Edwin Sim comments on a Foreign Affairs article by Nobel laureate, Michael Spence addressing the issue of why the US employment rate has not bottomed out despite signs of economic recovery.

Those of us following the US presidential election races this year can’t help but notice how prolonged high-unemployment rates have become a serious political issue in the US.

In the past, most economists expected that when down business-cycles improved unemployment figures inevitably follow.

However, during the current recession, the global economy’s structural evolution has for the first time resulted in diverging US growth and employment.

In a recent Foreign Affairs article, Nobel economics laureate Michael Spence said that although globalization has helped hundreds of millions of people in developing countries escape poverty, it has also hurt subgroups within some advanced countries.

Spence said that the challenge for the US was to find a right place in the rapidly evolving global economy that will allow it to retain its dynamism and openness while providing all Americans with rewarding employment opportunities and a reasonable degree of equity.”

To reach this objective, Spence said America will have to experiment forward.

Globalization’s effects

Spence said that during the past decade, developing countries such as China and India have become larger and richer and developed the ability to move up the value chain.

These countries are now increasingly producing high-value-added components that 30 years ago were the exclusive purview of advanced economies. “The climb is a permanent, irreversible change.”

Major emerging economies, he said are becoming more competitive in areas in which the US economy has historically been dominant, such as designing and manufacturing semi-conductors, pharmaceuticals and information technology services.

At the same, US job opportunities are also shifting away from the sectors experiencing most growth. As a result, the US economy is now experiencing growing income and employment disparities with highly educated workers enjoying more opportunities and less educated workers facing declining employment opportunities and stagnant incomes.

“The US government must develop long term policies to address distributional effects and their structural underpinnings and restore economic competitiveness and growth,”

Interesting US employment statistics

To support his assertions, Spence shows that between 1990 and 2008, the number of employed in the US grew from 122 million to 149 million (roughly 27 million jobs).

However, 98 per cent of these new jobs were in what he deems as the economy’s non-tradable sector, producing goods and services that must be consumed domestically. Government (22 million) and health care (16 million) were the largest non-tradable sector employers.

Together these two industries created 10 million new jobs between 1990 and 2008, or just under 40 per cent of the additions. “Retail, construction, hotel and restaurant industries also contributed significantly to job growth.”

Meanwhile, the tradable sector that produces goods and services that can be consumed anywhere, such as manufactured products, engineering and consulting services barely grew. “The sector which accounted for more than 34 million jobs in 1990, grew by a negligible 600,000 jobs between 1990 and 2008.”

What happened?

Spence said that except for the upper-end of the value-added chain, the US employment economic structure has been shifting away from the tradable sector toward the non-tradable sector.

“This is a problem because the non-tradable sector is likely to generate fewer jobs in the future. It is unlikely that government and health care in the US will continue growing as much as it had before the current economic crisis.”

Although many non-tradable jobs, particularly those involving manufacturing lower-value-added components moved to emerging countries, dramatic new labor-saving information and information innovations also eliminated many jobs throughout the US economy.

“The trend is causing virtually all US manufacturing sector employment to fall, except at the high end of the value chain.”

The tradable sector’s high-end includes finance, computer design and engineering and multinational company top-management. “These are the areas where the US economy continues to have a comparative advantage and can successfully compete in the global economy.”

According to Spence, the overall picture is clear: opportunities and incomes are high and rising, for the highly-educated people at the upper end of the US economy’s tradable sector but are drastically diminishing at the lower-end.

To restore employment however, Spence said that the US must focus on increasing tradable sector job growth.

Agreement on fundamental goal needed

The US needs to agree on a fundamental goal to restore rewarding full employment opportunities for a comprehensive-spectrum of Americans.

“With that objective as a starting point, it will also be necessary to develop ways to increase competitiveness and inclusiveness in the US economy.”

Although many people such as Warren Buffet argue that the market will solve employment and income disparities once the current economic crisis recedes and growth is restored, Spence said they may not be right.

“As long as these views dominate, it will be difficult to systematically address structural changes and employment in the US.”

The global employment structure evolution is creating distribution problems in the advanced economies. “Not everyone is gaining in those countries and some may be losing.”

Although everyone does benefit from lower-priced goods and services, manufactured in developing countries, most people also care greatly about being productively employed and in the quality of their work.

“Declining employment opportunities feel real and immediate: the rise in real incomes because of lower-prices does not.”

Spence said these distributional issues will more than likely remain because of the US  and global economies’ long-term structural evolution.

“With ample labor available in various skill and educational categories throughout the tradable sector globally, companies have little incentive to invest in technologies that save labor or otherwise increase the competitiveness of labor-intensive value-added activities in advanced economies.”

In short, the companies’ private interest (profit) and the public’s interest (employment) do not align perfectly. These conditions however may not last because if growth continues to be high in emerging countries, in two or three decades less labor will be available, “but two or three decades is a long time.”

Modest shifts required

Even though public and private interests are not perfectly aligned, Spence said they are also not perfectly opposed. “Relative shifts at the margin could bring them back to sync.”

Given the size of the global labor force, he said that it wouldn’t take much to restore employment growth in the US economy’s tradable sector.

“The right combination of productivity-enhancing technology and competitive wage-levels could keep some manufacturing industries, or at least some value-added pieces of their production chains in the US, and other advanced countries.”

Edwin Sim may be reached at edwinsim@humancapitalalliance.com

Edwin Sim comments on “The Paradox of Excellence” a best seller that explores the need for senior executives and business owners to remind their loyal long term customers about the value and impact they’ve had on their customers.

A business’s primary purpose should be acquiring and keeping customers. Determining what your customers value and focusing on always pleasing them maximizes customer satisfaction and creates shareholder value.

A most vexing problem for many senior executives and business owners, that have run successful and profitable businesses for decades, is how to remind loyal long-term customers about their value and impact they’ve had on their businesses.

“Forgetting this rule of thumb could result in the loss of so many things both valuable and important to us; our customer relationships, our market share, and our strong reputation amongst our peers,” said David Mosby and Michael Weisman in their best seller “The Paradox of Excellence”.

Creating a profitable and sustainable competitive advantage

The authors said businesses can create profitable and sustainable competitive advantages by understanding their own businesses and services through the customer’s eyes and reinforcing the real costs of failing to match these services with value perceptions.

Moreover, service providers that continuously provide services for years to their customers may become “invisible” as they develop into an integral part of the client organizations. These same service providers also frequently become scapegoats when something goes wrong.

In many cases the better a service provider does a job, the more its performance becomes invisible.

“Improved performance does not necessarily translate into higher perceived value. In fact, it is more likely to shift the customer’s view of commodity performance upward and view any new improved performance for granted,” they said

All businesses therefore should clearly understand that expectations and satisfaction are dynamic and interdependent.

It is simply not enough to be excellent and allow customers or especially competitors to define the playing field. “Organizations must constantly provide the context for which they want to be judged.”

A common error of vendors who perform extraordinarily well is setting customer expectations so high that is often difficult to sustain. “It often leads to service-providers allowing a single negative situation to characterize and define an entire relationship between itself and its customer.

Most importantly, services providers and all businesses must learn how to manage client expectations. “Excellence is critical to victory, of course. But it’s not sufficient alone,” they said.

Companies must work as a team to identify, understand and manage ever-changing customers’ expectations.

They must also reinforce the importance of constantly reminding clients of the value-added they are contributing to the organization and provide continuous positive reinforcement of their distinguishing value and determine how they are going to communicate that unique benefit.

“Try not to be a man of success but rather a man of value,” the authors quote Albert Einstein.

Performance and its value must be proactively kept visible because in many cases perceptions can be declining while performance is improving,

We must also constantly reinforce our excellent performance with our clients, not only when marketing to a new client or competing for a specific opportunity but continuously while we provide services.

A common error of many vendors who perform extraordinarily well is setting customer expectations so high that it is frequently difficult to sustain. “It often leads to service-providers allowing a single negative situation to characterize and define an entire relationship between itself and its customer.

