Friday, July 29, 2011

2011 Midyear Outlook: Global Financial Institutions

From Standard & Poor's
2011 Midyear Outlook: Global Financial Institutions Face Increasing Regulations Amid An Uneven Recovery
Quintanilla, Rodrigo
28 Jul 2011

In early July, CreditWeek editors sat down with some of Standard & Poor's Ratings Services' leading analysts for a roundtable discussion about global financial institutions. Panelists shared their views on the prospects for continued consolidation in the industry, the impact of new regulations, and the potential effects of a rise in interest rates in the U.S., among other key issues.

Analysts in the U.S. and Europe generally expect a gradual recovery for the sector to continue, but noted that the cost of complying with new regulations could cut into banks' profits. The outlook in Asia and Latin America is generally stable and more upbeat, with expectations for continued lending and growth in profits, although inflation remains a significant downside risk in emerging markets. Consolidation appears to have largely played out among the largest banks in most regions, although there is some room for more, particularly in some emerging markets in Asia—but tight regulations in these areas remain a big obstacle.

Participants in the discussion included Standard & Poor's Managing Directors Scott Bugie, Santiago Carniado, Ritesh Maheshwari, Craig Parmelee, Rodrigo Quintanilla, and Charles Rauch of Financial Institutions Ratings; Managing Director and EMEA Financial Institutions Criteria Officer Michelle Brennan; Senior Directors Devi Aurora and Daniel Koelsch of Financial Institutions Ratings; and Directors Barbara Duberstein and Stuart Plesser of Financial Institutions Ratings.

CreditWeek: What is our global outlook for the banking industry, and what do we see coming up in the U.S., Europe, Asia, and Latin America?

Rodrigo Quintanilla:  For the U.S., we currently see five key areas of risks and challenges.

The first is that the fragile economic recovery is creating headwinds for balance-sheet growth. In fact, Fed reports indicate that bank balance sheets are not growing, and the only new loan growth we're seeing is in the commercial and industrial segments.

The second area we're watching closely is real estate, both residential and commercial. For residential real estate, which is a major component of banks' balance sheets, prices are still coming down, and there is a backlog of inventory in foreclosures. With commercial real estate, or CRE, although losses have been very low, cap rates have also been very low because of continued very low interest rates. We're concerned that if rates were to rise, there could be a rise in delinquencies and losses, especially for some construction projects.

The third theme is that credit leverage has been responsible for a big turnaround in profitability for the banks. What this means is that loan-loss provisions have lagged net charge-offs; another way of saying this is that there have been loan-loss reserve releases. This has propelled pretax, preprofit returns on revenues for the Federal Deposit Insurance Corp. (FDIC) group of institutions to about 26% in the latest quarter, up from 20% at the end of fourth-quarter 2010.

This brings us to the fourth theme, which is the prospect for lower profitability. Top-line growth for U.S. banks remains slow and tepid: Earning assets are not growing very quickly, and institutions are redeploying any growth from deposits into security portfolios at lower rates. In addition, the potential for higher compliance costs related to the Dodd-Frank Act and other regulatory changes may also hurt banks' revenue-generating activities and profitability.

The fifth area we're watching is the impact of increased regulation and related surveillance on banks, including the burden-sharing that the Dodd-Frank act is imposing on bank debt. Various discussions are under way about capital and liquidity requirements under Basel III, capital buffers for large financial companies, and even an extra 1% surcharge for very large financial institutions. Absorbing these costs will be a key challenge for banks.

CreditWeek: And what about our outlook for the banking industry in Europe?

Scott Bugie:  Because Europe is such a large region, with a highly developed financial sector that has expanded globally, there is a global aspect to our outlook for Europe. European financial institutions have made significant investments in Latin America, Asia, and emerging Europe, as well as in the Middle East and Central Asia, and they have widespread networks in these regions.

Like the U.S., Europe is in a period of rebound and is still restructuring after the financial crisis and deep recession of 2009. Financial institutions, by and large, performed better in 2010 and so far in 2011, mostly due to a decline in credit-risk charges rather than growth in revenues.

The European economic recovery since 2009 has been slow but steady overall. Our forecast for real GDP growth in the eurozone in 2011 is 1.9%, which is not much higher than the 1.7% growth of 2010, but enough to support a continued recovery in the credit quality of bank borrowers.

The story isn't the same across Europe, however. The north has generally fared better than the south. Economic growth has been stronger in Germany, where export industries and a recovery of investment expenditures are driving the expansion. Credit-loss rates have been lower than expected in Germany. The story is much the same in the Nordic countries and the Netherlands, and we believe these trends will continue, if external demand remains relatively firm.

The growth prospects for Spain and Italy, where the recovery has been slower, are lower than those for the larger economies. This is true for Ireland as well. The boom-and-bust cycle of the real estate industry—in particular, real estate construction and development—has resulted in significant property supply overhang in Spain and Ireland, and to a lesser extent in the U.K., and these countries are still working through CRE losses related to this cycle.

As in the U.S., one result of the deep recession and financial crisis in Europe has been a reinforcement of bank regulation—essentially, regulators want more capital to cover risks and wider liquidity buffers. Regulations on liquidity ultimately may have the biggest impact. The net stable funding ratio under Basel III, in particular, could have a longer-term impact on the cost of funds. Maintaining more-balanced asset-and-liability maturities may result in narrow net interest margins in the industry. In addition, governments are imposing new bank levies and taxes—some are already in place. And the plethora of new regulations could raise compliance costs. Although it's still uncertain what the final impact of the various new regulations and taxes will be, it appears that they will result in somewhat lower bank returns. We're keeping our eye on how the changing regulations will affect the credit profiles of European financial institutions.

CreditWeek: What is the situation in Asia?

Ritesh Maheshwari::  Our outlooks on most Asian banks are stable, and we believe most can expect a bright economic future. The Asian systems in general are very well positioned, having had no housing bubble-type legacy problems, and we think most can continue to earn profits and grow their books while maintaining good asset quality.

Learning from the Asian financial crisis, the Asian banks have been continuously improving their risk-management processes, and regulators have tightened regulations. This has helped boost institutional strength overall—and that, not surprisingly, has kept the Asian banks in good shape, even through the global financial crisis. Therefore, they have maintained a strong, from their perspective, financial profile. Their capitalization remains sound. The funding bases—mostly domestic and deposit-related—have been a pillar of strength for Asian banks.

Earnings streams have also continued to be healthy, to the extent that even some foreign banks based in the U.S. and Europe are looking to Asia to expand their operations and garner earnings from this region. In addition, the outlooks for sovereigns in Asia, unlike in other regions, are generally either stable or gradually improving. Given that most are classified as "interventionist," this also bodes well for Asian banking systems, in that sovereigns won't be a liability; rather, they will be a source of support, if needed.

At the same time, inflation remains a significant risk for Asian banks. Emerging markets are highly sensitive to inflation due to the low incomes in these populations, so these governments are quick to respond to inflation. And that, in our view, is the source of the risk: A policy that is too fast or too drastic could cause asset prices to plummet or bring about a sudden hard landing for certain economies. That could present difficulties for banks, although we think most are well-placed in terms of capitalization, earnings, and funding to meet this challenge, should it arise—and in the most likely scenario, we don't think growth would slip by a significant degree.

