Discuss

Q&A for M*_Jason.R's Personal portfolio

M*_Jason.R — Sun, 22 Nov 2009 03:32:56 GMT

Ask questions related to the "Personal" Portfolio here.

Q&A for grybeard's leave it to the pros portfolio

grybeard — Sat, 21 Nov 2009 15:35:00 GMT

Ask questions related to the "leave it to the pros" Portfolio here.

Q&A for Robert T's Market timing-Inverted YC Portfolio

Robert T — Sat, 21 Nov 2009 11:13:52 GMT

Ask questions related to the "Market timing-Inverted YC" Portfolio here.

Q&A for Jack50's K Non-Taxable Nov09 portfolio

Jack50 — Sat, 21 Nov 2009 00:44:29 GMT

Ask questions related to the "K Non-Taxable Nov09" Portfolio here.

Q&A for rondom's In Retirement portfolio

rondom — Fri, 20 Nov 2009 19:03:43 GMT

Ask questions related to the "In Retirement" Portfolio here.

Q&A for nazcax's porto1 portfolio

nazcax — Fri, 20 Nov 2009 10:12:47 GMT

Ask questions related to the "porto1" Portfolio here.

Q&A for Lcark's nov19#1-9 portfolio

Lcark — Fri, 20 Nov 2009 00:52:50 GMT

Ask questions related to the "nov19#1-9" Portfolio here.

Q&A for ValuePanda's ValuePanda portfolio

ValuePanda — Thu, 19 Nov 2009 23:36:28 GMT

Ask questions related to the "ValuePanda" Portfolio here.

Q&A for rgj76248's Randall's Total Portfolio portfolio

rgj76248 — Thu, 19 Nov 2009 23:16:21 GMT

Ask questions related to the "Randall's Total Portfolio" Portfolio here.

Q&A for df21084's Retirement Shared Portfolio

df21084 — Thu, 19 Nov 2009 21:36:33 GMT

Ask questions related to the "Retirement Shared" Portfolio here.

Q&A for clwatt1950's core bonds portfolio

clwatt1950 — Thu, 19 Nov 2009 19:30:41 GMT

Ask questions related to the "core bonds" Portfolio here.

Mergers Beyond the Numbers: How CFOs Can Shine

QFinance — Thu, 19 Nov 2009 18:53:00 GMT

Sometimes bad things happen to good people. The best finance executives don't just count the numbers, court bankers, or dream up ideas to restructure the balance sheet. They backstop the CEO, and never in a more important area than strategy. Many observers think that's the special purview of the CEO. But that's just the point: it's lonely at the top. Today, more than ever, the CEO needs someone to talk with who possesses powerful, detailed insights about the business and is able to help think through, and maybe push back a bit on, various strategy options.

This is never more important than when hot on the trail of a merger, especially a big one, and even more so when it has the potential to rewire an entire industry. The strategy lessons from Jürgen Schrempp's days at Daimler should strike fear into the heart of every CEO and deliver the strong scent of opportunity to each CFO standing by and whispering into the ear of the chief. Schrempp's story provides a rich backdrop against which to paint a picture of basic strategic checkpoints as you travel along your next merger pathway.

Did it seem strange when the board of Daimler threw Jürgen Schrempp on to the side of the road? Sure, he had plenty of battle scars, but at the time he was let go Chrysler had been turned around and, according to him, Mercedes's quality woes were on the mend. So why boot him out?

Schrempp arrived in the Daimler boardroom with tremendous swagger, and if he could have made even half of what he promised come true he would have been able to maintain control of one of Germany's most powerful companies. That his accomplishments fell far short of his promises isn't news. The critical question is why?

Starting with the merger disaster also known as Chrysler, Schrempp certainly bought scale when he acquired this highly volatile American outpost from Bob Eaton, its recently appointed GM-trained leader. But Schrempp had no idea of how fragile Chrysler was, or how quickly the waters would turn rough for his American vessel. Why was his crystal ball so cloudy in this acquisition?

Coming from Mercedes, which for decades had enjoyed a nearly unassailable image of prestige, reliability and quality, he acted as if he failed to understand that the world is a different place for second- and third-tier brands. Once the merger was complete, the rapid descent of Chrysler into yet another of its serial spasmodic slumps was easily predictable, especially as Schrempp began to clean house of talented "car guys" like Robert Lutz, who had fashioned Chrysler into the modestly successful car company it was at the time of the acquisition.

Lack of Judgment
He further showed how little he was willing to learn with the Mitsubishi acquisition, not only in the poor management of the company, but in his strategy of attempting to make an also-ran into a top-tier company. It's a fine goal, but his lack of judgment while standing behind his grand design when all objective data indicated that Mitsubishi was a failure speaks of ego, not strategic savvy. Give him points for courage. Sadly, most boards today like the courage, but need results as well.

Schrempp's strategic error was his belief that any car company could be Mercedes as long as Mercedes owned it. Even a cursory glance at the history of the automobile industry would have shown this to be a silly belief--a Studebaker was never a Packard although the two companies merged, BMW had so much trouble dealing with Rover that it dumped much of the acquisition assets for pennies on the dollar, and Ford was not Jaguar just because it owned the prestigious marque. In fact, Ford may have tarnished some of the Jaguar brand's mystique through the smaller Ford/Jaguar mongrels it developed.

The strategies of Schrempp's three large brands, Mercedes, Chrysler, and Mitsubishi, were so utterly different that they required decidedly different approaches. Mercedes is a price-setter, with resale values that consistently led its rivals in the market. It rarely made the mistake of overproducing cars that later needed to be dumped at whatever clearance price the market would bear. Mercedes was, at the beginning of his reign, on the top of the automotive world, with a blend of significant volume and lofty price point jealously sought after, but not achieved, by any other maker. Mercedes' most important goal should have been to ensure that its leadership position remained solidly intact.

Chrysler, on the other hand, was a price-taker in almost every segment. Buffeted from below and above, Chrysler had a bumpy and often uncomfortable ride. Its image was fluid, messy, and unclear. At one time wild (and desperate) innovators with the original minivan (way back in 1983), by the time of the Schrempp purchase, it was unclear what rabbit it would pull out of the hat next to survive.

Unlike Mercedes, which had a distinct leadership position in the automobile business, Chrysler was more like soft clay, subject to hideous deformation by competitors. Chrysler needed new hit products, as it enjoyed with the striking 300 series full-size rear-wheel-drive cars developed by Wolfgang Bernard, an executive Schrempp later decided to fire.

Getting It Wrong
Mitsubishi was simply a mess, and Schrempp seemed unable to do anything to correct it. It can be argued that the situation worsened while operating with Mercedes as its partner. Mitsubishi needed a complete makeover, instead of the band-aid of special low-cost financing, often given to people who couldn't afford the monthly payments.

But his out of tune strategies didn't stop with these three large brands. Schrempp invested heavily in the Smart car brand in Europe, a micro-car where even the planned revenues would only have developed micro-profits. His upmarket and outsized ultra-luxury brand Maybach has missed all sales projections, and presumably loses money even as one of the most expensive cars in the world.

And as the goose that laid all these golden eggs, Mercedes, moved ever onward and downward, it suffered lower per-unit profits, while producing steadily increasing unit volumes. Schrempp did this by expanding into smaller car categories, while allowing the larger and mid-size Mercedes models to be challenged by a host of competitors. He also packed the cars with exotic electronics well before testing proved they were thoroughly reliable. His plant in the United States, which built the Mercedes ML-class SUV, had quality issues that would embarrass Hyundai.

It's a classic pattern of ambitious overreaching and misplaced enthusiasm without the discipline brought by clear strategic thinking, careful implementation, and frank assessments from a chief financial officer. His egregious errors extended even into personnel, forcing one of the key architects of the Chrysler renewal (Wolfgang Bernard) to walk the plank because the unfaithful executive dared point out that Mitsubishi was a hopeless mess. The revival of Nissan has shown that talented executives can make an enormous difference. Why force a good one out?

In the end, the timing was just about right. The board wanted to preserve some sense of order and needed a seasoned insider to take over the job, a role played by the well-proven Chrysler savior, Dieter Zietsche. Sure, they could have booted Schrempp sooner, but that would have made for much more turmoil at the top.