Companies must always reinforce their distinguishing values to the clients by providing timely and socially acceptable reinforcement of the distinguishing value delivered. We must make our invisible, high quality services visible to our customers.

How do we re-enforce our value to our long-term customers?

The key is establishing visibility of our value on an ongoing basis to our important customers by continuously communicating what’s unique and relevant about what we provide – the core point of our service differentiation.

These objectives can be achieved by simply redesigning IT systems and our sales teams and clients reports and by regularly updating our marketing materials.

Many companies don’t do enough to expose their performance levels because they mistakenly believe it’s more important to communicate with potential new clients rather than with long-term customers. They also assume that customers can easily observe any service improvements and readily recognize why they are a cut above the market.

We must remember that our long-term customers need context for evaluating our performance and the longer they stay with us, the more difficult it is to put our accomplishments into a competitive context.

Edwin Sim may be reached via edwinsim@humancapitalalliance.com

The Nation’s K I Woo speaks to an executive-search and talent-advisory professional about finding a new position.

With annual bonus payments in hand, many top executives are now open to being approached by leading companies in Thailand.

Even after successfully competing for years in a highly competitive job market, many senior executives still ask how they should assess the risks of any new opportunities.

Vauraporn Iamsupanimitr, vice president of Human Capital Alliance, a leading executive search-and-talent advisory company, recently told The Nation that senior executives must ensure that they have addressed several key issues when deciding whether they should leave their current position.

“Most importantly, these senior executives should understand what job elements are most important and what constitutes a healthy work-life balance for them,” she said.

Vauraporn, who has advised senior executives for more than a decade, said new companies usually mean unique corporate cultures and work practices.

She noted that in a recent Harvard Business Review article, Boris Groysberg and Robin Abrahams said job moves are seldom easy and nearly always emotionally fraught.

“Moves of all kinds entail significant internal and external challenges and often cause turmoil in one’s home and social life,” they said.

In addition, Groysberg and Abrahams’ research, she said, cited five common reasons why many senior executives experienced difficulties when moving into new jobs at new companies.

“These included not doing enough research, leaving for the money, going ‘from’ rather than ‘to’ a new job, overestimating one’s own abilities and thinking short term,” Vauraporn said.

In her own experience with top executives who are asked to consider new job opportunities, Vauraporn said many senior executives don’t pay enough attention to a potential employer’s financial stability and market position.

“At the same time, these executives are very careful when they scrutinise potential customers’ and acquisition target companies’ balance sheets,” she said.

Many people, she said, are so happy with a new job offer that they tend to overlook the new company’s future prospects. In addition, many senior executives don’t spend enough time carefully analysing whether their new official job title really reflects the role they are assuming.

Vauraporn also agreed with the Harvard study’s conclusion that while most executives contemplating job changes normally ranked money as the fourth or fifth important issue, they usually bumped it to first place when making the final decision.

“At the end of most negotiations, many executives are vitally concerned with their total compensation packages,” she said.

All executives contemplating moves to other companies should plan strategically in terms of their prospects and aspirations. “They should not apply any urgency by quickly getting out of their current job and move from one place to another in the hope of finding the right position.”

Another critical factor is arriving at a realistic understanding of their own skills, abilities and prospects. “Some senior managers tend to undervalue their prior organisations’ strength in helping them achieve their successes,” she said.

Many of these candidates tended to view their current companies as being the problem and not acknowledging that they themselves may be part of the problem. “These executives must be realistic and self-critical so that they can understand that their current frustrations and failures are often partially due to their own shortcomings and are not primarily from unfortunate external circumstances and environments,” she said.

Although in today’s fast-moving globalised economic environment, short-term thinking has often morphed into pumping quarterly revenues and earnings practices rather than sustainable growth, Vauraporn said senior executive job-seekers should think long-term and ultimately in their own career’s and their new company’s sustainability.

“The best protection for all senior managers contemplating job changes is a continuing quest for self-awareness, that truly recognises one’s innate skills and abilities, and the ability to successfully identify the intricacies of new challenges and opportunities,” she said.

Citing the Harvard Review study, Vauraporn also agreed with their finding that when executives discover they are in the wrong job they should cut their losses and move on.

“I agree with the professors’ view that the executives should undertake any new moves strategically and not hesitate to go down another road if it becomes evident that a certain kind of change won’t be right,” she said.

Vauraporn may be reached via nuch@humancapitalalliance.com

Source: The Nation

Edwin Sim, Managing Director of Human Capital Alliance explores why companies that are managed purely to maximize shareholder value may not be the answer to sustainability.

One of our most frequent discussions with clients is how they try to build sustainable businesses.

Initially in Thailand, many family businesses struggle with making the move to hire professional managers to help scale their businesses.

Once they decide to hire professional managers, they’re then faced with determining how performances can best be monitored and evaluated. Most importantly they must ensure the business grows sustainably over the long-term.

For more than three decades, many executives including Jack Welch of General Electric made “maximizing shareholder value” a top priority.

Welch was known for relentlessly pushing managers to become more productive and efficient. Companies that could not become number one or two in their industry would be sold off or abandoned.

As more and more CEOs across the country accepted Welch’s strategy, maximizing shareholder value became known more for slashing inventories, reducing costs and ruthlessly lowering employee head counts to hit profit targets.

GE’s Jack Welch and Coca Cola’s Roberto Goizueta were two poster boy CEOS that exemplified why “maximizing shareholder value” was the most effective way to run a business.

Welch transformed GE from a $US13 billion dollar market cap in 1981 to $US484 billion at his retirement in 2001. To keep increasing shareholder value, Welch pushed GE to achieve higher and higher growth.

Near the end of Welch’s illustrious career, GE’s biggest engine of growth, GE Capital accounted for about half of GE’s earnings. However, by 2009, GE was forced to take massive write-offs at GE Capital and saw its market cap drop as low as $75 billion.

In a 2010 Harvard Business Review article, “The Age of Customer Capitalism, Roger Martin said that “while the $471 billion increase in shareholder value that Welch oversaw seemed wonderful at the time of his retirement, particularly to shareholders selling out at the top, it  is questionable how much shareholders benefited in the long term.”

Later on in 2009, in a Financial Times interview Welch said that “shareholder value is the dumbest idea in the world. Shareholder value is a result, not a strategy… your main constituencies are your employees, your customers and your products.”

In his Harvard Business Review article, Martin, who is Dean of the University of Toronto’s Rotman School of Management questions whether maximizing shareholder value is really the overall key to building sustainable businesses.

“For three decades, executives have made maximizing shareholder value their top priority. But evidence suggests that shareholders actually do better when firms put the customer first.”

Martin said it was time to discard the popular belief that corporations must focus first and foremost on maximizing shareholder value. “The idea is inherently and tragically flawed.”

According to Martin, it’s impossible to continually increase shareholder value because stock prices are driven by shareholders’ expectations about the future, which cannot be raised indefinitely. He added that the data shows that focusing on shareholder value hasn’t done shareholders any favors. They have actually earned lower returns since corporation adopted it as their guiding principal.

Martin’s studies showed that from 1933 to 1976 when “professional management” was in vogue, the S&P 500 earned compound annual returns of 7.6 per cent. “From 1977 to the end of 2008, the S&P 500 did considerably worse with returns of only 5.9 per cent a year when maximizing shareholder was at its zenith.”

A business’s primary purpose, Martin said should be to acquire and keep customers. “To create shareholder value, you should instead aim to maximize customer satisfaction.”
Legendary management guru Peter Drucker also said that the primary purpose of a business is to acquire and keep customers.

Determining what your customers value and focusing on always pleasing them, Martin insists is a better optimization formula.

In promoting what he called the “customer capitalism” age, Martin warned of various constraints. “Companies will quickly go bankrupt if they made customers happier by charging ever lower and lower prices for ever greater value.”

Instead, companies he said should seek to maximize customer satisfaction while ensuring that shareholders earn and acceptable risk-adjust return on their investments.”