CreditWeek: What is our outlook on banking in Latin America?

Santiago Carniado:  We're expecting a stable situation overall, with well-capitalized banking systems and continued lending and growth in profits. But Latin America is also a diverse region, and the situation varies country by country. For instance, for 2011, we're expecting credit growth in Mexico of around 11%, whereas we expect about 15% growth in Brazil and perhaps less than 10% growth in Panama and Chile.

We think Mexico, Brazil, Panama, and Chile should maintain sound capitalization measures, with risk-adjusted ratios ranging between 8% and 10%. We're also expecting returns on assets to remain between 1.5% and 2%, on average, which will allow banks in general to continue streaming up dividends to shareholders.

On the down side, we are looking at what could happen if inflation goes above current levels in countries like Brazil, where such an increase might put some pressure on loan payment. Nevertheless, banks are still strongly capitalized and should be able to weather a moderate increase.

CreditWeek: Is our outlook on regional banks in the U.S. similar to our outlook on the larger, more-complex institutions?And how do we view the prospect for increased consolidation in the sector?

Barbara Duberstein:  For both the larger U.S. banks and the regional banks, we see a similar, constructive theme of a gradual recovery for the sector. The trends for the regional banks, however, are much more of a pure play on trends in the U.S. economy. That's because, obviously, regional banks don't have the global systemic issues–at least not directly–that the larger banks are facing, including exposures to some of the weaker European economies and trading revenue volatility and litigation issues. Their fundamentals tend to mirror the U.S. economy and reflect where we are in the credit cycle, with the concomitant uncertainties about the strength of the upturn.We continue to see encouraging asset-quality trends for the regional banks—not only for nonperforming assets, or NPAs, but also for more forward-looking indicators, such as classified assets and new NPA inflows. However, we are seeing divergence in the performance of some of the regionals. The biggest distinguishing factors continue to be loan underwriting and geography; for example, some of the banks with exposure to the Southeast aren't performing as well.

Regional banks' buildup of capital is a positive for the sector, although we're watchful for a possible decline. But at this time, the regional banks haven't announced large dividend raises or share buybacks. There is also some uncertainty about U.S. regulators' final capital rules for the regional banks, which we think should limit any substantial leveraging.

Lastly, like some of the larger institutions, the regional banks have faced some significant challenges in growing their loan books. Still, from a credit perspective, we can live with low loan growth. Our bigger concern is that the regionals will eventually loosen their underwriting standards to generate stronger loan growth. We're not seeing this yet, but we're watching for this potential asset-quality risk.

As to consolidation, we're seeing a moderate amount of mergers and acquisitions among the regional banks, and the environment for M&A appears favorable. Because asset quality is stabilizing, potential acquirers can be more confident about what they're getting into with an acquisition. However, we're not seeing a huge amount of deals among healthy, midsize U.S. regionals, and we've heard anecdotally that bid/ask spreads on those kinds of deals are a bit too far apart. Interestingly, however, we saw a phase when stronger banks were acquiring some seriously weakening banks: for instance, M&T acquired Wilmington Trust, and the Bank of Montreal acquired M&I. Those transactions turned out to be very positive in terms of event risk for the bondholders of the target companies.

The repositioning of some European institutions is also having a subtle impact on the regional banking sector in the U.S. For instance, Capital One plans to acquire ING Direct; and HSBC has put its upstate New York retail bank branches on the block, and some of the regional banks are rumored to be potential acquirers.
I would also add that the number of small FDIC-assisted acquisitions has declined—but that, of course, is a good sign that the industry is healing.

I would also add that the number of small FDIC-assisted acquisitions has declined—but that, of course, is a good sign that the industry is healing.

CreditWeek: Among the large banks in the U.S., will we see an increase in M&A now that the financial crisis is over and banks are looking to boost profits? And are the trends that we're seeing there the same globally, or are there variations from one region to another?

Quintanilla:   We think the new capital rules coming into play could have two negative results on M&A in the U.S. One is the impact of the Collins Amendment, which will raise holding companies' capital requirements and thus could make foreign institutions less inclined to participate in the U.S. Although this hasn't affected the Bank of Montreal's acquisition of M&I, we have observed that some foreign banks may be changing their structures. For instance, Barclays PLC and Barclays Bank PLC have each elected to be treated as a financial holding company under the Bank Holding Company Act. Financial holding companies may engage in a broader range of financial and related activities than are permitted to registered bank holding companies that do not maintain financial holding-company status.

The other impact is from the potential capital surcharge on the largest financial institutions. Essentially, the regulators are creating a disincentive for large institutions to become even larger. For this reason, we expect to see less consolidation among larger banks as acquirers, although we may still some M&A among midsize institutions.

Bugie:  One way for governments and regulators to deal with the "too big to fail" issue is to limit the size of financial institutions. But the global industry trend in recent years is the opposite.

During the financial crisis and afterward, a number of large institutions that were relatively healthy took over more-troubled institutions—resulting in the emergence of even larger financial conglomerates. Spain, hit harder and for a longer period by the recession than many other countries because of its large construction industry, has seen regulatory and government-driven consolidation among its regional savings banks, or "cajas." These mergers are an effort to build more mass and capital and achieve operational economies of scale. A couple of fairly big combinations of Spanish cajas are just coming to market this year. Examples of recent mega-mergers abound: BNP-Paribas taking over Fortis Bank, the joining of Commerzbank and Dresdner Bank in Germany, and Lloyds taking over HBOS plc in the U.K., to name a few.

From the vantage point of 2011, we don't see much more large-scale European bank M&A on the horizon. Looking forward, we expect to see some fill-in acquisitions for sought-after areas in the financial industry, including asset management and private banking. There are still many large financial institutions that are looking to build out—whether domestically or internationally—and expand their client base and scale. The emerging markets are still attractive because they offer better growth prospects, so we may see some action there among large global banking groups looking to move into these markets. Some financial institutions that want to exit certain markets may sell their operations to other institutions looking to enter.

CreditWeek: Are those the same trends we're seeing in Asia and Latin America?

Maheshwari:  In Asia, the picture is a bit different. Although Australia, Japan, Hong Kong, Singapore, and China already have some large, global-scale banks, I would argue that there is a need for more consolidation in certain emerging markets. And although there has been some progress, regulatory restrictions in those regions are a big obstacle to M&A.

Learning from the Asian financial crisis, many systems actively fostered consolidation, and some of them—including Singapore, Thailand, and Malaysia—actually achieved good results. Other nations, such as Indonesia and Taiwan, embarked on consolidation but didn't fully carry it through, while still others, such as India, never gave it any serious push.

However, the progress toward greater consolidation in the Asian emerging markets isn't encouraging. The regulators in these areas tend to be very prescriptive and conservative in their approach, and the banking markets are not so open to market-driven M&A. Majority ownership by foreign entities generally isn't permitted—in fact, a 10%-30% share is typically the limit—and this level of ownership doesn't give management sufficient control or provide enough incentive for significant M&A activity. In addition, the asking prices in certain markets, such as Taiwan, Indonesia, and Vietnam, are too high to make these deals feasible.