Accountability to Stockholders
It seems fitting that the guy who was outspoken on the need for boards to be more responsive to stockholder value was felled by his own board attending to that very demand. All the charisma and insider contacts with major stockholders can't take the place of a carefully crafted strategy. In the end, Schrempp simply wasn't able to measure up, and this doubtless stems from his lack of savvy and candid advice from his top executive team.

As a member of that team--and in many companies the most visible and important player outside of the CEO--good CFOs deliver powerful and measured advice, usually in private, and always backed by real data. A talented CFO sits in a unique position, able to guide the top executives without challenging the CEO's position. Great finance people get that way by bringing their special view of the numbers, but of much more besides, into clear focus for the CEO before it's too late.

If you want to be a star, push beyond the purely financial functions and think about the advice you would want if you were the CEO. Do this well enough, and some day you might just be one.

More Info

Please provide further reading: books, articles, reports, and/or websites.

Identifying and Investing in Niche (Alternative) Investments: Art, Wine, and Coins

QFinance — Thu, 19 Nov 2009 17:08:00 GMT

When it comes to investing, alternative investments have risen in popularity. If hedge or mutual funds, real estate, and bonds don't fill you with enthusiasm, there are plenty of other places to invest. And those with an interest in collecting works of art, wine, or coins may find that their investments, apart from giving pleasure, yield higher profits than the stock market.

Art may be a matter of personal taste, but the markets treat it like any other commodity, and the business of investing in it is based on a very simple principle-you buy something and hope its value increases. Success in the art marketplace is not easy: The proliferation of artists and the sheer quantity of works, media, periods, and styles can make collecting an intimidating prospect, and values can rise and fall terrifyingly. Nevertheless, for those who are prepared to do their homework, investing in art can be lucrative.

As the laws of supply and demand are on its side, good wine offers first-rate opportunities for the investor, making for a solid protective asset in times of uncertainty and market turbulence. High-quality wines are one-offs that can never be replaced. Therefore, it is often better to spend on a small number of good wines than to spread your investment too thinly; any wine of a good vintage offers a lower risk.

Coins can also be considered a form of investment. Their value will depend on a number of factors, including the age and availability of the coin, its condition (for example, whether it is dented, scratched, or stained), and trends in the market for precious metals. There are also bullion coins, such as the Krugerrand, which are composed mainly of precious metals and have little value beyond that of the metal itself.

Advantages

Art: High-quality pieces with good provenance make for good long-term investments.
Wine: A strong, defensive asset in times of uncertainty, and, if all else fails, you can drink your assets!
Coins: Have always been valued for their rarity and portability.

Disadvantages

Art: Making a speedy profit on a piece of art is a comparative rarity, if only because transaction costs-dealers' margins and auction house fees-tend to eat up margins.
Wine: It is vital that the wine is correctly stored, as it is not always simple to realize wine investments rapidly.
Coins: Well-established dealers, who have a key role in determining the value of coins, control the market.

Action Checklist

Only enter a specialty area if you have a genuine interest in the subject and will get real satisfaction from the process of collecting, buying, and selling.
To maximize your chances of success, you will have to do a lot of research in your field of interest.
Join associations or investment clubs and consider seeking professional help before taking the plunge.

Dos and Don'ts

Go into your primary area of interest with the aim of enjoying yourself rather than making money.
Research your area of interest and then specialize in a specific area, region, or time period.

Don't

Don't believe that you are going to make your fortune; there are plenty of other, safer places to invest your hard-earned cash.
Don't overreach: Success in the marketplace is not easy for the amateur, and enthusiasm often takes over from common sense.

More Info

Books:

Rush, R. H. Art as an Investment. New York: Prentice-Hall, 1961.

Sokolin, D., and A. Bruce. Investing in Liquid Assets: Uncorking Profits in Today's Global Wine Market. New York: Simon & Schuster, 2008.

Temple, P. Superhobby Investing: Making Money from Antiques, Coins, Stamps, Wine, Woodland and Other Alternative Assets. Petersfield, UK: Harriman House, 2004.

Articles:

Bolitho, N. "Noble coining it in." Investors Chronicle (November 5, 2007). Online at: www.highbeam.com/doc/1G1-171207154.html

Malaviya, N. S. "Investing in art." Economic Times of India (January 11, 2009).

Websites:

Christie's: www.christies.com

Sotheby's: www.sothebys.com

(Footer Quotes)

"Anyone who attempts anything original in the world must expect a bit of ridicule." Alberto Juantorena

Q&A for df21084's C3R portfolio

df21084 — Thu, 19 Nov 2009 16:48:14 GMT

Ask questions related to the "C3R" Portfolio here.

Rigidity in Microfinancing: Can One Size Fit All?

QFinance — Thu, 19 Nov 2009 16:45:00 GMT

Executive Summary

Despite rapid growth in outreach, microfinance providers often have yet to reach a large proportion of the market of poor households.
One explanation may be that microfinance practitioners have been slow to implement innovations to the standard lending methodologies.
By tailoring products to clients' needs and repayment capacity, flexible microfinance has the potential to reach many more clients at lower cost. This can be proven with randomized evaluations of flexible lending contracts.
Further work is needed to understand how this will impact on clients.

Introduction
In the span of a single decade microfinance has gone from being virtually unknown-to bankers, to development workers, and, most of all, to the poor-to being a household word. Ask anyone today to describe microfinance and most likely you will get a common answer: "That's when banks lend to groups of poor women to start little businesses." Much of this increase in awareness is thanks to the tireless work of industry advocates who have traveled the world convincing development organizations and funders that microfinance offers the best hope for large numbers of poor families to move out of poverty.

Practitioners, broadly speaking, have been offered three choices:

1 Grameen Bank-style solidarity lending, with 12-month loans offered to groups of five poor women;

2 FINCA-style village banking, with a four-month loan divided among a larger group of about 30 poor women; or

3 ACCION-style individual lending to the moderately poor.

On most other features, these options are strikingly similar. All three target entrepreneurs with capital for sewing machines, chickens, tortilla presses, and the like. And all emphasize operational efficiency through product standardization, and good repayment through frequent regular payments that start shortly after the loans are disbursed. Here we discuss ideas that can be seen as "tweaks" to the above standard models. These tweaks increase the flexibility with an aim to improving the quality of the service received by the client.

Lending Flexibility

Problems with the Standard Model
Looking back on the evolution of microfinance one begins to wonder if perhaps its advocates might have been too successful in their messaging. By sticking to this script, the industry may have stifled creativity and individualism in the development of financial services for the poor. Consider the repayment schedule adopted with near universality for group-lending clients: weekly payments that start only one or two weeks after disbursement of the loan. This despite the fact that microfinance institution (MFI) managers are well aware that most of their clients' enterprises will not start generating returns so rapidly.

Why is this important? Being poor is not just about having too little income-it is about having an insecure income. The income of the poor can vary dramatically from day to day, month to month, season to season. The poor have good weeks and bad weeks. But microloans, like all loans with fixed repayments, are made on the basis of the borrower's ability to repay in their worst week. Otherwise they would end up in arrears at some point during the loan cycle. This rigidity has several ramifications. First, by basing borrowers' repayment capacity on bad weeks, instead of average weeks, it greatly limits the size of the loans the poor can borrow. If I earn 50 rupees some weeks and 550 rupees other weeks, my debt capacity is not based on my average income of 300 rupees but on the 50 rupees that I can afford to pay in the bad weeks. As a result, borrowers with variable income and little recourse outside of money lenders to smooth that variability will be given a debt capacity that is much lower than ideal.

Second, it may screen out many potential borrowers entirely: for example, any entrepreneur who pictures a week in which she might have slow sales or a household emergency. Or existing clients may leave because they experience too many "close calls" and then drop out to avoid going into default. Incidentally, these should be the bank's best customers-they are clients of such strong integrity that they refuse to borrow for fear of defaulting! Third, it precludes potential innovations like bullet loans for agriculture (a bullet loans is a loan where payment of the entire principal of the loan, and sometimes the principal and interest, is or are due at the end of the loan term).