Edwin Sim may be reached via edwinsim@humancapitalalliance.com

Edwin Sim Managing Director of Human Capital Alliance discusses Harvard Professor Noam Wasserman’s research into how successful entrepreneurs optimize business opportunities.

Owners of many successful family businesses in Asia inevitably must decide whether to bring-in outside investors to help scale their already-thriving enterprises.

A recent study by Harvard professor Noam Wasserman indicates that many entrepreneurial business owners want to make a lot of money and also run the show.

In his Harvard Business Review article “Founder’s dilemma”, Wasserman’s research shows that in America it is tough to accomplish both successfully.
“Between making money and managing their ventures, those who don’t figure out which is more important to them often end up neither wealthy nor powerful,” he said.

Every would-be entrepreneur, Wasserman said want to be a Bill Gates, a Phil Knight or an Anita Roddick each of whom founded a large company and ran them for many years. “However, successful CEO-cum-founders are a rare breed,” he said.

Wasserman said that founders must be honest about their motives for getting into business. Are they in business to build and rule over an empire (the king option) or are they in it to make boatloads of money (the rich option)?

The rich options, he said enable businesses to become more valuable but it sidelines many founders by taking away the CEO position and control over major decisions.

The king options allow founders to retain decision-making control by allowing them to stay as CEOs and maintain Board control. “But often by building a less valuable company,” he said.

For founders, Wasserman said rich options aren’t necessarily better than king options or vice versa. “What matters is how well each decision fits with their reason for starting the company.”

Consequently, business owner entrepreneurs must eventually come to grips with what success really means to them by choosing between money and power.

“Founders who want to manage empires will not believe they are successes if they lose control, even if they end up rich and conversely, founders who understand their goal is to amass wealth will not view themselves as failures when they step down from their job.”

To fully capitalize on their successful business opportunities, Wasserman said entrepreneurs eventually realize that their limited financial resources, ability to inspire people and passion simply are not enough. They end up inviting family, friends, angel investors or venture capitalist to invest in their businesses. “They often must give up control of the businesses.”

Once a company’s board is in the control of others, the entrepreneur’s CEO job is at risk because the board’s task is quite straightforward. If the founder underperforms as CEO, the Board will find someone new.

On the other hand if right investors are chosen, the entrepreneur’s financial gains will soar. Wasserman’s research showed that founders giving up more equity to attract cofounders, non-founding hires and investors build more valuable companies than those  who with less equity.

“Founders end up with a more valuable slice but they have to give up most of the decision making.”

Entrepreneurs are also often convinced only they can lead their start-up to success. “I’m the one with the vision and desire to build a great company. I have to be the one running it”

Wasserman agreed that there is a great deal of truth to that point of view. “At the start the enterprise it’s only an idea in the mind of its founder, who possesses all the insights and the opportunity, about the innovative product, service or business model that will capitalize on the opportunity, and about who the potential customers are.

The founder, he said hires people to build the business according to that vision and develops close relationships with the first employees. He also creates the organization culture, which is an extension of his or her style, personality and preferences.

“From the get go, employees, customers and business partners identify start-ups with their founder, who take great pride in their founder-cum-CEO status’

However, founders, also often make decisions that conflict with wealth-maximization principles. “Some options had the potential for generating higher financial gains but others, which founders often chose, conflicted with the desire for money.”

Wasserman’s research also showed that four out of five entrepreneurs are forced to step down from the CEOs post. “Most are shocked when investors insist they relinquish control. They are inevitably always pushed out in way they don’t like – well before they want to abdicate.”

Change in leadership can be particularly damaging when employees loyal to the founder oppose it. “In fact, the manner in which founders tackle the first leadership transition often makes or breaks young enterprises.”

Edwin Sim may be reached via edwinsim@humancapitalalliance.com

Human Capital Alliance’s Vauraporn Iamsupanimitr discusses a recent study led by Harvard Business School associate professor, Boris Groysberg on common mistakes made by executive job-changers.

Senior executives considering new jobs should carefully and consciously assess the risks and realities so that they can avoid making mistakes that may result in major setbacks.

In today’s fast changing business environments, people are expected to change jobs many times before their retirements. Careers have become processes of continuous movements.

Recent US Bureau of Labor Statistics indicate that the average baby-boomer will change jobs 10 times.

In a recent Harvard Business Review article, “Five ways to bungle a job change”, Boris Groysberg and Robin Abrahams said that job moves are seldom easy and nearly always emotionally fraught. “Moves of all kinds entail significant internal and external challenges and often cause turmoil in one’s home and social life.”

After interviewing 400 search consultants from 50 industries and 500 C-level executives in 40 countries, including  HR heads at 15 multinational companies, Groysberg and Abrahams concluded that five common mistakes generally accounted for most problems.

In general these included:

1.    not doing enough research
2.    leaving for money
3.    going “from” rather than “to”
4.    overestimating yourself, and
5.    thinking short term

The researchers said that the mistakes were usually not independent of each other and generally followed predictable patterns and persisted throughout the course of careers.

These mistakes played out as a system of maladaptive behaviors that included dissatisfaction, unrealistic hopes, ill-considered moves, and more dissatisfaction

For instance, executives that fixated on money would often disregard the need for research. “Overestimating yourself can cause you to ignore a bad fit – a problem that research might help you anticipate.”

Some job seekers make all the mistakes at once. For instance, if they overestimated their value, they will feel unjustly treated at year-end reviews. “They will jump to the first company that promises a signing bonus without doing due diligence on the firm’s long-term prospects.”

The executives surveyed were not young untested professionals but included successful people that hadn’t looked for jobs for years or even decades. “Surprisingly, many of them were ignorant of job market opportunities.”

Many of these executives, they said assumed their new companies would be flexible about having them learn new areas of business as when they were young. “If they’re high up on the hierarchy, it may have been some time since they received truly honest feedback about their strength and weaknesses.

Mistake number one – not doing enough research

Many executive job seekers, the authors said neglect due diligence in four areas.

1.    If they don’t do homework on job market realities for their industry or function, they will be not fully informed and will be prone to unrealistic expectations.

2.    Many executive job-seekers don’t pay enough attention to a potential employer’s financial stability and market position even if they are people that would normally scrutinize the balance sheet of a company they are acquiring.

They assume companies offering them jobs are on solid ground. It is up to applicants to assess if new jobs will exist in six months.

3.    Many executives fail to consider the cultural fit.

Although hiring managers are supposed to attend to matching cultural fits, new hires suffer most if it’s a poor fit.

4.    Too many recruits assume the official job title and job description accurately reflect the role. Many companies are known to sweeten titles to attract top talent.

Additional, in badly managed organizations, people may find themselves in ill-defined jobs that have little relationship to formal titles.

Mistake number two – leaving for the money

The authors research showed that it was easy to fall for financially attractive offers.

Most search consultants said that although executives contemplating job changes rank money fourth or fifth in terms of importance, they usually bumped it to first place when making the final decision.

Mistake number three – going “from” rather than “to”

Often, many job seekers are so unhappy they are happy just to get out. Instead of planning their career moves, they lurch from one place to the next.

These people the authors said apply artificial urgency rather than wait for the right job and often fail to look strategically for opportunities that their current companies may have for them.

Mistake number four – overestimating themselves

The authors’ survey indicated that many executives believed they contributed more than they actually did at their current organizations. They tended to undervalue the organizations’ strength in helping them achieve their objectives.

Many of these job seekers, they said seem to have unrealistic view of their skills, their prospects and occasionally their culpability. “The often can’t identify sources of success and failure at their existing jobs.”

These candidates looked at their current companies as being the problem and not acknowledging that they themselves may be part of the problems. These people may also fail to be realistic and be self critical, and therefore think that external circumstances and environments have more to do with their frustrations or failures than their own issues.

“They may overestimate the salaries they can command and their capacity to deal with the new positions’ challenges, particularly, the difficulty of creating change at large organizations.

Mistake five – thinking short term

Executive job seekers with short term perspectives can make many mistakes.