For these reasons, although I think there is need for further consolidation, I don't see a great deal of potential.

Carniado:  In Latin America, the banking industry is already highly concentrated: In most countries, at least 70%-80% of total assets belong to the largest five or six institutions. Nevertheless, we have seen some acquisitions in the past year. Some Colombian banks have purchased assets in Central America, and in Brazil, certain stronger banks have bought other troubled banks. In Mexico, there was a merger between Mexican-owned banks. We expect some acquisition activity to continue, but we're not expecting significant consolidation.

CreditWeek: Which lines of business—such as auto loans, credit cards, real estate, or general business loans—will contribute most to banks' profitability?

Quintanilla:  In the U.S., the most profitable product lines traditionally have been related to consumer lending, regardless of the cycle. And although that hasn't changed, an increase in losses related to consumer assets may have hurt net profitability a bit. But by and large, in terms of gross profitability, the consumer product lines are typically more profitable.

Nevertheless, some of the commercial lines could be very profitable on an aggregate basis: That is, banks may be able to grant some business loans at a preferential rate, but other products could be associated with that loan origination, including deposits, cash management, fees, and so forth. So profits in this area will depend on how quickly the banks can cross-sell different products to enhance the profit profile of a customer.

Revenue growth for the U.S. banking system has been kind of tepid overall, and we haven't seen a lot of loan growth. The only loan category that has shown any signs of life is commercial and industrial lending. We don't expect this to change dramatically this year, although we do think the leverage in the industry will decrease over time.

CreditWeek: Would that be the case in other regions as well?

Michelle Brennan:   In Europe, several institutions have come through several years of flattened results from some of their investment-banking operations, or from taking on interest-rate risk exposure as a response to the relatively accommodating actions by the authorities in terms of interest rates. We expect to see a reduction in the contribution of some investment-banking operations, in particular interest-rate-driven earnings, for some banks in Europe this year and into 2012. Heightened regulation, including tighter capital requirements against trading activities, will also likely restrain investment-banking earnings.

As for retail and commercial-banking profitability, the picture varies between markets. In some markets where the consumer and the private sector are under more pressure, the level of new business activity is still quite low, and this is hurting earnings. We're seeing this, for example, in countries where the housing markets are still working through their corrections, and profits from mortgage lending are still relatively depressed, such as in the U.K.—Ireland in particular—and Spain to some extent.

Some new restrictions on fees and investigations into misselling are also hitting profits. For example, in the U.K., some misselling cases are related to sales of insurance products to particular borrowers, and that is having quite a noticeable impact on retail earnings in some situations.

Maheshwari:  In Asia, we're seeing two distinct trends.

In high-growth markets that are investing in infrastructure and industry, such as China and India, we are seeing more growth in commercial lines than in consumer assets. The growth opportunities in China, for instance, are such that some of the other systems are trying to capitalize on them. Hong Kong Bank, for example, is clearly trying to expand its books by branching out into China, and the same is true for banks in Taiwan and even Singapore. In India, too, portfolio growth is happening more in the commercial lines and, to some extent, in infrastructure loans.

In other systems that are maturing and where growth has stabilized—including Australia, Malaysia, Korea, Thailand, Japan, and Hong Kong—bank margins are gradually narrowing. These banks are trying to boost margins by penetrating further into small and medium enterprises and consumer asset classes: namely, residential mortgages, followed by auto loans and unsecured credit. That is typically the order in Asia, with the exception of some outliers, like Indonesia, where there is no significant residential mortgage market and auto loans and unsecured credit dominate consumer assets.

Carniado:  In Latin America, as in the U.S., consumer lending generally contributes the most to profitability, with a return on assets close to 2% overall. Personal payroll loans dominate in Panama, while in other areas, including Central America and Mexico, credit cards are a prominent contributor. In Brazil, auto loans and payroll loans are important contributors to profitability.

Although commercial lending has been a target for banks and is increasing, it's growing much more slowly than consumer lending did. So although we expect growth in commercial lending to continue, consumer lending will remain the greatest contributor to profitability.

CreditWeek: Many economists are predicting a rise in interest rates during the next year. How would this affect the banks?

Quintanilla:  Standard & Poor's recently conducted a study on the likely impact of rising interest rates across the financial services, including asset managers, banks, and money-market funds. We concluded that unlike in other cycles of tightening, because rates have been so low for so long, and credit has practically been free, banks and most financial companies would actually benefit from higher interest rates. Typically the concern is that higher rates would hurt banks that are more spread-dependent, but with rates so low, the value of free funds is extremely low as well. So we believe that a rise in interest rates accompanied by a strengthening economy could actually provide a revenue boost for many financial institutions, at least initially.

We're also coming off a cycle in which credit losses have been very high. This suggests that further along in the tightening cycle, credit losses could start creeping upward as well.

In general, however, we would expect most financial companies to benefit from higher rates, at least initially.

Maheshwari:  A rise in interest rates in the U.S. could have a profound impact on Asian banks. The recent low interest rates have caused investors to put their money into high-growth markets in Asia, which has been boosting some of the asset markets here. When interest rates start to rise, we expect these capital flows to slow down and maybe even reverse. And local banks leveraging to buy those assets at higher interest rates will translate into higher holding costs and could put pressure on asset prices. So we might see some pressure on some banks' profitability or asset quality.

CreditWeek: Both in the U.S. and elsewhere, are there signs that bank lending might be picking up? And to what extent are banks going to be able to help nonfinancial corporate borrowers meet their refinancing needs?

Bugie:  In Europe, we expect credit to remain flat in 2011, but it may start to pick up a bit next year. We're still in a period of recovery and absorption of the credit bubble that burst in 2008. In the so-called peripheral countries, however, real credit growth is likely to be negative.

In Europe, it's not so much that banks lack the liquidity to lend into the economy, but more that borrowers are deleveraging. Certainly, banks are more reluctant to lend into the construction industry—there's been more significant deleveraging in that area. But at this point, we don't anticipate a big credit crunch due to regulatory changes or any other factors during the next few years—except in systems that have agreed to reduce the overall size of their balance sheets under EU-IMF programs, specifically in Ireland and Portugal.

Quintanilla:  In the U.S., lending standards appear to have eased in the past year, according to the Fed's quarterly senior loan officer survey and the Office of the Controller of the Currency's annual report and survey on credit conditions. But this is, of course, compared with the very tight conditions of 2008-2009. So although the easing has not reached precrisis levels, the banks seem to be more willing to lend at this time.

The Fed's reports on banks' balance sheets—which indicate growth only in commercial and industrial lending, in particular—also bear this out. However, outside of commercial and industrial lending, there hasn't been much growth, and we think that the new capital requirements are also making bank management teams more cautious. The final rules about the new minimum capital standards are not out yet. There has also been a lot of capital-planning reporting to the Fed, including stress testing, in response to mandates from the Dodd-Frank act, and liquidity requirements still need to be ironed out. Overall, the combination of higher capital requirements and potentially very high liquidity requirements has made banks more cautious about new lending than they would normally be in this part of the credit cycle.