These limitations help to explain why, despite years of growth, MFIs still fulfill only a small fraction of the financial needs of the poor. This year the Microcredit Summit Campaign has reported that its members reach a total of 150 million borrowers (Daley-Harris, 2009). This is a stunning achievement, and yet only a dent in the estimated two billion households that lack access to financial services. The need to identify ways to reach this market with appropriate financial services cannot be ignored.

How to Be Flexible: Some Suggestions
How can we practically implement flexibility in the current structure of microfinance? A full portfolio of flexible financial products has yet to be developed, but there are some promising ideas. We give three examples, each highlighting a different element of flexibility. First, we observe that flexibility can be prebuilt into the contract. For example, in India the monsoon is a difficult time for everyone. Contracts could reflect this by reducing payments during this period in a prespecified manner. Similarly, dairy farmers face two months a year without milk. Again, the contract could prespecify a smaller loan payment during this period. Prespecification of flexibility has many benefits. Notably, clients are not led to believe that they can negotiate down other payments. The flexibility is not after-the-fact. It is actually a "rigid" flexibility, with tightly delineated rules. As a result, it also eases technological and logistical concerns of management information systems, cash management, and loan officer fraud.

Second, one could provide a less rigid flexibility by prespecifying a number of low payment periods, but not their timing. For example, one could give clients several tokens and tell them that each token can count for one weekly payment. In this way, the client agrees to a slightly higher payment each week in return for getting a few difficult weeks-of their own choosing-off. Again, the creation of a token ought to ease the logistical problems of MIS, cash management, and fraud. Yet it still provides the borrower with a great deal of flexibility.

Finally, consider an MFI that feels that its borrowers could handle 2,000-rupee larger loans than they currently receive. Should it just increase the initial loan size? What if instead it told all borrowers that they would be eligible for a second 2,000-rupee loan at any point during the cycle? This second loan might actually help the client more than simply increasing the initial loan by 2,000 rupees since it gives the client a safety valve in case of emergencies.

Why Have People Been Afraid of Flexibility?
Fixed-debt contracts may be problematic, but there are sensible reasons for using them. First, a flexible payment stream may generate many operational headaches. For instance, portfolio monitoring requires clear information on default status. It may be difficult (or impossible) to distinguish between someone exercising their flexibility and someone who is intending to default further. The faster lenders deal with default, it is often believed, the better they are able to recover the loans. Furthermore, depending on how the flexibility is structured, it could cause confusion in the field. It is easier to train staff to collect equal and constant weekly payments. The flexibility should be such that staff can easily understand and implement it.

Second, cash management problems may arise. If clients experience correlated shocks (for example floods or droughts), they may (should!) use the flexibility to help smooth out those shocks. This has implications for the lender if it is seeing a shortfall in repayment at the exact moments it wants to have more cash on hand to lend to individuals. Third, flexibility may put the lender at risk of loan officer fraud. The loan officer, for instance, could claim that the client exercised her "flexibility" when in fact she repaid. (As noted above, this can be mitigated by prespecifying the payment schedule: if the client is expected to pay 50 rupees in a given week, the MIS will raise a flag if any other payment is recorded.)

Last, varying contracts might weaken the repayment discipline of borrowers. Some argue that the key difference between debt programs and savings programs is that debt provides a commitment to make weekly payments, whereas with savings there is no such commitment. Thus, this is one reason why rotating savings and credit associations (ROSCAs) and chit funds exist, to provide individuals with a commitment to save. If the debt requirement allows some flexibility, some fear that this will erode the repayment discipline. Borrowers may forget which weeks to pay and which not, or find it hard to turn on and off the habit of putting money aside to pay the loan. Either way, the fear is that having a few weeks off will lead to lower repayment when the payments are required.

These costs of flexible contracts are often better articulated than the benefits. Yet qualitatively the benefits could be huge. Will these products work? Will operational hurdles prevent them from working? Will they erode repayment discipline and increase default? Or will they allow for much larger loan sizes and greater client income growth? We simply do not know. A common retort is that borrowers can use other sources of income or debt to fill in the gaps. This misses the basic point about the financial policy for the poor: these alternatives either do not exist or are very expensive. Why cede this important and potentially lucrative financial service without ever testing the water? There is only one way to know if microfinance can be more flexible: by testing. As with any new idea, there is no way to know how well it works without careful experimentation. As we note above, the point is not that flexibility will impose no costs on the organization. Flexible products may be trickier to implement, or they might have ambiguous effects, like increasing portfolio-at-risk while increasing profitability. The challenge for MFIs is to find those aspects of flexibility which can expand their reach and impact without hampering continued growth.

To examine these theories in a practical way, at Innovations for Poverty Action (IPA) we use randomized control trials to test new products and services for the poor. To determine whether the benefits of a new idea outweigh its costs we measure its impact, benchmarked against the traditional methodology.

Flexibility Works: Some Examples

Group versus Individual Liability
For years a central part of the conventional wisdom of microfinance was that microfinance worked because of group liability: banks could safely lend to poor borrowers with no collateral because they would guarantee each others' loans. True, repayment rates among microfinance clients have been impressive. But, like the inflexible repayment schedules, there may be costs as well as benefits: How many potential clients might be deterred by the group-liability contract? How many don't borrow because they don't want to be responsible for other people's loans? We used a randomized control trial to measure the effects. Working with a rural bank in the Philippines, Giné and Karlan (2008) randomly selected groups of their microfinance clients to switch from group liability to individual liability, with all other aspects of the loan contract remaining constant. Following up three years later, the authors found no increase in default among individual-liability clients. On the other hand more clients had joined the individual-liability groups, suggesting that on average clients much prefer individual liability. In an expansion of that study, the authors tested with new clients by randomly marketing in some villages individual-liability loans, and in other villages group-liability loans. Again, there was no difference in default. The bank officers were much less willing to make individual liability loans, suggesting that the flexibility was perceived as too much for their staff, and they restricted the supply of credit. Whether it was right or not we cannot tell, since we do not know whether those not approved for loans would have defaulted or not.

Repayment Frequency
In another study that tested one of the key assumptions of microfinance contracts, Field and Pande (2007) experimented with altering the frequency of payments, from weekly to monthly. After one year, they found no change in default. This simple test has vast implications: if clients can meet far less often with no effect on repayment, MFIs can drastically reduce their staff costs. Those savings can be passed along to clients, potentially making credit more affordable to the poor. And more clients may join if there's less of a burden on their own time. Naturally, more time may yield different results, and proper testing and patience can help us to learn the answer to these important questions.

Evaluating Flexible Contracts
This same type of analysis can be applied to carefully examine the flexible lending contracts we describe above. In each case a (randomly selected) group receiving the innovation would be compared to clients offered only the traditional contract. The analysis can go much beyond simply "does it work?" The treatment and control groups can be evaluated on any number of dimensions: repayment, client retention, MFI profitability, etc. For example, flexibility might actually save on loan officer time. If every monsoon we know that clients have a tough time paying, might it not be more cost-effective to have lower or less frequent payments during that period rather than use valuable loan officer time to chase down "delinquent" clients?

Further, flexible contracts may greatly increase the impact of the loan. Clients with rigid contracts may take actions which reduce the return on their investments. Owners of milk animals may underfeed during difficult times. Asset owners may sell off (productive) assets to repay debts. Freedom from Hunger, through its MAHP program, is helping the MFIs CARD, CRECER, and Bandhan to offer emergency health loans to their clients. It would be useful to evaluate this type of product to determine whether it is able to prevent the destruction of this value. Potentially, such a product could be as useful as the initial loan itself. Or if clients can't handle the additional debt burden, it could have negative spillovers, destabilizing their borrowing groups. If the impact is positive, however, the increased income from retaining productive assets could allow the MFI to further increase loan size.

Conclusion
Rigorous evaluations will become only more important as new technologies are developed to improve the efficiency and scale of microbanking. These same technologies, such as handheld computers for loan officers, have the potential to greatly increase the flexibility offered to clients-by making on-the-spot credit decisions, or handling variable repayment amounts, for example. We have focused here on one issue in particular: the flexibility or rigidity of debt products; but with the deployment of any new technology we are faced with the same unknown: how well does it work? The goal of our research around the world, as with the Innovations for Poverty Action, the Financial Access Initiative, and the Massachusetts Institute of Technology Abdul Latif Jameel Poverty Action Lab, is to bring about consensus about the circumstances under which different products and features and services are optimal for clients and institutions. Related work will shed more light on other important aspects of flexibility, including loan tenure, loan size, group size, and guarantee requirements.