For instance, if they overestimate their abilities, they may believe they should be paid a high salary now and not after they’ve proved themselves. Some people leaving organizations for more money are often overly-influenced by immediate short-term information and considerations.

The authors conclude that the best protection against career management mistakes is self awareness, which they said is a broad  concept that encompasses not only an understanding of one’s career-relevant strengths and weaknesses but also insights into the kinds of mistakes they you are prone to make

Knowing how to correct tendencies, how others perceive us and when to consult a trusted mentor or network is critical.

If an executive takes a wrong job, the authors said the experts were unanimous in their views” “Cut your losses and move on.”

They suggested that these executives should make their next moves strategically. “Don’t hesitate to go down another road if it becomes evident that a certain kind of change wouldn’t be right.”

Executives, they said should understand what elements of a job make it truly satisfying for them and what constitutes a healthy work-life balance.

Vauraporn Iamsupanimitr may be reached at nuch@humancapitalalliance.com

K I Woo, Senior Advisor of Human Capital Alliance Limited gives us an interesting view from China on the continuing US/China currency debate.

Encouraged by Nobel laureate economist, Paul Krugman and New York Senator Charles Schumer the US media continuously blames China’s currency manipulation as a key reason for America’s seemingly protracted 10 per cent unemployment rate and huge trade deficits.

Although their accusations contain elements of truth, China’s “undervalued” currency is only one of many reasons why the US has suffered protracted high unemployment rates and huge trade deficits with China especially during the current US recession.

Nevertheless, everyone including many Chinese experts are wondering whether a currency and trade war between the US and China will be the only solution that will satisfy US politicians facing imminent elections.

Currency war could launch a trade war

Huang Yiping, Professor of Economics at Peking University’s China Center for Economic Research and Citigroup’s former Chief Economist in Asia recently said that any currency war would include a trade war wherein the US would implement Congress-passed punitive import tariffs against China.

“But such measures would (also) have to pass scrutiny the World Trade Organization.”

Although import tariffs would reduce Chinese exports to the US, the gap Huang said would probably be filled by exports from other low-income countries. Many of these import tariffs would lead to unpopular higher consumer prices and could also lead to higher US inflation.

Perhaps more importantly, these import tariffs, “given the differences in comparative advantage between China and the US, it is doubtful that the lost jobs would go to the US.”

For now, Huang said the Chinese government is content with trying its best to avoid a sharp currency adjustment that could significantly damage its export sector.

He believes that the risks of a trade war are manageable. “Both the US and Chinese governments appear to favor multilateral frameworks for resolving the renminbi dispute.”

Moreover, the leadership in most countries believes that economic imbalance issues are ultimately global issues. “A critical question, however, is what specific policy approaches the G20 (they) might adopt dealing with such problems.”

Why renminbi appreciation alone is not relevant?

Another leading Beijing-based think-tank economist argues that appreciating the renminbi (yuan) will not significantly uplift the US economy.

Yao Yang, Director of Peking University’s China Center for Economic Research (CCER) said recently that the renminbi’s appreciation would not be a great help in reducing the U.S. trade deficit and creating jobs.

“As the two countries are the two biggest trade partners in the world, neither China’s nor the U.S.’ economic issues are merely domestic. Instead, it’s global,” Yao said.

China’s trade surplus with the United States in 2007, Yao said stood at 206.6 billion U.S. dollars, and it declined to 143.4 billion dollars in 2009 due to shrinking external demand in the wake of the global financial crisis.

“ However, 44 percent of the surplus was contributed by U.S. companies operating in China, and 20 percent by other foreign companies there.”

Using Apple’s iPhone, as an example, Yao said the product, assembled in China, alone accounted for $US1.9 billion of China’s trade surplus with the United States in 2009.

“Most of China’s trade with the U.S. is compensation trade, which may account for 60 percent of the total (bilateral) trade,” Yao said. “The yuan’s appreciation may somewhat increase China’s trade surplus, contrary to the common sense.”

It means China can import raw materials and equipment at relatively low prices, he added.

Even if China is forced to give up exporting some of its products once the yuan appreciates, Yao said the United States will still have to buy those products, which it usually does not manufacture, from other countries — which neither helps bring down its trade deficit nor create jobs, he said.

Moreover, a CCER’s model showed if the yuan appreciated by 5 percent against the dollar, the U.S. employment rate will rise by only 0.03 percent and even if the yuan appreciates by 20 percent, it only helps to raise U.S. employment by 0.16 percent.

Meanwhile, the model also showed that the increase in the yuan’s value is unlikely to affect the U.S. gross domestic product (GDP) much — if the yuan rises by 5 percent, the U.S. GDP would go up 0.02 percent, while China’s GDP would contract 0.56 percent.

“In general, our research shows that the impact of the yuan’s appreciation on the economies of China and the U.S. is minor. The attempt to fix U.S. economic problems by urging the yuan to appreciate is not effective.”

Attacking root causes of imbalances

Economist Huang said global leaders would do much better attacking economic imbalances by attacking their root causes.

He added that is was rather simplistic for anyone to blame China’s currency policy and an undervalued renminbi as the root cause of US currency problems.

Currency values, he said are important but no one should expect the mere depreciation of the dollar would be sufficient to reverse the US current account deficits and resolve the country’s unemployment problems that have been mired at 10 per cent for the past several years.

China and the US and much of the world should be addressing structural imbalances that are the root cause of the current economic disputes.

“Therefore, it is better to adopt more comprehensive policy approaches to deal with the problems,” he said.

Addressing China’s structural imbalances

During the past 30 years, Huang said China has adopted an asymmetric market liberalisation approach which has contributed greatly to current economic imbalances both within China and globally, especially with the US.

“While product markets are almost completely liberalised, factor markets remain heavily distorted.”

These product factor distortions he said have artificially lowered China’s production costs that have in effect subsidized producers, exporters and investors and are behind China’s structural imbalance problems.

“Therefore, completion of factor market liberalisation should be a critical part of the reform program necessary to rebalance the Chinese economy.”

Exchange rate must also appreciate more quickly

Although China’s exchange rate policies that have kept the renminbi relatively weak are undoubtedly also a key production factor distortion, Huang said that China is also moving toward its liberalization.

“Increasing exchange rate flexibility is consistent with China’s announced policy goals. China has to do our part by introducing a more flexible exchange rate and reducing the current account surplus,” he said.

Huang said that China’s faster appreciation of the renminbi could also be part of its efforts to prevent China from becoming the victim of the Fed quantitative easing policy (QE2).

“When the dollar liquidity flows outside the US, China will be one of the favorite destinations because of its strong growth, high interest rates and expectations of currency appreciation. If it doesn’t adjust its current policy, China could be the next big bubble,” he said.

In order to avoid that unhappy outcome, Huang said the Central Bank will let the renminbi rise steadily. “That might attract more hot money inflows, but it is better than a one-step adjustment.”

The central bank he said must raise interest rates more swiftly. Although this policy may encourage more capital inflows because of the wider interest rate differential between China and the rest of the world.

Therefore, the Chinese authorities, he said should also consider temporary measures to control capital accounts. An exchange rate adjustment will take some time and more restrictive capital controls may provide a better environment for that adjustment.

“More importantly, capital account controls can help stop US dollar liquidity at the border. But of course, such controls should be temporary and for the adjustment period only. Once a large part of the adjustment is done, we should abolish those controls and re-accelerate capital account liberalisation.”

How China’s production factor distortions caused economic balances

China’s large current account surplus, Huang said is caused mainly by broad distortions of the factor markets, which generally decreased costs of production and artificially improved competitiveness of China exports.

“Exchange rate misalignment is only a part of that broad distortion picture. Relying exclusively on currency adjustment to correct the overall external imbalance requires an outsized appreciation, which is difficult for China to accommodate at this stage, both politically and economically.”

The exceedingly low savings ratio in the US before the subprime crisis, he said was similarly by a number of structural factors.

“Simply depreciating the US dollar by a significant margin is unlikely to be sufficient to substantially lift the savings ratio.