Maheshwari:  We're seeing two general lending trends in Asia. In the high-growth markets, where there is activity and demand, the regulators are actively trying to contain emerging inflationary pressures by tightening monetary conditions. For instance, just recently China increased its interest rate again, as regulators attempt to contain inflation by limiting the availability of credit. Indeed, China, India, and even Australia to some extent have continued to tighten their systems a bit to put the brakes on current growth.

In the rest of the Asian markets, which are generally either maturing or matured, current growth has been very gradual. So essentially there is demand, but the regulators don't want all that demand to be satisfied, because they think it would lead to some unfavorable consequences for the economy.

Carniado:  In Latin America, the story is a little bit different, because growth in lending continued during the crisis. Thus, for most of these countries, we're not seeing a scenario in which growth needs to return to precrisis levels. Instead, there was a slow-down in growth in some countries that is now reversing.

Nevertheless, we may not see the same level of growth as in previous years in countries such as Brazil and Chile that have raised interest rates, which could hurt demand for credit. In other countries, we think growth will resume at a healthy pace. In general, we're expecting growth in the region to average between 13% and 15% during 2011.

CreditWeek: How is the banking sector positioned in terms of housing? If there were to be a full-scale double-dip in housing prices, how would that affect the banking sector?

Devi Aurora:  Housing assets make up about one-third of aggregate bank portfolios in the U.S., so it is obviously a very important category. And although we're now in the sixth year of the housing correction, there is still uncertainty as to exactly how well this segment is going to hold up.

To gain some insight, we conducted a study that estimated the impact of a double-dip in home prices on U.S. banks—specifically, a decline of 15%, as opposed to the baseline 5%—coupled with an increase in mortgage rates to 6.5% and a substantial steepening of the yield curve.

The study showed three general areas of impact. One is that a correction of this nature would push delinquencies, loan modifications, and foreclosures higher, and the combined impact of the increases could cause credit losses to rise anywhere from $30 billion to $35 billion for the sector as a whole.

Secondly, we assumed that the severity of losses related to some of the legacy loans made in 2005 though 2008 that the system is still working through could cause representation and warranty expenses for banks to increase by roughly $30 billion to $33 billion.

And thirdly, the higher interest rates would cause originations to drop, contributing another $6 billion-$12 billion loss.

Taken together, these outcomes would yield another potential hit of about $70 billion-$80 billion for the banking sector overall, which would work out to roughly one-third of banks' projected pretax operating income. So this is no small impact that we're talking about in terms of what could conceivably result from a double-dip.

CreditWeek: And that segues into our next question: How do you view the regional banks' exposure to real estate losses? And are the trends in CRE similar to or different from the trends in housing?

Duberstein:  By their nature, the U.S. regional banks have a lot of exposure to real estate lending. And for the U.S. banks as a whole, CRE is a major focus for us in both good times and bad—we always closely monitor the risk characteristics and performance of banks' CRE portfolios. We think the good news is that the regional banks have already dealt with the worst losses and the worst of their CRE loan types; the residential construction loan portfolios have accounted for the largest part of the regional CRE losses during this cycle.

That said, many regionals still have substantial NPAs in their income-producing CRE portfolios, including loans in the retail, office, and hospitality sectors—although we've been a little surprised to see that for many banks, nonconstruction CRE appears to have stabilized, particularly in the past few quarters, with declining inflows into NPAs.

We think this stabilization is probably tied to improvement in the sponsors' and borrowers' liquidity and financial health, and to small upticks in property values and cash flows as the economy has slightly improved. The low interest rate environment has also probably helped a lot.

We're still cautious on CRE, and particularly if the economy does not pick up further, we think CRE would see the greatest impact. We think a scenario combining a sluggish economy with a rise in interest rates would be particularly problematic for CRE borrowers and those loan books.

On the residential side, we think that most banks have already identified and taken losses on the poorly underwritten product originated before 2008, and that the newer originations have been much better underwritten, with lower loan-to-value ratios. Of course, another substantial decline in housing prices would definitely put pressure on even these newer, better-quality loans. However, although it is a risk, a major further decline in housing prices is currently not built into our ratings expectations for the regional banks.

CreditWeek: How about investment banking and trading? How are those contributing to banks' bottom lines?

Stuart Plesser:  In 2009 and 2010, investment banking and trading were significant contributors to global banks' bottom lines—and they still are in 2011 so far, but less so than in the two prior years. There was less competition in trading back then, particularly in 2009. As a result, bid/ask spreads were wider, as some of the less financially sound banks were just getting back on their feet at the time. Easy money from the government also helped drive profits. This, combined with losses in the retail-banking segment, helped make investment banking and trading very important in terms of global banks' profit generation.

But let's remember that in 2008, this was not the case. Indeed, sales and trading, which we consider to be a volatile, less-stable source of business, was the segment that actually got the banks into the most trouble in terms of depletion of capital. The marks on this business when it goes wrong come quickly, and can deplete capital much quicker than a held-to-maturity book of business.

This year, we expect trading revenues to decline as a percentage of banks' bottom lines. This is due to a combination of improving profitability in the banks' retail segments as credit losses abate—which on its own will lessen the percentage of overall profits for investment banking and sales and trading—as well as macro concerns, including sovereign and debt-ceiling issues that will likely lower trading volume in 2011. Trading profits for the rest of the year will likely hinge on the way sovereign issues are resolved and whether there is conviction in the markets to take more risk and trade more. Right now, a lot of investors seem to be in a defensive mode. What may help a bit is that there were also macro issues in 2010, so year-over-year comparisons are not that difficult.

Some trends in the just-completed second quarter include significantly higher advisory activity, weakness in commodities, and riskier mortgage products compared with the first quarter, largely due to price declines for these products. We believe that banks that rely on a pure, "plain vanilla" flow trade to service existing clients likely performed better than those partaking in more exotic products and those that still engage in some proprietary trading.

There are a lot of legislative and capital changes that are going to hurt profitability in the sales and trading business. For starters, as Basel 2.5 is implemented, there will be higher counterparty capital charges, which will likely hurt volume and margins. In addition, legislation calls for many over-the-counter derivative contracts to move to clearinghouses. This is likely going to reduce margins, as pricing will become more transparent.

So overall, although we think that investment banking will contribute less to global banks' bottom lines, we still consider it an important business, as it's necessary to help facilitate the banks' large multinational clients. This segment, at the very least, helps bring in business for which banks collect fees in segments outside of sales and trading.

CreditWeek: China is becoming an increasing economic factor for many global industries. What do we see as the future for banking in China?

Maheshwari:  We expect economic growth to remain strong in China, which will create continued strong demand for credits and banking services and keep the Chinese banks in a prominent position in the economy. Indeed, the economic growth in China has become a magnet for banks in even the mature Asian markets, which are trying to enter however they can. Most of these banks have set up local subsidiaries and then grown organically, and many Western banks are also following this path.

Because banks all around the world are chasing the Chinese credit markets, regulators in China are keeping continuous control of credit delivery to avoid the inflationary pressure that excessive credit might cause.