More Info

Article:

Field, Erica, and Rohini Pande. "Repayment frequency and default in micro-finance: Evidence from India." Journal of the European Economic Association 6:2-3 (April-May 2008): 501-509. Online at: ksghome.harvard.edu/~rpande/papers/repayfreqjeea_1107.pdf

Reports:

Daley-Harris, Sam. "State of the Microcredit Summit Campaign report 2009." Washington, DC: Microcredit Summit Campaign, 2009. Online at: www.microcreditsummit.org/uploads/socrs/SOCR2009_English.pdf

Giné, Xavier, and Dean S. Karlan. "Group versus individual liability: Long term evidence from Philippine microcredit lending groups." Working paper. May 2009. Online at: karlan.yale.edu/p/GroupversusIndividual-May2009.pdf

Websites:

Innovations for Poverty Action (IPA): poverty-action.org

Financial Access Initiative (FAI): financialaccess.org

Abdul Latif Jameel Poverty Action Lab: www.povertyactionlab.com

Rules vs. Discretion in Supervisory Interventions in Financial Institutions

QFinance — Thu, 19 Nov 2009 16:38:00 GMT

Executive Summary

One of the most critical moments in financial-sector supervision is when supervisors need to decide if they should "intervene" in a "problem bank" (a bank that is gliding towards insolvency or is already insolvent). This decision is critical because, if supervisors wait too long to intervene, the worth of the bank will continue to erode, losses to depositors may increase, and systemic risks may increase, ultimately leading to high costs to the government and, thus, the taxpayers.
In the wake of every banking crisis, the debate about "rules versus discretion" in supervisory intervention flares up. This discussion regarding supervisory intervention in problem banks focuses on the incentives for supervisors to act swiftly and decisively in order to minimize losses to depositors, and society more widely.
In this debate, rules are often proposed as the preferred solution (with some discretion left), because the closure of a financial institution remains a tricky event where many interests collide (private, political, business), and even independent supervisors can be seduced by self-interest if the stakes get high. The rules-based intervention system in the United States (prompt corrective actions) has proven many of its merits over the years, and made the product ready for export to other jurisdictions around the world. Until recently, most European supervisory frameworks relied more on discretion than rules, but the 2007-08 financial crisis seems to change the mood, and more voices are being heard in favor of a rules-based system.

Introduction
Financial supervisors' main task is to monitor the behavior and actions of the institutions under their area of responsibility. They check compliance with the regulatory framework, and, when necessary, impose sanctions and enforce them. So, in every jurisdiction, a key component of the regulatory and supervisory framework is the nature, timing, and form of intervention by the supervisors in case the health of an individual institution fails. The supervisors step in to address the problems in the financial institution in an effort to protect the depositors of this institution and of other institutions, as well as the taxpayers' money by avoiding or limiting contagion (the systemic risk).

Supervisors typically have a toolbox of instruments and sanctions at their disposal, ranging from orders to comply with specific rules, over monetary fines, to the ultimate sanction, closure of a financial institution. Typically, these sanctions are graded. They start from small corrections when the problems are still minor, in the hope the bigger interventions can be avoided.

Practice around the globe has amply shown that the decision as to when and how to intervene in a problem bank is the Achilles heel of the supervisory process. Reasons abound for this! Firstly, a weak regulatory framework inherently leads to weak supervision and lack of enforcement rules. For instance, the regulatory framework may lack pointers for supervisors regarding the timing of an intervention, may not be specific enough regarding the intervention instruments, or may leave the supervisors without the power to collect the critical data to properly analyze a financial institution's health. Secondly, politicians may dissuade supervisors from intervening in a problem institution for fear that this (connected) institution gets a bad press, or worse.

Judgment is another factor that could influence the supervisory decisions. Supervisors faced with bank problems may believe that these problems are temporary, and will go away without supervisory action. Finally, some form of self-interest may also be at play. Supervisors faced with a problem bank may take a "not on my watch" approach, and hide the problems as long as possible. This behavior can be explained by the fact that society may see the problems in a bank as a reflection of weak supervision, which is damaging for the supervisor's reputation.

Whatever their cause, these situations typically lead to forbearance, i.e., refraining from addressing an institution's problems head-on. Such forbearance is bound to lead to a deepening of the problems in that specific institution, and ultimately to an increase in the costs of addressing them, among others, because these problems could be contagious. These costs will eventually fall on the shoulders of the depositors, the government, and ultimately the taxpayers.

Starting from this reality, the "rules versus discretion" debate in supervisory intervention is about the question: in order to limit political interference, reduce the risk of judgmental errors, and self-interested behavior, and thus forbearance, should the supervisor, when intervening in an individual bank, be bound by strict rules, or have the discretion to take action when deemed necessary?

Origin of the Debate: How to Deal with Time-Inconsistency in Policies?
The "rules versus discretion" debate in economic policy goes back to the seminal paper by Kydland and Prescott (1977). They introduced the distinction between time-consistent and time-inconsistent policies. The issue with time-inconsistent policies is that they produce good results in the short run, but will ultimately fail to produce the long-run policy goals set forth. Politicians have a tendency to renege on their long-term commitments for short-term gain, for example, in the run-up to elections. A key issue in settings where the time-consistency problem arises is the ability or inability of the government to make binding commitments about future policy. The authors argued that in such situations policies should be bound by rules, which is superior to leaving discretion to policymakers. Rules imply commitment, and therefore produce time-consistent policies, while discretion implies the absence of commitment, and therefore opens the door to time-inconsistencies. The issue has been widely debated with respect to monetary policy (with the emergence of the independent central bank as a broadly accepted institutional solution to the time-inconsistency problem, rather than the strict imposition of a monetary rule) and fiscal policy (fiscal rules).

From the above examples, it can be seen that bank supervision faces similar risks of time-inconsistency, when it comes to dealing with weak or ailing institutions. Bank liquidations are typically politically unpopular, as they can result in genuine hardship for depositors and other creditors, many of whom will also be voters. Vote-maximizing politicians with short time horizons may be concerned about the short-term costs of bank closure, whether fiscal, in terms of lost votes, or in terms of lost campaign contributions. So they will be sensitive to demands of these groups, particularly if these are politically well organized. Politicians may be tempted, as a result, to put pressure on supervisors to organize a bailout, exercise forbearance or grant dispensations from regulatory requirements to avoid short-term costs. But short-term forbearance may be the cause of higher longer-term resolution costs.

To eliminate time-inconsistency in bank resolution, it has also been proposed that bank supervisors are granted a fair degree of independence from the politicians, for the same reasons as central banks in matters of monetary policy. It has been argued that independent supervisors would not fall into the trap of time-inconsistent policies. Their reaction functions would differ from those of their political masters. So supervisors will act decisively, and without interference from politicians, when they need to deal with an ailing bank. However, some have argued that this is not enough because the incentives faced by supervisors differ from those faced by central bankers. This critique of regulatory forbearance was mainly developed in reaction to the observed behavior of regulators during the S&L problem in the United States in the 1980s. In this account, regulatory forbearance arises not only from political influence but also from the self-interested actions of supervisors. The incentive structure they face encourages them to "sweep problems under the carpet", at least until they have left office. Supervisors face more complex pressures than monetary policy-makers, because so many (private, public and political) interests are at stake when the decision is taken to close and liquidate a financial institution. Thus, even an independent supervisor could come under pressure when faced with an ailing bank, particularly if that bank is politically connected or is a national champion (or both).

"Prompt Corrective Actions"-A Rules-Based Solution
This above analysis highlights the need to pay close attention to the regulators' incentive structures, remuneration arrangements, and accountability measures. More specifically, the view emerged that supervisors, even politically independent ones, would benefit from the presence of intervention rules to avoid succumbing to political and other pressures. An influential proposal by Benston and Kaufman (1988) promoted a system of predetermined capital/asset ratios that would trigger structured actions by supervisors. They called it structured early intervention and resolution (SEIR). Their proposal opened the rules versus discretion debate for supervisory intervention. Instead of leaving the decision as to when and how to intervene in ailing banks (discretion) in the hands of supervisors, they proposed rules specifying when and how supervisors need to intervene. A version of SEIR was adopted by the United States as "prompt corrective action (PCA) in the 1991 Federal Deposit Insurance Corporation Improvement Act (FDICIA) (see Making It Happen). The main objective behind systems of SEIR is to minimize the losses for depositors, deposit insurance, and, by extension, taxpayers.