Fortunately, global rebalancing is already occurring. “In the US the current account deficit as a share of GDP has already halved from its pre-crisis peak, while in China the surplus as a share of GDP has already shrank by two-thirds.”

China’s recent external balance readjustments, Huang said were to a certain extent – a result of changes in domestic factor markets. “Factor costs have been on the rise despite the global financial crisis.”

During the past year, the Chinese government began to reduce price distortions for most resource products in order to improve economic efficiency, and the impending labor shortage pushed up wages by close to 20 per cent. Global electronics firm Foxconn Plc in Guangdong province was a prime example of a Chinese based company that raised its salaries by about 20 per cent for its 500,000 employees.

Government rebalancing policy initiatives

Political leaders such as Premier, Wen Jia Bao repeatedly emphasized in 2010 that structural balances are detrimental to China’s sustainable local and international development. (footnote)

China’s existing growth pattern has been described as “unstable, unbalanced and unsustainable.

Economist Huang said that one of the most widely identified imbalance problems is the rising share of investment in GDP, which increases the risk of excess capacity and low returns. A persistent current account surplus, he said also means that China, as a low-income economy, has been exporting capital despite domestic investment needs.

Most of the current account surplus is held as foreign exchange reserves, which have relatively low returns and are vulnerable to exchange rate risk. “In addition, the surpluses indicate the degree to which Chinese growth is dependent on external demand.”

Income inequality has also drastically increased. Other growth quality problems include inefficient resource use, serious pollution, and corruption among local government officials. If these problems persist, China’s strong economic growth will be unsustainable.

Changing the growth model is one of the top policy priorities under Wen’s government, which has already undertaken a range of policy measures to adjust China’s economic structure.

For instance, it has taken various steps to stimulate consumption, contain investment growth, reduce overcapacity in certain industries, and reduce external account surpluses.

The fundamental cause of structural imbalance lies in the unique pattern of market liberalisation during the reform period when product markets were completely liberalized but distortions remained in the factor markets.

Such distortions Huang said artificially increased profits for manufacturing production, turning China into a global manufacturing centre through the supply of cheap labour and cheap capital and resources.

Cost distortions have also contributed to oversized investment and exports. This is probably why growth has been so strong in China, but exports and investment have been even stronger.

To alleviate the existing structural risks, Huang said the authorities need to change their policy course.

Attacking root cause – factor-market distortions

Huang suggests that China must attack the root cause of the imbalances and inefficiency problems by eliminating is factor-market distortions.

“The fundamental solution to deal with the imbalance problem is to implement a comprehensive package of factor-market reforms.”

The comprehensive package, Huang said essentially calls for an end to the asymmetrical approach to market liberalisation. “Steady liberalisation of factor markets and the elimination of cost distortions should be top priorities for the next stage of reform.”

Labor-markets should be gradually fundamentally fundamental way to stimulate consumption. The government, he said has implemented new urbanization policies that will allow more rural migrants to officially work in urban areas and also intends to extend the social welfare systems to all rural residents.

Huang added that another positive breakthrough could be the introduction of market-based interest and exchange rates. The China Interbank Offered Rate, he said was a good starting point for a government trying to form a market-based term structure for interest rates.

“But the financial system needs to cater better for the needs of the private sector, which will be the backbone of the Chinese economy. This means market-based interest rates. It also means that the exchange rates should be more flexible.

Land-ownership rules must also be reformed to reduce distortions to land use. The current collective ownership, Huang said said is vague, creating room for corruption and hinders the modernisation of the rural economy.

“In the cities, the government should stay out of the direct negotiation of land prices and private property development.”

Abolishing other cost distortions

The state sector in China that executes much of the policies handed down by the Central Government. Huang said the state sector should be reformed so that is shares more profits with households.

One option, he said is for the State to collect more taxes from state-owned enterprises and then redistribute the gains to broader society. In broader terms, the state sector should gradually give up much of its monopoly power or be privatised.

Huang admitted that the complete liberalisation of factor markets and the elimination of cost distortions are likely to take years to complete. “When completed, they will signal China’s full transition to a market economy and will help lock China’s growth onto a more sustainable path.”

Undoubtedly, China’s recent factor price adjustments as suggested by economist Yao and Huang are an important means to change the renminbi’s real effective exchange rate and impact China’s current trade composition.

“A rapid rise in wages, for instance, not only directly benefits consumption but also forces industries to move toward inland provinces, another positive factor for promoting domestic demand,” Huang said.

US doesn’t cite China for manipulating currency

China’s seemingly pragmatic policies to avoid currency and trade wars with the US seem to be working, at least for now.

In February 2011, the Obama administration declined to cite China for manipulating its currency to gain trade advantages against the United States. (footnote AP)

“Treasury’s finding came in a report it must submit to Congress every six months as to whether other countries are manipulating their currencies. American manufacturers have been pushing for China to be cited. That could result in penalty tariffs being imposed on Chinese imports.”
In refusing to cite China, Treasury said Chinese President Hu Jintao had assured President Barack Obama in Washington that China would intensify its efforts to “further enhance exchange rate stability.”

The future – Henry Kissinger

In a recent interview US television interview with Charlie Rose, US statesman, Henry Kissinger said

“We have to [work] together, which is not the operating style of our societies. If both countries recognize—which I think they are beginning to do—what their real task is, that it isn’t just to stop the immediate day-to-day tensions but to have some vision. … Now, how well they can do it, how quickly, that remains to be seen.

Kissinger also said that each side has its own view.

The Americans, Kissinger said argue that “the Chinese can’t be trusted, that the Chinese really want world domination, that they are taking advantage of us in the transfer of technology and also that the Chinese in the last year have conducted themselves in a more assertive way than we have been accustomed to.”

On the other hand, Kissinger said China believes that it has suffered more than a century of humiliation and that it’s now their turn to demonstrate at least equality.

However, Kissinger concluded that based on Hu Jintao’s recent speeches, China’s governing group during his recent speeches that long-term cooperation is important. “It’s also the evolution that the Obama Administration has undergone.”

Edwin Sim, Managing Director of Human Capital Alliance presents interesting anecdotes about the troubled Greek economy.

Everyday when we turn on our televisions or open our newspapers, we hear or read how Greece, Spain or Italy are about to default on their loans.

To make matters worse, the broadcasters tell us if their big brothers Germany and France don’t do something about it, the whole world may be driven into a 1930’s-like depression.

Networks such as CNN, BBC and Fox News parade a whole slew of talking-heads, noted economists and experts who try to explain what happened. Everyone seems to be blaming others for the problem.

However, amid all the noise several facts can be deducted, especially if we look at Greece.

In the last several decades, the world’s wealthiest societies grew  rich by devising better and better ways to give people what they want. Many governments, especially in Europe and the USA are in trouble today because they pandered to their electorates – providing short-term rewards by sacrificing long-term sustainability.

It is apparent that from 2002, much of the developed world including its individual citizens fueled economic growth by borrowing money that they probably could not afford to repay.

Some reports indicate that worldwide debts, public and private, more than doubled from 2002 from $84 trillion to $196 trillion in 2008, when the US sub-prime crisis almost triggered a global economic melt-down.

Greece is a country of about 10 million people, a bit fewer than Bangkok and its surrounding areas. A few years ago, the International Monetary Fund (IMF) and the European Central Bank (ECB) agreed to lend Greece $US145 billion.

As of 2011, in addition to $400 billion of outstanding government debt, the Greek government owed another $US800 billion in pensions. The total amount of $US1.2 trillion meant that every Greek citizen owed about $US250,000.

A large part of the Greek economy’s growth from 2000 onward came from foreign loans extended to the country.

In 2001, Greece entered the European Monetary Union (EMU) and began using the Euro instead of its drachma. More importantly, by switching to the Euro, the Greek government suddenly realized that it could borrow Euros at five per cent per annum versus its prior 18 per cent rate.

By joining the EMU, Greece was able to effectively borrow with an implicit German government guarantee and was therefore afforded much lower interest rates. The Greek government used these new found funds to satisfy their electorate with many populist but costly programs.