Essentially, this also means that if anything were to go wrong with the Chinese banking system, or if asset quality were to decline because of a slow-down, even of a temporary nature, the impact would extend far beyond China to the many systems that are increasing their exposure to the country.

CreditWeek: We've said that current capital levels are not an indication of credit strength. Are there countries where bank capital levels might not meet regulatory minimums?

Brennan:  As a preface to this discussion, I'd like to emphasize two key points. One is that regulatory capital measures are still inconsistent across countries globally. Although Basel III may lead to greater consistency, it will only happen during an extended period of time. Currently, we still see significant differences between the conservatism or stringency of different regulatory capital definitions in various countries.

The second main point is that, because of the limited comparability of regulatory capital measures, we focus primarily on Standard & Poor's own measures of capital—in particular, our risk-adjusted capital framework, which we use to assess banks' capitalization. Our belief is that capital is still a relative weakness for the credit quality of many midsize and large banks globally, particularly in Europe. Because the regulatory capital measures are not necessarily as tough in some countries as in others, we really try to look past them when assessing capital.

However, regulatory capital ratios are important because they're part of the licensing arrangements that enable banks to operate, and they can also be important drivers of market confidence in various banks.

At the moment, there is a lot of debate about the quality of capitalization for various banks in Europe. Last year, the Committee of European Banking Supervisors, or CEBS, which was akin to an umbrella group for European banking regulators, carried out a round of stress testing. Many believe the stress test on capitalization was not harsh enough and failed to identify some cases where banks were clearly undercapitalized.

The successor organization to CEBS, called the European Banking Authority, or EBA, is now working on a set of capital stress tests of various European banks. We expect the results of those tests to be published within the next few weeks, and many in the market believe some banks will fail the capital stress test. [The EBA subsequently published the stress test results on July 15, 2011.]

It's important to think through what failing the EBA stress test means. First of all, an institution has to achieve a 5% core Tier 1 ratio after the application of the stress, which is higher, or more demanding, than the current regulatory capital requirements. That is, this benchmark of a 5% core Tier 1 ratio is tougher than what is currently required for a bank to be legally in accordance with the terms of its license.

We see the EBA's use of a core Tier 1 ratio as useful because one of the problems with the 2010 stress test was that the capital ratio measurements, which included various hybrid measures for different banks, were pretty inconsistent. In some cases, they allowed banks to fare relatively well under the stress scenario despite having instruments that had a limited ability to absorb losses and that wouldn't be considered part of the capital base under our criteria.

In addition to considering the 5% core Tier 1 ratio, we also have to think about what type of stress the EBA is applying. The scenario that the EBA's stress test incorporates is relatively harsh, so it's not the expected or most likely outcome for banks. Still, we think it could be even harsher—it does not represent an extreme event.

Institutions that fail the test may then have to show what actions they are taking or plan to take to improve their capital measures. In some cases, it may also be important for governments to indicate the means of support that might be available to those institutions. There have already been various actions in Europe in recent months in which certain governments sponsored or helped encourage either the restructuring or the recapitalization of various entities. We have also seen some private-sector capital-raising in countries like Italy, for example.

In Germany, a range of institutions looked at converting certain elements of their capital bases—for example, silent partnerships—to make them more compliant with the future Basel III requirements. So there is a theme emerging that banks are trying to improve the quality and size of their capital bases.

A risk for the market is that this transition toward better capital takes time, and not all institutions are able to build capital at the same pace or to the same extent. I think that for the rest of 2011, we're likely to see a range of institutions increase their efforts to strengthen capital. However, for some banks, weak capitalization will continue to hold back ratings. Concerns about capital may also lead to fragile market confidence in those entities, which might affect access to funding in some circumstances.

CreditWeek: Do we believe that the increasing consolidation of the world's stock exchanges will likely alter their credit quality significantly? If so, why?

Charles Rauch:  The exchange and clearinghouse industry has entered a period of rating volatility. We took more rating and outlook actions in the first half of 2011 than we did for all of last year. Most of the rating actions during the first half of 2011 were negative in direction.

Earlier this year, we entered what many consider to be a second round of industry consolidation. The first occurred in 2006, when we saw a number of transatlantic and cross-border mergers among stock exchanges looking for geographic and product expansion, especially into derivatives trading and clearing.

We're still seeing these themes in round two, but we're also seeing an emphasis on cost-cutting—not just in the back office, but also in the front office. A good example would be Deutsche Boerse and NYSE Euronext, which plan to combine Deutsche Boerse's Eurex and NYSE Liffe to create a trading platform in Europe that covers both the short end and the long end of the interest-rate curve. This is similar to the CME-CBOT merger in the U.S.

We've placed our ratings on a number of companies on CreditWatch or taken other rating actions after their merger announcements. However, some of these deals have fallen apart. For example, London Stock Exchange Group and unrated TMX Group scratched their planned merger after it became clear that TMX Group shareholders would not approve the deal. Also, NASDAQ OMX Group and unrated IntercontinentalExchange had made an unsolicited offer to acquire NYSE Euronext, but gave up due to regulatory roadblocks.

The NYSE Euronext-Deutsche Boerse transaction is the only significant merger among rated exchanges pending now. This transaction will take place under a new holding company based in the Netherlands, which will own the two subsidiaries. We placed NYSE Euronext on CreditWatch Positive and Deutsche Boerse on CreditWatch Negative. As we stated in our Research Update, it's very possible that we will assign separate ratings to the two entities after the transaction closes because they have very different financial profiles and operate under different regulatory jurisdictions.

I don't think you can make any overarching generality that consolidation is either good or bad for the industry. However, consolidation within the broader financial industry is having a growing impact on exchanges and clearinghouses, since their membership mostly consists of banks and brokerage firms.

The growing consolidation among the membership means that more and more revenues and counterparty credit exposures are concentrated among a few large members, and these large members can put pressure on the exchanges to reduce fees, or worse, weaken their financial safeguard systems.

CreditWeek: Under the terms of Dodd-Frank, it seems that some financial institutions in addition to banks might be considered "systemically important." What impact would that have on our view of these institutions, specifically in terms of ratings?

Craig Parmelee:  Simply being named a systemically important financial institution, or SIFI, would not necessarily affect our ratings on these entities. However, we expect systemically important institutions to be held to higher regulatory standards. If they are required to maintain more-conservative financial profiles due to the regulatory requirements, it could have a net positive impact on our view of these companies, and in some cases, this could benefit the ratings.

Although the question is directed toward nonbank financial institutions, I think our bank criteria proposal offers a good example here. Under our proposal, we have set a certain range of capital that would be neutral to the ratings; if an institution were to maintain capital above that range, it would benefit the rating directly. Thus, if SIFIs are required to maintain capital above this threshold, it would directly benefit their ratings. The offset is that the higher regulatory burden for SIFIs could hurt profitability and even competitiveness, in some cases.

However, in the U.S. under Dodd-Frank, the specific prudential regulatory standards for systemically important nonbank financial institutions—and, for that matter, for banks as well—have not yet been established. So it's a bit of a wait-and-see as to exactly what their impact will be on credit quality.