Since the adoption of PCA in the United States, a number of countries, including Japan, Korea, and Mexico, have followed this example. Many more are contemplating the adoption of such an approach to supervisory intervention. In the aftermath of the 2007-08 financial crisis, the debate has been vividly reopened with calls from various circles, academic and policy, for more rules in the intervention process. So, given this growing appetite for rules-based systems, the question really is: are rules-based systems so much superior to discretion? Let's have a look at advantages and disadvantages of both in order to draw some conclusions.

Rules-Based Systems

By determining the pace and nature of intervention, rules-based systems can prevent excessive forbearance, so action is taken in a timely way, when the bank's obligations can probably still be met, thus limiting the costs to depositors and/or taxpayers, and forestalling contagion.
Indeed, PCA starts when the regulatory capital ratio is still positive, giving the bank managers incentives to recapitalize the bank or look for a suitable merger partner.
A rules-based system, by its nature, provides better (or additional) protection for supervisors against political influence, or legal action. The supervisor's defense would simply be: "I was doing what the law told me to do." This is, in general, a useful buffer against political interference, and is particularly important in countries where supervisors do not have a great deal of political independence (such as many middle- and low-income countries).
A rules-based system provides clear signals to the banks and to the public what to expect. It provides clear incentives to banks to comply with rules designed to protect their solvency; it is a public promise that the supervisor will intervene in a timely way to avoid losses. It thus promotes public confidence.

Discretion-Based Systems

A discretion-based system provides the supervisor with the flexibility to pursue an optimal solution in terms of timing, cost, and type of action. All bank failures are different, and ex ante legislative criteria for bank intervention are too crude to provide an effective and low-cost system of bank intervention.
Discretion could also avoid that capital is destructed when intervention is unnecessarily rapid and intrusive. The supervisory authority is a better judge of the actual situation, and the most adequate remedial measures, than any ex ante legislator. In some cases, exercising forbearance may increase the probability that a distressed bank may recover.
By being able to operate more discreetly, unnecessary unrest in the markets and with depositors, and other creditors can be avoided.
Rules-based systems such as PCA rely on regulatory measures of a bank's capital. Such measures may deviate significantly from the bank's economic capital. Bank capital is also a backward-looking policy instrument. For these reasons, judgment, rather than rules may be better to make a proper assessment of a bank's situation.

Clearly, both approaches come with advantages and disadvantages. So, drawing a clear-cut conclusion is not all that simple. A rules-based system is clear and able to shape anticipations of all stakeholders, but it is also rigid. A discretion-based system offers more flexibility but may be insufficiently proactive and transparent, and may provide insufficient incentives for prudent behavior of banks. So, perhaps, for a complex operation such as financial supervision and intervention, it is dangerous to think too much in "either/or" terms, particularly because every case for intervention is different. It seems more prudent to think of an intervention strategy that is based on a fair dose of both discretion and rules.

In that regard, reliance on discretion is more desirable at the beginning of the process, when problems are first detected, giving supervisors leeway to adjust measures to specific circumstances. Rules-driven interventions have more merits once the situation becomes more urgent. How would such an intervention strategy operate?

In a "normal times" situation, supervisors evidently watch a bank's capital adequacy ratio, as well as other ratios. However, given the complex nature of financial operations, these days their attention goes more to a financial institution's risk-management systems and strategies. This approach to supervision gained more weight since the adoption of the Basel II framework (Pillar 2). The point of gravity of supervision is on qualitative assessments of risk management systems. In the wake of the current crisis, this tendency is likely to continue. Qualitative principles are therefore likely to be elevated relative to mechanical rules that were "gamed" leading up to the current crisis.

The implication of this new approach to supervision is that in the very early stages of emerging problems-the transition from a "normal" situation to one of distress-reliance on rules would not be adequate. Supervisors should assess strategies and mainly rely on their discretion to suggest corrective actions.

However, once it is clear that an institution's situation continues to deteriorate, and quantitative measures point in the same direction, intervention rules should kick in, and supervisory discretion should be reduced and eliminated.

So, we would see a gradual transition from qualitative and discretionary interventions to more rules-based interventions. For such rules to operate effectively, what are the necessary ingredients of an intervention system? Well:

1 first of all, the language in the law should be clear that the supervisor is mandated to intervene;

2 the triggers for action by the supervisors should be clearly defined, objective, and non-debatable;

3 the actions to be taken by the supervisors should also be clearly specified;

4 an indication of the timeframe within which imposed actions should be taken by the supervised entity needs to be given;

5 the law should specify a range of sanctions that should be taken if actions are not implemented.

Furthermore, a rules-based intervention system needs solid, up-to-date financial information on the bank's financial conditions. As indicated earlier, a fair degree of supervisory independence is desirable under a rules-based intervention system, but on the other hand, rules rather than discretion tend to shelter supervisors from political interference. Just like for any supervisory action, supervisors that enjoy legal protection for actions taken in good faith are in a better and stronger position than colleagues that do not enjoy such protection. Legal protection is an important requirement for effective supervision.

Making It Happen

Table 1. The United States FIDICIA System for "Prompt Corrective Action." (Source: Board of Governors of the Federal Reserve System)

Capital level trigger

Mandatory and discretionary actions

10% > capital adequacy ratio > 8% or 5% > core capital ratio > 4%

Bank cannot make any capital distribution or payments that would leave the institution undercapitalized.

Capital adequacy ratio < 8% or core capital ratio < 4%

Bank must submit a capital restoration plan; asset growth restricted; approval required for new acquisitions, branching, and new lines of business.

Capital adequacy ratio < 6% or core capital ratio < 3%

Bank must increase capital; restrictions on deposit interest rates and asset growth; may be required to elect new board of directors.

Capital adequacy ratio < 4% or core capital ratio < 2%

Bank must be placed in conservatorship or receivership within 90 days; approval of FDIC required for entering into material transactions other than usual core business, extending credit for any highly leveraged transaction, changes in accounting methods, paying excessive compensation or bonuses.

More Info

Book:

Nieto, Maria, and L. Wall. "Prompt corrective action: Is there a case for an international banking standard?" In D. Evanoff, G. Kaufman, and J. La Brosse (eds). International Financial Instability: Global Banking and National Regulation. World Scientific Studies in International Economics Series, Vol. 2. Singapore: World Scientific, 2007, ch. 23.

Articles:

Benston, George J., and George G. Kaufman. "Risk and solvency regulation of depository institutions: Past policies and current options." Federal Reserve Bank of Chicago Staff Memorandum no. 88-1 (1988): 1-67.

Benston, George J., and George G. Kaufman. "FDICIA after five years." Journal of Economic Perspectives 11:3 (Summer 1997): 139-158. Online at: econpapers.repec.org/RePEc:aea:jecper:v:11:y:1997:i:3:p:139-58

Kydland, Finn E., and Edward C. Prescott. "Rules rather than discretion: The inconsistency of optimal plans." Journal of Political Economy 85:3 (June 1977): 473-491. Online at: www.jstor.org/pss/1830193

Notes

1 The views expressed in this chapter are the author's and should not be attributed to the IMF, its Executive Board, or its Management.

See Also

John Kenneth Galbraith
The Age of Turbulence: Adventures in a New World
Banking and Financial Services

Sovereign Wealth Funds - Profiles of the Top Ten Players

QFinance — Thu, 19 Nov 2009 16:34:00 GMT

Though Sovereign Wealth Funds (SWFs) have been around in various forms for decades, the leading players have risen to a new level of prominence over recent years. In particular, since the onset of the global credit crunch, several leading SWFs have taken full advantage of their massive level of liquidity to secure major stakes in financial services companies in urgent need of capital injections.