In his 2011 best-seller, Boomerang, Michael Lewis said that the Greeks may not know how many workers, they have in the public sector.

“The Greeks have teachers who don’t teach, tax collectors on the take, well-paid railroad employees and hospital workers must be bribed to pay for overpriced supplies.”

According to Lewis, in 12 years, the Greek public sector wage bill doubled in real terms. “The average government sector job pays three times a private sector job.”

The most egregious example of government waste was the Greek national railway which had revenues of 100 million Euros. At the same time, its employees were paid annual wages of 400 million Euros and the company also spent an additional 300 million Euros in other expenses.

Lewis said the average Greek state railway worker earns 65,000 Euros a year. “Twenty years ago, the Minister of finance said it would be cheaper to put all Greek rail passengers into taxis and it still is.”

In addition, the Greek public school system, which Lewis said is one of lowest ranking in Europe employs four times as many teachers as the highest ranked, Finland.

To continue being elected, various Greek governments have also implemented very generous but under-funded pension programs that are virtually bankrupting the country. “The retirement age for arduous jobs is 55 for men and 50 for women.”

More than 600 Greek professions are deemed arduous including hairdressing, radio announcers, waiters and musicians.

An ancient Greek orator, Isocrates probably said it correctly.

“Democracy destroys itself because it abuses its right to freedom and equality and because it teaches its citizens to consider audacity as a right, lawlessness as a freedom, abrasive speech as equality, and anarchy as progress.”

Greek governments have not only been inept on the spending side. The have also been very lax collecting taxes from high income individuals.

According to Lewis, most Greek doctors report incomes of less than 12,000 Euros per year because no taxes are payable on incomes of less than 12,000 Euros. “the problem is not the law, but its enforceability. If laws were enforced, every doctor in Greece would be in jail.”

Greece’s funding problems are not isolated cases of government mismanagement. Many US cities in the 1970s began deferring wages increases for their employees including teachers, firemen and teachers by offering them great retirement benefits.

By the 2000s many of these pension liabilities are coming home to roost.

San Jose, which is in the heart of California’s Silicon Valley has one of America’s highest per capita incomes. “The city owes so much money to its retired employees that it could cut its debts in half and still wind up broke.”

“Police and fireman pension benefits eat up 75 per cent of discretionary spending because over the past several decades, the city has repeatedly caved-in to its unions.”

The city’s pension costs were $73 million per year when the current Mayor was first elected and now its $245 million. “In three years it will be $400 million.”

Lewis said that city is legally obliged to make these costs and can only respond by cutting elsewhere. “Libraries are closed three days a week, park services are cut and police and fire-fighter are laid off.”

From a high of 7,450, San Jose now has only 5,400 city workers.  “By 2014, the city of one million would be service by 1,600 public workers.”

Human Capital Alliance Senior Advisor K I Woo reviews Michael Lewis’s description of how a savvy investment manager make huge profits from the global subprime crisis. Part 4 of a 4 part series.

Although the sub-prime led global meltdown that began in 2007 forced several huge financial institutions into bankruptcy or government led bailouts, some savvy investors made a tremendous killing.

In his new best seller, The Big Short – inside the doomsday machine, Michael Lewis the author of Liar’s Poker describes how several US investors made fortunes by innovatively devising new techniques that helped them benefit massively from the ensuing housing bubble burst that finally came in 2007.

“You couldn’t short houses (shorting is a technique that allows a person to make money when prices goes down},” he said.

Although investors could anticipate that large US developers such as Pulte Home or Toll Brothers would suffer from a housing bubble burst, Lewis said shorting their shares (on the Stock Exchange) would be expensive, indirect and dangerous.

“Stock prices could rise for longer than the investor could save solvent,” he said.

Innovative investing

The amazing element of Lewis’s best seller was his ability to re-tell the successful exploits of four groups of investors that had realized as early as 2000 that the real estate market was heading into a bubble and would eventually burst.

Although each one of these investors had a hunch that real estate prices were ready to burst, Lewis said no readily available investment vehicle or techniques were available for them to make huge amounts of money on their investments.

Consequently, these four separate investors spent much time researching the housing and housing finance markets before secretly implementing their innovative investment ideas.

We will focus on one investor, an eccentric northern California-based medical doctor named, Michael Burry.

Michael Burry

Michael Burry was an eccentric investor who suddenly wanted to know how sub-prime mortgage bonds worked when he sensed that the housing market was fast becoming over-priced. “He was wondering how he could short sub-prime mortgage bonds,” he said.

According to Lewis, Burry spent the end of 2004 and early 2005 scanning hundreds of sub-prime bond prospectuses and soon discovered that the quality of assets was worsening.

“In Burry’s view, standards had not just fallen but hit bottom,” Lewis said.

The bottom, Lewis said even had a name, “the interest only negative amortizing adjustable-rate sub-prime mortgage”. With this type of loan, Burry discovered that home buyers were given the option of paying nothing at all, and rolling whatever interest they owed into a higher interest balance.

Burry quickly could see that someone with no income could qualify for such a loan. “What Burry couldn’t understand was why a person who lent money would want to extend such a loan,” Lewis said.

At that point, Burry decided that the lenders must be watched not the borrowers.

Looked at local lenders

As early as 2003, Burry began researching local mortgage lenders in northern California. He discovered that many of them were dreaming up new instruments to increase their loan volumes, often to unqualified buyers. But why?

He soon discovered they immediately sold them to large banks such as Goldman Sachs, Morgan Stanley and Wells Fargo, that quickly packaged them into bonds and sold them off.

At this point, Lewis said Burry knew that the housing bubble was set for a huge bust.

“Complicated financial stuff was being dreamed up for the sole purpose of lending money to people who could never repay it,” Lewis said.

Tactical investment problem

However, Burry soon realized that the different floors or tranches of sub-prime bonds could not be shorted. “You could buy them or not buy them, but you couldn’t bet explicitly against them,” Lewis said.

Credit default swaps

A few years earlier, Burry had discovered Credit Default Swaps (CDS) which he realized were not swaps but insurance policies on corporate bonds, with a semi-annual premium payments and a fixed term.

“For instance, you might pay $200,000 a year to buy a ten-year credit default swap on $100 million of General Electric (GE) bonds,” Lewis said.

The most an investor could lose was $2 million ($200,000 premium for 10 years) but he could also make $100 million if GE defaulted and bondholders received nothing.

By buying CDS on bonds of companies that were financially weak, Burry discovered that investors could really leverage their investments.

In 2004, he began buying CDS on companies that he thought might suffer from a real estate downturn: mortgage lenders, mortgage insurers and real estate developers. However, this type of investment would not optimize his investment returns.

“These companies might lose money but there is no guarantee they would go bankrupt,” Lewis said.

Burry needed a more direct tool for betting against sub-prime mortgage lending.

Idea – Credit default swaps on sub-prime mortgage bonds

Burry thought about CDS for sub-prime mortgage bonds when he began researching the development of the market. Initially, he wondered why banks needed to buy CDS when they could just refuse to lend to the borrower if they weren’t sure about their credit.

He quickly realized that many people wanted to bet on whether GE would default on their bonds and why wouldn’t they want to bet on subprime bond defaults. Many people were making money by putting together CDS buyers and sellers.

Burry realized that CDS would solve the single biggest problem with his investment idea – timing. During his research, he thought that sub-prime loans made in 2005 would not go bad for two years because that’s when the teaser interest rates were to be re-set.

He was also afraid that if he did not quickly purchase the CDS on n sub-prime mortgage loans no one would sell insurance on the bonds once they found they were ticking time bombs.

Needed to prod Wall Streets to create them

Lewis said Burry needed to prod the Wall Street firms to create CDS for sub-prime mortgage loans. At the same time, however, Burry also worried that some firms were too heavily involved in subprime mortgage loans and could go under if the housing market crashed.

“There was no point buying insurance from a bank that went out of business the minute the insurance became valuable,” he said.