Rauch:  I'd just like to add our view about some of the clearinghouses. We believe the large clearinghouses in the U.S. are already systemically important, because they have effective monopolies in the separate markets they serve, and none, in our opinion, has the expertise or capacity to take over a failed clearinghouse.

Section 802 of the Dodd-Frank act states that financial-market entities that conduct multilateral clearing and selling activities—in other words, clearinghouses—may reduce some risks, but may also create others.

We've identified some new risks that may emerge from the Dodd-Frank mandate for central clearing of over-the-counter derivatives. First, entities that wish to enter this space will need to develop new risk and margining methodologies, which may not have been tested in the real world. Second, OTC derivatives, for the most part, are less liquid than listed futures and options. This could be problematic if a member defaults and the clearinghouse has to unwind less-liquid derivative products to make counterparties to the trade whole. Third, clearing of OTC derivatives offers a very big profit opportunity, which is bound to attract new entrants and could upset the current market equilibrium, which could destabilize the ratings.

Because Dodd-Frank acknowledges that there are new risks, regulators are specifically looking at clearinghouses as systemically important and recommending new financial controls and regulations for them.

Daniel Koelsch:  I'd like to add an interesting Canadian perspective here, regarding the point that regulators may hold these institutions to higher standards. In Canada, rather than designating the Canadian Directors Clearing Corp., or CDCC, as systemically important, regulators more likely are going to declare what they call the Canadian Derivatives Clearing System as systemically important. Although they will still hold the CDCC to higher standards to ensure that the system is not in jeopardy, the actual "systemically important" designation will not apply directly to the entity we actually rate.

CreditWeek: Do we expect banks, particularly those in developing markets, to encounter difficulty in meeting measurements of market risk to comply with Basel III?

Bugie:  Nothing we've seen indicates that regulators in developing markets will take actions that would fundamentally change how financial institutions engage in their capital-market activities. These businesses can be rather concentrated in the global investment banks and certainly contribute less than the commercial banking lines of domestic banks in those markets. Most developing countries—such as Brazil, China, India, Russia, and Turkey—are trying to expand their capital markets, make them more liquid, and broaden the investor base in both equity and fixed income. We don't anticipate regulation that would run counter to that trend.

In developing and mature economies alike, the basic model of market-based economies with open borders and significant cross-border investment flow looks to continue. Regulations that require more capital for trading operations or that limit proprietary trading may result in some business migrating toward institutions that have a different regulatory charter, and that may affect banks specifically. But overall, we don't think the new regulations will reduce capital-market volumes. In fact, regulations that require standard derivative contracts to be traded in central clearinghouses may narrow bid-ask spreads in certain products and increase trading volumes.

Maheshwari:  The banks' capital-market activities are generally not yet playing a big role in developing Asian market economies, with the exception of Japan, Australia, and Korea. I don't expect regulators to spend a lot of energy looking at these markets and trying to make regulations more stringent. In fact, the regulators are in more of a developmental mode, trying to expand the banking systems so that they can play a bigger role in the economy.

As for Basel III, considering the developing nature of these markets, the banks have been capitalizing on the abundance of credit opportunities, and not really dabbling in market-related activities so much. When we look at these banks' risk-weighted assets, it's no surprise that credit risk makes up more than 90% of them, rather than market risk or operational risk. So meeting the market-risk requirements doesn't seem to be a big area of concern at all.

Carniado:  In Latin America, countries are at various stages in applying the Basel guidelines. The largest countries, like Mexico and Brazil, already consider the measurement of market and operational risks in their regulatory frameworks. Some others, for instance in Central America and the Caribbean, will require more time because of potential difficulties from local-market participants, as many of those countries are not yet in Basel II.

In midsize countries, we have a mix. Whereas Chile and Peru should be able to meet the requirements under Basel III, Argentina, for example, has not yet moved into Basel II. In general, we believe only a few countries are prepared to adopt Basel III in the next few years, whereas most of the systems will require an extended period of time to meet these guidelines.

CreditWeek: Keeping the focus on developing markets, what do we see as the key risks for banks in countries with less-developed economies?

Bugie:  For most developing countries, the risk of debt-driven expansion leading to economic overheating and a potential disorderly correction is timeless. Clearly, many developing economies are at a different point in the business and credit cycle than mature economies, which are going through a restructuring and cooling-off phase with some deleveraging. Many developing countries—Turkey and Brazil are good examples, but we could cite others—are in a credit boom that is accelerating economic growth.

The risks are not visible during the expansionary period, but they may emerge during a slow-down and correction.

Maheshwari:  Most of what Scott just said is true for Asia as well, but in some countries more than others. India and Vietnam are already showing signs of overheating, and while China is not yet at that level, it is another one to watch, considering its rapid growth.

I'd also like to highlight that capital inflows into Asia have been giving rise to another risk factor: namely, that the eventual collapse of any asset bubbles that form later in the cycle could damage those economies, and a slowdown or reversal in these capital flows might lead to a slump in such asset markets.

However, we aren't seeing these issues to any significant degree in any markets as of yet, but the prices have gone up significantly in China and India, for instance, as well as in some of the smaller systems, like Hong Kong and Singapore.

Carniado:  In Latin American, in general, the two risks banks will face is the level of resilience of the country's economy overall and the credit risk derived from variables in the legal frameworks. The main challenge for banks in Latin America will be to sustain high levels of capitalization and profitability while trying to increase market penetration of still-underbanked economies.

CreditWeek: What are regulators doing to put the brakes on the banking systems' growth? They have been pretty active in the past with raising reserve requirements. Are they doing the same thing in China and India now?

Maheshwari:  The reserve requirement tool is only being used in China, and that's partly because they have to use a tool that essentially "mops up" surplus liquidity. The tools that other systems have been using are policy-rate increases, which have had varying levels of effectiveness. India, for instance, has already done more than 10 such changes during the past three years.

In addition, China has done a little bit of tightening on the property side, and Hong Kong and Singapore have tried to tighten their lending norms—and to some extent even taxation—to keep bubbles from forming in the property markets in these smaller systems.

CreditWeek: When Standard & Poor's rates banks and other financial institutions, how does it take into account sovereign risk?

Aurora:  Factors such as economic resilience and imbalances and credit risk in the economy tie in directly to the analysis and insight that inform sovereign ratings. In addition, in evaluating industry risk, we assess the government's ability to provide funding support to the banking systems in general, although this element is not explicitly linked to the sovereign rating. This feedback loop works both ways: Although sovereign ratings are linked with certain aspects of our banking industry country risk assessments, or BICRA assessments, we also look at the contingent liability to the sovereign of the risk posed by a systemic crisis in the banking sector.

Maheshwari:  I'd like to add one more point here, which may seem obvious but I think is worth noting. Standard & Poor's does not rate banks higher than the associated sovereign foreign currency ratings, which ends up being a real hurdle for bank ratings in some systems. This is just one other way sovereign ratings end up affecting the ratings on financial institutions.

CreditWeek: Will the increase in bank regulation in developed nations that followed the financial crisis tend to push more risk away from banks and into other financial institutions?

Koelsch:  Looking at the clearinghouses specifically, by taking on more over-the-counter business, they are assuming a lot of the risk that used to reside within the banks.

