff Kimbrough, vice president for deepwater operations at Houston-based drilling consultancy New Tech Engineering.

Kimbrough cautions that transforming corporate cultures will take time because choosing the more conservative operation can easily cost $10 million to $20 million. Not all companies have leaders who readily support these decisions, says Kimbrough: "The courage to do that doesn't come overnight. It comes from years and years of support from senior management."

Regulatory ideas for how to push a culture of safety appear in a 30-day safety review delivered to Secretary of the Interior Ken Salazar late last month, and include establishing new drilling guidelines, operator certification requirements, and tougher inspection regimes. Kimbrough says the Interior Department must simultaneously boost its internal training so that it can effectively review drilling plans.

Attention has also focused on the failed blowout preventer, or BOP, that could have saved the Deepwater Horizon. The Interior safety review calls for upgrades to BOPs to address various failure mechanisms that may have doomed the Deepwater Horizon, such as placement of redundant shear rams strong enough to cut through the toughened threading between casing pipes.

One inherently safer option that many petroleum engineers are considering is bringing BOPs to the surface. In this scheme the BOP on the wellhead thousands of feet below the ocean surface is backed up by a second BOP on the drill rig that would be accessible for more regular inspection and testing. Doing so would mean hardening the risers that link the wellhead and the drill rig to handle extreme pressures.

It's a suggestion that Kimbrough thinks is impractical. "The cost would be somewhere near prohibitive," he says. "Just the cost to develop the system would be astronomical." Mandating something like that would delay new drilling by at least several years. "You're talking about years to develop and test and prove up something like that."

But Bommer says the potential costs are likely to be small compared to the economic impact and incalculable ecological damage that the Gulf region has sustained from BP's leak. In Bommer's view, if such "brute force" safety engineering pushes oil and gas companies to question whether it's economically viable to tap deepwater reserves, so be it. "Cost is the last thing people should be thinking about now," he says.

Another area pegged for technology development is deepwater leak response. BP's ad-hoc response to the Deepwater Horizon leak has revealed the lack of equipment and procedures for high-pressure remote operations. BP's CEO Tony Hayward acknowledged as much last week, saying that despite assurances in its drilling permit applications, BP "did not have the tools you would want" to respond to a deepwater leak.

In fact, the tool shortage for deepwater intervention is an issue long recognized by petroleum engineering researchers. The months-long process of drilling a relief well was, until now, the only proven fallback available in cases where the BOP fails to stop a blowout. A 2003 presentation by Texas A&M University researchers modeling deepwater blowouts cited reliance on relief wells as evidence of a "fatalistic mind-set in the industry."

The lack of progress since then supports that assessment. Since 2005 Congress has left deepwater research primarily in the hands of the Research Partnership to Secure Energy for America, a U.S. Department of Energy-supported petroleum industry consortium in Sugar Land, Texas. But RPSEA has focused its $17 million annual budget for deepwater R&D on production-related issues.

Drilling engineers say the BP accident could finally provide the impetus for deepwater response tools. Funding to perfect some of the schemes that BP has thrown at the spill, they say, should spawn an entire deepwater response industry, analogous to the well-control contractors who secure hundreds of dangerous onshore wells per year worldwide.

James Pappas, RPSEA's vice president of technical operations, claims that his consortium is already beginning to refocus its research agenda toward safety-related R&D. For example, he sees an opportunity to improve sensing capabilities inside deepwater wells after the drill bit is pulled: "That's a weak spot right there, a blind side, that we haven't really addressed as an industry."

But Pappas and other engineers acknowledge that better training, BOPs, and response tools may not convince an outraged country that a sequel to the Deepwater Horizon disaster is impossible. They say it may take more radical upgrades to drilling technology to lift the current six-month moratorium. "We have to go back to square one and prove that we're reliable and responsible enough to take care of our business," says Pappas.

By Peter Fairley

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