Burry didn’t bother calling Lehman Bros and Bear Stearns because they were the most exposed to the mortgage bond market.

He called Goldman Sachs, Morgan Stanley, Deutsche Bank, Bank of America, UBS, Merrill Lynch and Citigroup. “Five of them had no idea what he was talking about; two came back and said that, while the market didn’t exist, it might one day,” Lewis said.

Nevertheless, within three years after Burry’s call, Lewis said CDS on sub-prime mortgage bonds would become a trillion dollar market and precipitate hundreds of billions of dollars worth of losses inside big Wall Street firms.

Wall Street firms didn’t share sense of urgency

When Burry set out to bet against the sub-prime mortgage bond market in early 2005, Lewis said the Wall Street investment banks didn’t share his sense of urgency. “Mike Burry wanted to place his bet now, before the US housing market woke up and was restored to sanity,” he said.

“Its going to blow up before I can get this trade on,” Burry wrote to his investors.

Burry: first CDS subprime retail customer

Lewis said that within months after Burry broached the investment banks on buying CDS for sub-prime mortgage loans, the idea “reshaped” their businesses so that CDS became “smack at the center” of their businesses.

“The original mortgage bond market had come into the world in much the same way, messily, coaxed into existence by the extreme interest of a small handful of people in the margins of high finance,” Lewis said.

While the original mortgage bond market had taken years to mature; this new market, he said would be up and running and trading tens of billions of dollars worth of risk within a few months.

Next step – developing standardized contract

CDS on a pool of home mortgage loans were more complicated, Lewis said because the pool didn’t default all at once, rather, one homeowner at a time defaulted. The dealers, led by Deutsche Bank and Goldman Sachs – came up with a clever solution; the pay as you go credit default swap.

“The buyer of the swap – the buyer of insurance – would be paid off not all at once, if and when the entire pool of mortgages went bust, but incrementally, as individual homeowners went into default,” he said.

Lewis said the first CDS contract on subprime mortgage bonds took months to compete. One of the sticking points was requiring the entity that sold the CDS, either Goldman Sachs or Deutsche Bank to post collateral, to reflect the increase in the CDS value.

“He didn’t want to buy flood insurance from Goldman Sachs only to find, when the flood came, Goldman Sachs washed away and unable to pay him,” Lewis said.

May 19, 2005 – Burry’s first subprime mortgage deal

Mike Burry finally did his first subprime mortgage CDS deal on May 19, 2005. “He bought $60 million in credit default swaps from Deutsche Bank – $10 million each on six different bonds,” Lewis said.

The reference loans that Burry bet against were the worse mortgages. “He’d read dozens of prospectuses and scoured hundreds more, looking for the dodgiest pools of mortgages,” Lewis said.

Within a short period, Lewis said Burry discovered that Deutsche Bank and Goldman Sachs didn’t care which bonds he picked to bet against. “The market made no sense but that didn’t stop Wall Street firms from jumping into it, partly because Mike Burry was pestering them,” Lewis said.

For the first few months, Burry was able to short at most $10 million at a time. “Then in late June 2005, he had a call from someone at Goldman Sachs asking him if he’d like to increase his trade to $100 million at a pop,” he said.

By the end of July 2005, Lewis said Burry owned CDS of $750 million on sub-prime mortgage bonds and was privately bragging about it.

By April 2006, Lewis said Burry had finished buying insurance on sub-prime mortgage bonds. “In a investment portfolio of $555 million, he had laid off $1.9 billion of these peculiar bets,” Lewis said.

“I believe no other hedge fund on the planet has this sort of investment, nowhere near to this degree, relative to the size of its portfolio,” Burry wrote to one of his investors.

Burry then began wondering what madman would sell him so much insurance on bonds he had handpicked to explode.

Goldman Sachs had made it clear that they were only acting as agents between the insurance buyer and the insurance seller and taking healthy fees from both parties along the way.

Who was on the other side of the CDS trade

While Burry was buying his $100 million tranches, he guessed right that Goldman wasn’t on the other side of the trades. “Goldman would never be so stupid as to make huge naked bets that millions of insolvent Americans would repay their home loans,” he said.

Ultimately, after three years he found out that the party on the other side was triple A rated AIG.

June 14, 2007 Bear Stearns sub-prime hedge funds go belly-up

Even though the markets were regularly reporting that many sub-prime mortgage lenders were having problems, Burry discovered that his CDS prices were not really reflecting these developments up until about June 14, 2007. “On June 14, the pair of sub-prime mortgage hedge funds effectively owned by Bear-Sterns went belly-up,” Lewis said.

During the ensuing two-week period, Lewis said the public-traded index of triple B-rated subprime mortgage bonds fell by nearly 20 per cent. Since Burry’s biggest positions were with Goldman, he called his sales person to determine the value of his positions, so that he could collect collateral as agreed. “On June 20, Grinstein (his Goldman sales woman) called back to tell him Goldman has experienced “systems failure”, Lewis said.

Within days the sub-prime mortgage markets began a protracted free-fall as major financial institutions such as Lehman Bros, Citigroup and Merrill Lynch among others began announcing huge sub-prime mortgage losses.

August 31, 2007 – Burry begins cashing out

On August 31, 2007, Burry began unloading his portfolio of credit default swaps. “Just a few months earlier, Burry was being offered 200 basis points for his credit default swaps, which peaked at $US1.9 billion. Now he was being offered 75, 80 and 85 points by Wall Street firms desperate to cushion their fall,” Lewis said.

At the end of the third quarter of 2007, Burry would report that his fund was up more than 100 per cent for the year. On a total investment portfolio of less than $US550 million, Burry realized profits of $US720 million from buying CDS on sub-prime mortgage loans.

Human Capital Alliance Senior Advisor K I Woo looks at how Wall Street quants played a major role in the 2008 global economic meltdown. Part 3 of a 4 part series.

Everyone is still curious how a few sub-prime loans to lower-income US neighborhoods could possibly ignite a global economic crisis.

Many people blame different villains including Alan Greenspan for keeping low interest rates for too long, rapacious real estate agents that lured unqualified buyers into purchasing new homes and greedy bankers that made fortunes repackaging mortgages and selling them to sophisticated investors globally.

An unprecedented decade-long US housing boom and the development of lightly-regulated securitization and related derivatives markets also are obvious culprits.

During this same time, a much less publicized group of mathematics and computer-trained PhDs or “quants” also played a key role in developing Wall Street’s new forays into computerized trading and derivatives.

In his best seller, “The Quants – how a new breed of math whizzes conquered Wall Street and nearly destroyed it”, Scott Patterson shows how these “geniuses” were able to confound even the most sophisticated financial experts with complicated investment models designed to virtually print money.

“Many of the models created an illusion of order where none existed,” he said.

Initially, the quants’ investment strategies used complex computer models to exploit the differences in pricing for various securities.

“They used brain-twisting math and superpowered computers to pluck billions in fleeting dollars out of the market,” he said.

Huge investment bank profits

According to Scott, these tech-savvy quants began dominating Wall Street in the early 1990s, helped by their theoretical breakthroughs in the application of mathematics to financial markets. “The quants applied those same breakthroughs to the highly practical, massively profitable practice of calculating predictable patterns in how markets moved and worked,” he said.

By the mid-1990s major investment banks such as Goldman Sachs and Morgan Stanley began hiring PhDs from prestigious universities such as the University of Chicago, MIT and Princeton to design computer models that could find cheap-versus-expensive opportunities across the globe. In 1995, Goldman agreed to seed a small internal hedge fund with $10 million, Patterson said.

Global Alpha, Patterson said was a group that would go on to become one of the elite trading operations on all of Wall Street. “During some years these internal proprietary trading desks accounted for as much as 25 per cent of the firms’ net income,” he said.

Many of these computer-driven internal hedge funds, Patterson said ran on their own with minimum human interference and churned out hundreds of millions of dollars of profits every year.