Among alternative asset managers, we've seen business-development companies and hedge funds, for example, moving into credit—areas that the banks previously occupied or that securitization used to cover.

If regulation limits what banks can do, and proprietary trading would be such a case, risk could indeed move to hedge funds, but that is not a forgone conclusion. And some of the risk might even go away entirely, in the sense that, for example, traders might trade far less capital at hedge funds than they would have in a bank environment.

Bugie:  New regulations should not result in a decline in capital-markets activity. The decade-long trend of expansion of the market-driven global economy with significant cross-border investment flows is well established. We believe the trend of disintermediation will continue—this means that more debt securities will be issued and will change hands. And the markets will need intermediaries to facilitate purchases and sales, and services to help manage risks. There is a good case for the regulators' push for banks to maintain very high capital to back certain business lines such as securities sales and trading. The proposed increases in risk weighting of counterparty credit risk in the trading book are substantial. But if the increased capital requirements push banks away from certain segments, the business may simply move to other nonbank players in the market.

Maheshwari:  In Asia, we're not expecting any significant tightening of regulations because there is no particular problem that the regulators need to address at present. They continue to introduce monetary tightening measures in high-growth economies, however, including hikes in policy interest rates, a bit of control on the credit growth of banks, and, in the case of China, a hike in banks' reserve requirements.

To the extent that these measures increase the cost of credit and reduce the availability of credit, they could push lending to other, unregulated sectors. However, it's very difficult to put a finger on the extent of this "shadow banking" market, given the lack of information available. We're continuing to look at it and believe it may not be immaterial in size, but we are not yet able to gauge the risk it could pose to the whole system.

CreditWeek: What is our outlook for private equity funds?

Koelsch:  We see a bifurcated picture for private equity: The big funds will continue to attract money and get even bigger, while the smaller ones may struggle with the rising tide of regulatory compliance and capital-raising. The operating environment clearly supports a structurally larger fund.

There's also a lot of dry powder in the system currently. According to PitchBook, of the $1.5 trillion the industry raised during the past 10 years, $477 billion of undrawn commitments from investors remained as the industry entered 2010. The fund-raising was driven primarily by demand from limited partners and the private equity firms' desire to maximize the fund sizes. Oaktree Capital recently returned $3 billion in funds to its investors, citing difficulties finding investment opportunities for one of its distressed-debt funds as the economy improves. It will be interesting to see how the industry deals with the challenge of finding good investments and meeting performance expectations.

At the end of the day, returning funds to investors really means giving up fee income. But competing for investments could put pressure on valuations and, eventually, performance. The financing capacity of the large, established private-equity firms, like Carlyle, Blackstone, Blackrock, and the like, has enabled them to fund huge new pools of investments, and a lot of that money is now flowing to emerging markets, including some markets in Asia.

CreditWeek: How will 2011 be remembered for the financial sector?

Brennan:  For the European financial institutions, the number-one topic to look out for this year has been funding, specifically the funding pressures and refinancing issues that banks are facing.

I also see two big themes for the European financial institutions in 2011. The first is that 2011 has been the year when the interdependencies between the various sovereigns' fiscal and budgetary situations and the banking system became very apparent in parts of Europe. We've seen a range of countries in which the banks are working through the impact of tighter sovereign positions.

The second is that 2011 is when we've really seen the kick-off of the race to improve capital. Some of the stronger institutions are taking steps to raise capital and strengthen their balance sheets. And some national authorities are also encouraging some of their small to midsize banks to strengthen their balance sheets.

It's the start of what we believe will be a long-term transition. The worry is that some institutions may start a bit too late and end up falling behind in the race to improve capital—and for that reason, these entities may find investors are less willing to take on more exposure to some banks in various European economies.

Plesser:  I think in the U.S., 2011 will be remembered as the year of the lobbyist for the U.S. banking industry. There has been a spate of public outcry about pending regulations and what that could mean for the banking businesses as they attempt to compete in a global world. I think the banks understand what's at stake and that if certain regulations in Dodd-Frank and Basel III, for that matter, are enacted in a punitive way, the banks' ongoing profitability could take a big hit.

This is their year to fight it and to protect their businesses—maybe even in an overtly aggressive way, including challenging politicians and regulators publicly, if need be.
Bugie:  2011 may be remembered as the year that the global regulators hammered out an agreement on the best set of regulations for financial institutions. There are several important meetings for the rest of the year in which the financial authorities will work together on global coordination—a critical issue. Maybe they'll nail it—and we'll all remember 2011 as the year they figured things out and agreed.

CreditWeek:  A peaceful note to end on.

Thanks, Sean..

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Saturday, July 2, 2011

New York Times Sells Half Its Stake in Boston Red Sox Article: New York Times Sells Half Its Stake in Boston Red Sox

New York TImes sold more than half its 17 percent stake in the company that owns the Boston Red Sox, according to a filing with the Securities and Exchange Commission Friday.

Full Story:

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Thanks, Sean..

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Thursday, June 2, 2011

20 Percent Mortgage Down Payment Under Fire

Adversity makes strange bedfellows, and today's mortgage market is nothing short of adverse.

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Thanks, Sean..

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Sunday, May 8, 2011

The Class That Built Apps, and Fortunes

Students who took the first "Facebook Class" at Stanford University turned their homework into a fortune, almost overnight. "It had this feeling of a gold rush," said one investor who saw potential in the class projects.

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Thursday, May 5, 2011

National Home Prices Double Dip Article: National Home Prices Double Dip

Home prices have double dipped nationwide, now lower than their March 2009 trough, according to a new report from Clear Capital.

Full Story:

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Sunday, April 3, 2011

Baseball Set for Data Deluge as Player Monitoring Goes Hi-Tech

Baseball Set for Data Deluge as Player Monitoring Goes Hi-Tech

April 1 (Bloomberg) -- On a Saturday morning in March, some 400 people crowd a conference room at the Boston Convention Center. Mostly men, and mostly paying customers, they are there to listen to six other guys talk about baseball statistics.

It's day two of the Massachusetts Institute of Technology Sloan Sports Analytics Conference, an annual gathering dubbed "Dorkapalooza" by ESPN's Bill Simmons. The buzz from the panel is about something called Fieldf/x, Bloomberg Businessweek reports in its April 4 issue.

"Do you feel like Fieldf/x will essentially make all other fielding stats irrelevant?" asked the moderator, the writer Rob Neyer.

"Yes," said Tom Tippett.

Tippett is the director of baseball information services for the Boston Red Sox, which means he's in charge of gathering and crunching numbers to help put together a winning team.

"I kind of feel like I have to throw away everything I've done for the last 20 years and start over," he said.

But in a good way. Fieldf/x will create a digital catalog of virtually every movement at every Major League Baseball game in every park. Already in place in San Francisco's AT&T Park, it is coming to four more venues this year. If all goes according to plan, it will be in every major league park by 2012.

Fieldf/x is a motion-capture system created by Chicago- based Sportvision. It uses four cameras perched high above the field to track players and the ball and log their movements, gathering more than 2.5 million records per game. That means you could find out whether Ichiro Suzuki truly gets the best jump on fly balls hit into the right-field gap, or if Derek Jeter really deserved that Gold Glove last year.