Middle Eastern and Asian nations benefiting from natural resources or mass manufacturing account for the overwhelming majority of the leading global SWFs, though Russia and several US states such as Alaska also operate sizable funds. The ten leading global players are as follows:

1 Abu Dhabi Investment Authority (ADIA). Established by the United Arab Emirates in 1976, ADIA is by far the world's biggest SWF, with assets estimated at $875 billion.* As much as 75% of ADIA's assets are thought to be administered by external fund managers. With a spread of investments among industrial and financial firms in the Middle East, ADIA caught the headlines in 2007 with a $7.5 billion investment in US banking giant Citigroup.

2 Norwegian Government Pension Fund. Norway's decision to invest the proceeds of its North Sea oil and gas operations into this $300+ billion* pension fund has created one of the world's biggest SWFs. Established in 1990, it is also by far the most transparent, having created a panel of experts to ensure that the 7,000 companies in which the fund invests meet its strict ethical criteria. Following the advice of this panel, the fund famously de-invested in Wal-Mart, citing concerns over the retail giant's labor rights record in developing economies.

3 Government of Singapore Investment Corporation (GIC). Thought to be among the world's five biggest SWFs, the investment management unit of the Singaporean government is believed to manage assets of around $330 billion.* Established in 1981, GIC prefers to keep a relatively low profile, despite delivering average investment returns of nearly 10% per annum in dollar terms since 1982. GIC holds major stakes in Swiss bank UBS and US energy firm AEI.

4 China Investment Corporation. With its origins in the investment business of China's central bank, CIC was established in its present form as recently as 2007. CIC oversees the investment of China's foreign exchange reserves, estimated to be in the region of $200 billion.* CIC lifted its stake in fund management group Blackstone to 12.5% in 2008, and it has also recently expanded its other interests in financial services, holding a 9.9% stake in Morgan Stanley.

5 SAMA Foreign Holdings. With assets believed to be in the region of $300 billion,* this Saudi Arabian SWF is generally regarded as one of the least transparent of the major global funds of its kind. Presently outsourcing equity to professional asset managers, SAMA (Saudi Arabian Monetary Agency) could soon be overshadowed by a new SWF planned by the Saudis to manage some of their enormous oil-derived wealth.

6 China Development Bank. Established in 1994, CDB has combined domestic infrastructure investments (such as the controversial Three Gorges Dam) with overseas interests, acquiring stakes in banks such as the UK's Barclays. CDB is thought to hold assets worth around $225 billion.*

7 Kuwait Investment Authority. Run by the Kuwait Investment Office, the country's investment arm, which traces its roots back to the early 1960s, holds assets worth around $250 billion.* 10% of Kuwait's annual oil revenues are channeled into the fund, which invests globally across a range of asset classes.

8 Temasek. The Singapore state-run investment fund was established in 1974, with assets recently estimated at around $160 billion.* In common with many of its peers, Temasek has been active in the global financial sector, acquiring stakes in institutions such as Merrill Lynch, Standard Chartered, and Barclays.

9 Russia National Welfare and Oil Stabilization Funds. With origins dating from around 2004, the Oil Stabilization Fund has invested exclusively in foreign government bonds. In early 2008 the Fund was split into two: The Reserve Fund is thought to hold assets of around $162 billion,* while the National Welfare fund, Russia's official SWF with assets estimated at $125 billion,* absorbs some of the proceeds from the country's energy industry.

10 Investment Corporation of Dubai. Formed in 2006, the Investment Corporation of Dubai is thought to have assets of at least $13 billion,* including its subsidiaries Dubai International Capital (DIC) and Dubai World. As well as a high-profile stake in HSBC, the group also holds investments in electronics giant Sony and automobile manufacturer DaimlerChrysler.

Advantages

SWFs' stated aim of investing for the long term can lend stability to the shareholder bases of the companies in which they invest.
These funds have been a valuable source of large-scale investment for some companies in need of capital as the credit crunch has deepened.
Many SWFs aim to secure nonvoting shares in their target companies, helping to alleviate concerns in some countries over foreign ownership of key assets.

Disadvantages

The lack of transparency associated with SWFs can create concerns over the motives behind some investments.
Some proposed SWF investments can meet with political or regulatory resistance, on protectionist or national-interest grounds. A noted example occurred when Dubai World's acquisition of P&O prompted US politicians to insist that the acquirer would dispose of several major P&O-owned US ports.
Concerns have been raised over some SWFs' commitment to upholding high regulatory standards.

Action Checklist

A commitment to the adoption of best practice principles proposed by the IMF can help SWFs to overcome some concerns over issues such as their motives, governance, and transparency.
Governments should ensure that their national SWFs manage their investments to the economic benefit of their citizens.

Dos and Don'ts

SWFs should be sensitive to local concerns over their investment objectives when striking overseas deals.
In situations where SWFs seek an active, controlling stake in a company, SWFs can overcome their lack of perceived expertise in some sectors by employing acknowledged industry experts to run their acquired businesses more efficiently.

Don't

Don't view SWFs as an automatic source of funding for Western financial institutions which find themselves in difficulty.
Don't allow the funds to ignore the value of effective communications and improved investment transparency and disclosure.

More Info

Books:

Carson, Thomas N., and William P. Litmann (eds). Sovereign Wealth Funds. New York: Nova, 2008.

Davis, Steven H. Inside China Investment Corp. London: McGraw-Hill, 2008.

Articles:

Elson, Anthony. "The sovereign wealth funds of Singapore." World Economics 9:3 (2008): 73-96.

Schuette, Patrick "Tamed tigers: Sovereign wealth funds as passive investors." Illinois Business Law Journal (November 2008). Online at iblsjournal.typepad.com/illinois_business_law_soc/2008/11/tamed-tigers-so.html

Websites:

Abu Dhabi Investment Authority: www.adia.ae

China Investment Corporation: www.china-inv.cn/cicen

International Monetary Fund: www.imf.org

International Working Group of Sovereign Wealth Funds: www.iwg-swf.org

Organisation for Economic Co-operation and Development: www.oecd.org

Sovereign Wealth Fund Institute: www.swfinstitute.org

Note

*Asset size estimates taken from Norton Rose's June 2008 "Sovereign Wealth Funds and the Global Private Equity Landscape Survey" (available on www.nortonrose.com) and The Times December 27, 2007.

Q&A for df21084's C1R portfolio

df21084 — Thu, 19 Nov 2009 16:31:54 GMT

Ask questions related to the "C1R" Portfolio here.

The Origins and Current State of the Buyout Market for Pension Funds

QFinance — Thu, 19 Nov 2009 16:25:00 GMT

Executive Summary
The article looks at the way the market for annuities buyout activity has developed over the last decade and at the stresses that market is experiencing as a result of the global downturn through 2008/2009. The following topics are covered:

The origins of the buyout market as a "rescue" for distressed companies, now taken over by the Pensions Protection Fund
The risks facing annuities providers, that the assets will be insufficient to meet the liabilities, and the longevity risk
The pressures in the market pushing companies towards pensions buyout, despite the high relative cost of this solution
Different types of providers in the market
The dynamics of buyout pricing
The trend for larger and larger schemes to adopt a buyout solution

Introduction
The buyout market for final salary pension or defined benefit (DB) schemes began more than a decade ago in the UK, with Legal & General as the sole provider. At the time, the focus was on distressed companies going into insolvency or administration. A buyout enabled the liquidator to separate off the company's pension scheme, with its statutory obligations to pay benefits to members, from the company. Instead, the buyout provider would take over responsibility for the scheme and the liquidator would be free to sell on the viable parts of the company, unencumbered by the liability constituted by its pension scheme.

In this context, it is important to remember that, from the company's perspective, while a DB pension scheme might be a very important part of its overall reward package for employees, the pension fund is, ultimately, just another debt on the company's books.

For taking over the scheme, the provider would charge the company a fee, and the fee would cover any shortfall between the company pension-scheme's assets (which would be transferred to the provider) and its liabilities. The liabilities are the totality of the benefits that the scheme is obligated to pay to members for the life of the scheme (i.e. until the last scheme member dies). Often, though, the company was unable to pay the fee because of insolvency, and so the member benefits would be reduced. This line of business from insolvent companies is effectively closed now, as a result of the introduction of the Pension Protection Fund (PPF). The main lines of business are with solvent companies looking to de-risk their liabilities.