Business was good, Patterson said because pension funds and endowment funds were diving in and investment banks were expanding their proprietary trading operations such as Global Alpha at Goldman Sachs, PDT at Morgan Stanley and one at Deutsche Bank.

“Hundreds of billions poured into the gunslinging trading operations that benefited from an age of easy money and globally interconnected markets,” he said.

Battle for bonuses

In the late 2000s as the proprietary trading desks began churning out hundreds of millions of dollars of profits, many quants realized that they could make more money for themselves if they formed their own hedge funds. Some of the fund managers’ bonuses had made them among the top paid investment bank employees but even these amounts paled in comparison what they could make operating their own private hedge funds.

Managers wanting more income simply walked out the door and started their own operations and quickly earned a lot more than they had at the investment banks.

As a result, new hedge funds were started everyday to compete in an ever-expanding market. “In 1990 hedge funds held $39 billlion in assets. by 2000 the amount had leapt to $490 billion and by 2007 it had exploded to $2 trillion,” he said.

The great hedge fund bubble

As a result, Patterson said thousands of hedge fund fund jockeys became wealthy beyond their wildest dreams. “One of the quickest tickets to the party was a background in math and computers,” Patterson said.

The money poured in – crazy money, he said. “Pension funds across America burned by the dot.com collapse in 2000, rushed into hedge funds, the favored vehicle of the quants, entrusting their members’ retirement savings to this group of secretive and opaque investors,” he said.

Cliff Asness, a University of Chicago PhD left Goldman Sachs to start hedge fund AQR in 1998 with $1 billion had $40 billion by mid 2007. “In 2002, Anness pulled down $37 million. The following year, he raked in $50 million.

These hedge funds according to Patterson unwittingly primed the bomb and lit the fuse for the financial collapse that began to explode in spectacular fashion in August 2007.

“Despite their chart-topping IQs, their walls of degrees, their impressive PhDs, their billions of wealth earned by anticipating every bob and weave the market threw their way, their decades studying every statistical quirk of the market under the sun, no one saw the train wreck coming,” he said.

Patterson said a hint to the answer came a century ago from Isaac Newton after he lost 20,000 pounds in the South Sea bubble. “I can calculate the motion of heavenly bodies but not the madness of people,” he said.

How did home loans get involved?

To compete with higher paying hedge funds, in the 1990s, Patterson said banks themselves morphed into risk hungry hedge funds to keep talented traders.

As investment bank hedge funds became major profits centers and as new hedge funds were being formed to invest money in the early 2000s, several investment experts such as Edward Thorpe, Patterson said realized that it was becoming impossible to put up solid returns without taking on too much risk.

Many banks then began churning up their very profitable home mortgage securitization businesses that had developed during the past several decades.

To ensure that they could sell more product, the investment banks began expanding their standard home mortgage securitizations into sub-prime loans in the early 2000s. The investment banks then developed many sub-prime-based derivatives products that expanded the investor pool and generated hugh fees.

Collateralized Debt Obligations

Initially, the mortgages were packaged into collateralized mortgage obligations (CMOs) and sold in tranches that represented different risks. The higher risk tranches paid the highest interest rate.

“Some CMO had more than 100 tranches,” Patterson said.

These different tranches were sold to many investors all over the world with different risk appetites. By tranching the sub-prime loans, the investment bankers opened a whole new investor market for housing loans.

Over time, the bonds became more and more complex, sometimes with bunches of the highest risk tranches from different bonds packaged into collateralized debt obligations (CDOs). Everywhere along the chain, the investment collected fees for putting together the bonds and selling them to investors.

The investment bank and hedge needed the quants to calculate the interest rates and risks associated for each tranche.

Inevitably, they used very complicated mathematical formulas and models that few people understood.

Business was booming. Everyone wanted to buy the securitized home mortgages, many of which were rated Triple AAA by the rating agencies.

In 2004, when the banks began packaging CDOs with sub-prime loans, Patterson said $157 billion were issued. By 2005 it rose to $273 billion and $550 billion by 2005.

Eventually, most of these bonds imploded and became a major cause of the 2007 global economic crisis.

As CDOs boomed – housing prices took off all over US

According to Patterson, as the CDO business boomed and brought in billion dollars of fees for investment bank, housing prices all over the US also took off.

Wall Street investment bank were virtually fighting to buy all the sub-prime loans they could get their hands on so they could repackage them and sell them to hungry yield investors all over the world.

To ensure that they could obtain enough some banks such as Morgan Stanley began buying sub-prime originators.

“Morgan Stanley in 2006 pumped-up its sub prime mortgage business by paying $706 million for sub prime mortgage lender Saxon Capital,” Patterson said.

Massive “warehouses” were also set up to park sub-prime mortgages until they were ready to be sold. These were placed into off the books Special Purpose Vehicles that were funded by commercial paper.

“Any hitch in the chain would result in disaster,” he said.

Huge profits – ignored risks

As the investment bank continued churning out huge profits, Patterson said the SEC in 2004 allowed them to use more leverage by loosening up capital reserve requirements. “The SEC also allowed them to rely on own quantitative models to determine risk,” he said.

Leveraging, he said permitted the Banks to purchase more and more of the housing assets and generate more profits and fees without increasing their capital bases. However, leveraging could also result in larger losses when markets inevitably turn.

Despite a bubbling housing market that many experts was about to burst, Patterson said Banks such as Morgan ignored the risks.

Morgan stock price was sky high and they could raise capital easy because they were showing huge profits. “Their leverage ratio rose to 32 to 1 and their profits increased 70 per cent in Q1 2007 to $2.7 billion,” he said

Sub-prime defaults begin in 2007

A bad omen was on the horizon when homeowners began defaulting in 2007.

Patterson said it began when HSBC boosted expected subprime losses by 20 per cent to $10.6 billion. “They had previously snapped up sub-prime lender Household International,” he said

Why did it trigger global crisis

According to Patterson, the quants overwhelming influence in investment operations helped exacerbate the housing crisis that quickly mushroomed into a global economic crisis.

Almost everyone understands that Wall Street sold many of the sub-prime mortgage bonds overseas especially to yield hungry European banks. The bursting of the housing bubble resulted in huge losses for all sub-prime investors and quickly led to a global crisis.

However, for Wall Street, Patterson said the most terrifying aspect of the ensuing meltdown were the hidden linkages in the global money grid that no one was aware before. The quants sophisticated computer models that had consistently churned out money for years had not taken these risks into account.

For instance, in many of the computer driven investment models, the program would buy a company’s bonds and short its shares or options until temporary value differences realigned. To generate higher profits many of these “bets” were leveraged and traded by computer hundreds of times each day.

However, as the housing market and the sub-prime market began crashing, Patterson noted that many of the computer driven models supposed outcomes no longer worked. For instance, the programs bets began going in opposite directions and caused billions of dollars of losses.

Hedge fund margin calls

According to Patterson several hedge operators later said that when the sub-prime mortgage collapsed, it triggered hedge fund margin calls that forced unwinding position in stocks.

Because many hedge funds were leveraged as high as 30 to 1, they were forced to sell other liquid securities to meet margin calls on crashing sub-prime securities.

“Dominoes started falling – hitting other quant hedge funds, forcing them to sell and unwind positions in everything from currencies to futures contracts to options in markets around the world,” he said.

As a result of the sub-prime crisis and its highly-leveraged environment, Patterson said a vicious feedback loop ensued and billions of dollars evaporated in a few days. “It caused a complete reversal of quant strategy outcomes,” he said.

Other elements that fed the boom

As the housing market continued rising and sub-prime securities fueled the boom, Patterson said Wall Street continued innovating new products that eventually help the downturn implode into global economic crisis.

He also added that Wall Street’s demand for more sub-prime loans and the fat fees they spit out were key factors that allowed and encouraged brokers to concoct increasingly risky mortgages with toxic bells and whistles.

Of the 25 top subprime mortgage lenders, Patterson said 21 were either owned or financed by major Wall Street or European banks according to report by Center for Public Integrity.

“Without the demand from investment banks, the bad loans would never have been made,” he claims.