Risks Facing Providers
There are two major classes of risk involved in a provider taking over the liabilities and assets of a pension scheme. The first involves the risk that the future returns on the assets of the scheme will not be sufficient to meet the expected payments when they fall due, and the second is the longevity risk.

This is the risk that members in the scheme will live longer than expected. When calculating whether a scheme is fully funded or is in deficit, actuaries have reference to the average or expected lifespans of all the members of the scheme, in order to calculate the benefits the scheme is going to have to pay out over its lifespan.

As providers are in business, ultimately, to add value for their shareholders, Legal & General, and then Prudential, which was the second player to enter this market in 1997, took-and still take-a very prudent view of these risks. The returns risk was managed by investing in low-to-negligible-risk securities, such as government bonds, with some investment-grade corporate bonds.

The second risk is something of a movable feast, as longevity at present is on the increase, and no one knows where that process will end. That risk was, and is, managed by charging a premium which allows for longevity to improve in the future. For many companies, however, the combination of low-yielding assets and the buyout premium made the buyout just too expensive to contemplate.

Pressures in the Market Pushing for DB Scheme Buyouts
However, several things have happened which, combined together, have predisposed many financial directors and CEOS of companies with final salary schemes to be much more energized about finding ways to close their final salary schemes-something that they can only do in law by effecting a buyout (or a buy-in) with a provider. Without retelling the whole saga of the decline of the final salary scheme market in the UK, which is a fairly well known and well documented story, it is fair to say that a combination of accounting changes, which look to reflect scheme deficits much more prominently on a company's balance sheet, and legislative changes, which have considerably added to the burden final salary schemes impose on companies, have effectively sounded the death knell for the vast majority of UK final salary schemes.

Other countries have tended to go much more towards defined contribution schemes. Again, in brief, the difference between the two types of scheme-a final salary scheme and a defined contribution (DC) scheme-is that in the former, the employer makes a promise that they will pay x proportion of an employee's final salary, and then takes on the responsibility for funding that promise. In a DC scheme, on the other hand, the employee builds up his or her own "pension pot", and it is the employee who takes the risk that that pot will not be big enough to provide a decent pension for them on retirement. As no "promise" has been made about the level of benefit that will result, there are no funding issues, and a DC scheme cannot be in deficit in the same way that a final salary scheme (DB scheme) can. Nor does it import any market volatility into a company's balance sheet-all market volatility resides with the member.

The total final salary scheme liability on the books of UK companies is estimated at around £800 billion. A figure on that scale, once it became clear that companies would increasingly be exploring the buyout of their scheme as an option, is sufficiently large to attract new players into the buyout market. This is exactly what we have seen over the course of the last few years.

Different Types of Providers: Insurers versus the Rest
It is worth pointing out that where a provider is an insurance company, such as L&G or Prudential, it is subject to regulation, and the regulator will want to see that the company is in a position to remain solvent throughout the projected life of the liabilities that it is taking on. This precludes an insurance company buyout provider from using non-matching assets, such as exposure to the equity markets, for example, as an asset class in which to invest to meet scheme liabilities. Given the ups and downs of the equity market, a provider can expect that, from time to time, the value of equities in their portfolio could dip below their acquisition value, rendering the scheme technically insolvent-which is not a position an insurance company could adopt.

However, a non-insurance company provider that is not subject to the same regulatory regime, might take a view that, while equity markets can show extreme volatility over the short term-the state of the markets at the end of 2008 and the start of 2009 being a spectacular case in point-over a 20-to-30-year period, equities, so the argument goes, generally deliver a very stable level of returns, well in excess of bonds. The non-insurance player can do a number of things differently. They can buy the entire company, and, as the employer, they then have wider options as to what contribution decisions they take, and can engage with scheme trustees in a way that would not be appropriate for an insurance company. The point is that they are very different from insurance companies, and they can engage with the trustees and seek to influence them on issues such as investment decisions.

This opens the way for providers from outside the insurance sector to be very competitive on their pricing of alternative buyout solutions. Their offer is different, but it may seem to be a very attractive option for the corporate, as it is not just the pension scheme that they are potentially buying, but the whole subsidiary. If it was not performing well, that could be very attractive to the corporate. However, employers who are looking at risk management of their DB schemes have a number of options, and they need to be mindful of the ultimate risk to members. There may well be considerable risks to a company that disposes of its pension fund to a provider who later fails, and leaves pensioners bereft of benefits. At the very least, the prospect of large numbers of angry former employees mobbing the company's premises would constitute a formidable "hit" to the company's reputation and brand.

In practice, the arrival of new entrants to the market tended to drive down buyout prices. In the main, the business that has been done to date has been written at what we would regard as reasonably sensible levels. However, there have been one or two instances where the buyout has been done by a new entrant at a level that seems to underprice the risks involved quite significantly. It is not unusual for new entrants to some markets to seek to "buy" market share by discounting product, but the pensions market is not a market where discounting to buy business makes sense. While price is clearly an important factor, and driven by an assessment of longevity risk and assumptions about future investment returns, the pension-scheme trustees will also want to satisfy themselves that the provider they are doing a transaction with is financially strong, and will be around for the lifetime of the pension scheme.

The Dynamics of Buyout Pricing
Interestingly, during 2008, the premium over and above the value of scheme assets that financial directors had to find in order to dispose of their final salary schemes shrank quite remarkably. This had very little to do with competition among providers, and much more to do with the behavior of pricing in the corporate-bond markets. Basically, as the risk of defaults has increased in the corporate-bond markets, it has become more risky to hold these bonds, so the returns for holding them have had to climb. Yields on corporate bonds are now at record levels. For a pension-scheme buyout, if we assume the simplistic example of a fund that holds all its assets in cash, the higher the corporate-bond spread goes, the lower the price on the buyout will be.

When finance directors are asked how much of their time they find they have to devote, on average, to managing issues related to their final salary scheme, the answer tends to be more than they actually want to. It also restricts the company's ability to do certain things, it could influence merger decisions or divestments, or even listings or delistings. Again, this demonstrates why so many finance directors feel some urgency about disposing of their final salary schemes, if they can do so at affordable prices.

One of the consequences of this has been an enormous growth in the number of buyout quotations providers are being asked to produce. In almost all instances, requests for buyout quotations do not come directly from the companies themselves. These requests are "intermediated" by EBCs (employee benefit consultancies). In a large number of instances, the requests turn out to be more of the nature of exploratory queries. This is to be expected, as it is a very big decision for a corporate, but it does mean a great deal of work for providers who want to turn all quotes around quickly.

One option for the provider is to provide an initial "fast track" or indicative response, which does not guarantee a premium and makes some approximations based on the fairly limited level of information provided by the company (for example, "for a scheme of this size, with 200 employees, with this age profile, and with this kind of asset base, we would be likely to charge a figure of x." Once a company has demonstrated that its interest is real and serious, then a guaranteed quotation would be provided.

Buyouts Move Up the Scale
One definite trend that can be seen from the early days of the buyout market to today is a definite "surge" in the size of schemes being proposed for buyout. During 2008, some of the largest pension buyout and buy-in deals ever were completed (in fact, eight of the 10 largest bulk-purchase annuity transactions completed in 2008 were buy-ins). Until 2008, the largest buyout deal done involved a scheme with liabilities of £400 million. Prudential did a buy-in in 2008 for £1 billion, as did another provider, and the market is aware of enquiries concerning schemes for £3 billion-plus worth of liabilities.

Conclusion
One obvious direction for the bulk-purchase annuity market to go in, as the deal sizes increase beyond the £1 billion mark, is a move to syndication, as one sees in the corporate finance arena, where a "club" of financial services providers get together to share the risk and debt in a large deal. Conversations in principle have already taken place between major providers in this space, and there is no reason why providers cannot compete vigorously on some deals, and work in conjunction with others on other deals. In conclusion, one can expect the pressure of the recession to focus the minds of company boards yet more firmly on the challenges presented by the pensions debt on their books, and the ongoing, long-term drain on their resources that this debt represents. Consequently, all the signs are that we expect the bulk-purchase annuity market will continue to grow in the years ahead.

Making It Happen
Any company interested in pursuing a buyout solution will want to talk first of all to a consultancy, such as Watson Wyatt or Mercer and will want to get a range of quotations from insurance providers. It is then a matter of weighing up the advantages of "escaping" from the continuing obligations associated with running an in-house Final Salary Scheme, versus the cost of a buyout and the surety being offered to members.

More Info

Reports:

A Perspective on Pensions in Crisis from Across the Pond - Speech by Stephen Haddrill, Director General, Association of British Insurers www.abi.org.uk/Media/Articles_and_Speeches/964.pdf

Pensions: Challenges and Choices - The first report of the Pensions Commission www.fsa.gov.uk/pubs/pensions/pensions_report1.pdf

Applying the Gordon Growth Model

QFinance — Thu, 19 Nov 2009 16:21:00 GMT

This checklist examines the Gordon growth model, its principal applications, and its main strengths and weaknesses.

Definition
The Gordon growth model is a tool that is commonly used to value stocks. Originally developed by Professor Myron Gordon and also known as Gordon's growth model, the aim of the method is to value a stock or company in today's terms, using discounted cash flows to take into account the present value of future dividends.

The model requires three inputs:

D: The expected level of the stock's dividend one year ahead
R: The rate of return the investor is seeking
G: The assumed constant rate of future dividend growth in perpetuity.

The formula is as follows:

Gordon growth stock valuation per share = D ÷ R - G

Advantages

The main strength of the Gordon growth model is that the valuation calculation is easily performed using readily available or easily estimated inputs.
The model is particularly useful among companies or industries where cash flows are typically strong and relatively stable, and where leverage patterns are also generally consistent.
The model is widely used to provide guideline fair values in mature industries such as financial services and in large-scale real-estate ventures. The model can be particularly appropriate in the valuation of real-estate investment trusts, given the high proportion of income paid out in dividends and the trusts' strictly defined investment policies.

Disadvantages

Although the model's simplicity can be regarded as one of its major strengths, in another sense this is its major drawback, as the purely quantitative model takes no account of qualitative factors such as industry trends or management strategy. For example, even in a highly cash-generative company, near-future dividend payouts could be capped by management's strategy of retaining cash to fund a likely future investment. The simplicity of the model affords no flexibility to take into account projected changes in the rate of future dividend growth.
The calculation relies on the assumption that future dividends will grow at a constant rate in perpetuity, taking no account of the possibility that rapid near-term growth could be offset by slower growth further into the future. This limitation makes the Gordon growth model less suitable for use in rapidly growing industries with less predictable dividend patterns, such as software or mobile telecommunications. Its use is typically more appropriate in relatively mature industries or stock-market indices where companies demonstrate more stable and predictable dividend growth patterns.

Action Checklist

The Gordon growth model is generally more effective among companies and industries where dividend payments tend to be high-ideally, close to free cash flow to equity (FCFE). FCFE is a measure of how much cash a company can afford to pay out to shareholders after allowing for factors such as debt repayments and various expenses. Consider whether the entity to be valued exhibits such high dividend payments before making use of the model.
Take into account other company-specific factors before applying the model to particular stocks. For example, consider how changes to the regulatory environment could affect a company's prospects.
In the case of individual company valuations, consider whether a shift in the management's geographical horizon or major investment programmes could affect cash flow and future dividend patterns. Remember that the Gordon growth model does not take into account possible fluctuations in future dividend growth rates.

Dos and Don'ts

Understand the underlying characteristics of the company, industry, or market index before deciding whether to use this model.
If appropriate, use the model for easily calculated outline valuations.
Consider the benefits of using other valuation tools in conjunction with or as alternatives to the Gordon growth model.

Don't

Use the model for companies, industries or market indices where growth rates are rapid or leverage is subject to sudden swings.
Make the mistake of blindly applying the model to companies in isolation.
Totally ignore non-quantitative factors that could have a major bearing on future valuations.

More Info

Books:
Gordon, Myron J. The Investment, Financing, and Valuation of the Corporation. The Irwin Series in Economics. New ed. New York: Greenwood Press, 1982.

Hitchner, James R. Financial Valuation: Applications and Models. 2nd ed. Hoboken, NJ: Wiley, 2006.

Articles:
Jackson, Marcus. "The Gordon Growth Model and the Income Approach to Value." Appraisal Journal 62:1 (January 1994): 124-128.

Kiley, Michael T. "Stock Prices and Fundamentals: A Macroeconomic Perspective." Journal of Business 77:4 (October 2004): 909-936.

Website:
Myron J. Gordon's homepage: www.rotman.utoronto.ca/~gordon

(Footer Quotes)

"People who are making decisions about the future often don't have access to some of the best ideas in the company, which may be at the periphery or at lower levels." Rosabeth Moss Kanter

Q&A for M*_Edgars's Discuss request portfolio

M*_Edgars — Thu, 19 Nov 2009 05:57:46 GMT

Ask questions related to the "Discuss request" Portfolio here.

Q&A for NEWTEACHER's Hall Of Famer portfolio

NEWTEACHER — Thu, 19 Nov 2009 15:09:10 GMT

Ask questions related to the "Hall Of Famer" Portfolio here.

Avoiding Avoidable Mistakes

M*_JohnR — Tue, 17 Nov 2009 21:40:00 GMT

I quite enjoyed James Kwak's recent exercise in retirement planning. Plugging in various possible savings rates and investment returns, Kwak explores what retirement might look like for a hypothetical youngster who expects to retire as a 65-year-old in 2051.

One of the major lessons of Kwak's piece is the impossibility of investing out of the hole created by a low savings rate. Even with rates of return, and starting to invest at the tender age of 22, investing at the national savings rate of 2.4%-3.6% (the estimate varies according to the time period selected) won't lead to anything more than a supplemental portfolio. Forget about a nest egg that can replace Social Security for meeting basic needs, or combine with Social Security to make for a dream retirement. It ain't happening.

Another critical lesson is the importance of avoiding avoidable mistakes (to use the words of Morningstar's Don Phillips) when implementing the savings. Kwak estimates that investors may squander 400 basis points (i.e., 4 percentage points) of performance per year versus an unmanaged index by selecting higher-cost active managers who are moderately unsuccessful at picking stocks, and by chasing hot funds.

I find Kwak's estimate of slippage to be too high, but on the other hand, he has assumed a stock-only portfolio for his analysis, with its accompanying higher rate of return. Which is very generous. So I agree with his final resting point that investors who make the common mistakes of overpaying for second-tier active management, and of buying high and selling low, figure to make 200-250 basis points per year of real, after-inflation return.

All of which tells me, thank goodness for target-date funds. They take arrows from their critics and stern pokes from their friends, but they do an excellent job of avoiding avoidable mistakes.

High fees? Yes, given their economies of scale, target-date funds should do better, but nonetheless the asset-weighted average annual expense ratio for the category is a moderate 0.69%, well below the industry average.

Poor active management? Of the three largest target-date families, which have most of the industry assets, one indexes (Vanguard), one has had successful active management (T. Rowe Price), and one is in an intermediate-term slump but has had good active management over the longer term (Fidelity).

Buying high and selling low? Target-date investors are the stablest investors in existence. They hardly ever make trades.

I recommend Kwak's piece--or something in a similar vein--to policymakers. It makes quite clear how critical it is to devise a system the reduces the avoidable mistakes.

On a side note, what should pop up in my e-mail today but a prompt to an article entitled Target-Date Funds' Future Questioned. The thesis is that investors have soured on target-date funds after last year's losses, and that target-date funds won't be able to survive another market downturn like 2008's in their present form.

To which I respond, huh? This will be the biggest year yet for new cash flows into target-date funds, surpassing 2008, which in turn supplanted 2007. As for the possibility of suffering through a similar down market, well 2008 was the second-worst loss for common stocks over the past 138 years. Sure, target-date funds will disappoint mightily if they lose 25%-35% again anytime soon. It's pretty unlikely that they will, however.

Q&A for Dsambu1000's Mod Alo. 11/2007 portfolio

Dsambu1000 — Wed, 18 Nov 2009 05:03:42 GMT

Ask questions related to the "Mod Alo. 11/2007" Portfolio here.

Q&A for worker's Recommended portfolio

worker — Tue, 17 Nov 2009 21:16:36 GMT

Ask questions related to the "Recommended" Portfolio here.