Changes in Pay, Recruitment

The deluge of numbers will send analysts scrambling to answer just such questions. What they find will change the way teams choose and pay their players, and the way fans watch and talk about the game.

Motion capture, or optical tracking, promises to rid sports of the biases of the human eye and quantify the formerly unquantifiable art of being in the right place at the right time.

In the National Basketball Association, teams have begun using it to sort out the conditions that make for a high- percentage shot.

In European soccer, clubs are mapping the endless streams of passes and moves to determine which lead to goals.

In baseball, it promises to solve the age-old statistical riddle of defense, a feat that could make and break players and ball clubs.

Glowing Puck

Curiously, Fieldf/x has roots in one of the most unpopular additions to sports of all time, the much-reviled glowing puck, which annoyed hockey fans for two years between 1996 and 1998.

In 1998, three Fox Sports executives who had helped to create the effect left to form their own company.

Under its original chief executive officer, Bill Squadron (now the head of Bloomberg LP's Bloomberg Sports, which markets sports statistical analysis to professional teams and fantasy sports players), Sportvision went on to build the technology that gave fans the yellow line that marks first downs on football broadcasts and the data boxes that shadow cars during Nascar races.

In 2001, the company worked with ESPN to create "K-Zone," which showed Sunday night baseball viewers the location of pitches as they crossed home plate. Creating K-Zone required a batch of data that became useful on its own.

K-Zone Upgrade

After several years of negotiations with the MLB, Sportvision created an upgrade of K-Zone called Pitchf/x that uses a pair of cameras set along the baselines to capture every pitch roughly 40 times on its path between the mound and the plate. In 2007, MLB installed Pitchf/x throughout the league at a cost of about $2 million.

The point, at first, was to evaluate home-plate umpires' calls. The league wanted "a thoughtful, objective way that would be the same in every ballpark," said Bob Bowman, CEO of Major League Baseball Advanced Media.

Under a co-licensing agreement, Sportvision went on to sell Pitchf/x to broadcasters while the major league's Advanced Media unit (known as BAM) used it in its online game-tracking service called Gameday.

BAM also provides the raw data for free to all 30 teams, who use it to evaluate pitchers and hitters.

"That was a tremendous amount of data," said Mike Chernoff, the 29-year-old assistant general manager of the Cleveland Indians.

Digesting it, he said, was a major undertaking.

"We continue to find useful pieces," he said.

The data gave front offices a taste for motion capture.

Sportvision began cooking up broader applications. Hank Adams, who succeeded Squadron as CEO, recalls a 2009 meeting with the Chicago White Sox.

Questions, Questions

"We had shown them data capture on one play, a steal, and they kept asking us questions," he said. "'Do you get the initial lead? Do you get the secondary lead? Do you get the windup time, the pitch time, the pop time, the time it takes to throw down to second base?'" The answer in every case was yes.

"You could see it on their faces," said Adams, "'Oh my God, what are we going to do with all this data?'"

The widest frontier is in fielding. No one knows this better than John Dewan, the owner of Baseball Info Solutions. He has spent decades building the current standard in defensive metrics.

Complete Picture

Dewan estimates that game analysts are collectively about 90 percent along the way to the creation of a complete picture of hitters, and close to 85 percent with pitchers.

With fielders, he said, they started with a severe handicap. For over 100 years, scorekeepers have described a player's work in the field based only on what he does after he gets to the ball. If a shortstop gathers in a grounder and throws it to first in time to make the out, he is credited with an assist. If he bobbles it and can't make the throw in time, he gets an error.

According to Dewan, this basic accounting captures only about "5 percent of the information of what a player is all about."

Dewan's life story is largely the story of trying to close this gap. The 56-year-old Chicago native is one of baseball's Moneyball revolutionaries -- the statistical analysts chronicled in Michael Lewis's bestselling 2003 book.

Before getting into baseball, Dewan spent 10 years as an insurance actuary. In 1982, he came across a copy of "The Bill James Baseball Abstract."


"I was absolutely mesmerized," Dewan said. "He was doing with baseball data what I was doing with insurance."

James, the Moses of Moneyball, is now a senior adviser to the Red Sox.

In 1984, frustrated at the lack of information in the standard box score, James enlisted his Abstract readers in Project Scoresheet. The idea was to standardize and collect the work of amateur scorekeepers to create a more complete database of statistics.

Dewan signed on early. He wrote a program to log the data and soon became the project's director. In 1985, he decided to try to make a living out of it, investing $30,000 to found STATS Inc. He ran the company from a bedroom of his Chicago home with his wife, Sue, and co-founder, Dick Cramer.

Initially, Dewan, James, and the rest of the so-called sabermetricians (after the Society for American Baseball Research), focused on gathering and analyzing data for a familiar set of events: balls, strikes, hits, walks, stolen bases, home runs, and so on.

Overvalued Stats

Moneyball is essentially the story of how the values placed on these events were upended when they began to look at the data carefully. It turned out that, when it comes to producing runs, and therefore wins, batting average and stolen bases had long been overvalued, while the ability to draw walks had been overlooked.

Oakland A's General Manager Billy Beane listened to the analysts before other GMs took them seriously and used their insight to build a team of slow-footed, patient hitters who made the playoffs four years running from 2000 to 2003.

Now, James acolytes occupy most major league front offices, and have built an online industry around baseball statistics. The approach's popularity has also eroded its effectiveness.

"The statistical analysis game has grown on what I would call stats of outcomes," said Vince Gennaro, the author of "Diamond Dollars: The Economics of Winning in Baseball," meaning the Moneyball heroes were simply rethinking the traditional numbers.

"We were looking at what happens at the batter-pitcher match-up, and then analyzing that to death."


Now the game is moving, he said, toward looking at "attributes and processes," at not just what happened, but how.

At STATS, Dewan helped to pioneer this transition. Looking for a better way to assess defense, he decided to divide the field into hundreds of zones and then count how often fielders were able to make outs on balls hit into those zones.

He then measured each fielder against the average: If a center fielder, for instance, made a catch on a ball that 70 percent of major leaguers would also catch, he was credited with .3 toward what Dewan dubbed his Ultimate Zone Rating.

In 2000, News Corp. bought STATS and the Ultimate Zone Rating system with it. Dewan left and founded Baseball Info Solutions two years later. There he refined his system, increasing the number of zones to more than 3,000 and converting the zone rating into a number of runs saved by a fielder's play.

20-Run Saving

In 2010, little-known Daric Barton of Beane's Oakland A's led all first basemen by (theoretically at least) saving 20 runs.

At BIS, compiling these numbers is a laborious task. The company employs about 20 "video scouts" at its offices in Allentown, Pennsylvania. They watch video of every game at least three times and tag every batted ball with a direction (from 135 to 225 degrees), distance (0 to about 400 feet, depending on the size of the park), pace (hard, medium, or soft), and type (grounder, fly ball, line drive, or "fliner").

The results are information that major-league teams pay to see, though Dewan won't say how much. The BIS data, however, is limited. It has nothing to say, for example, about where a fielder was standing when the ball was hit. And it is liable to human error, with a margin of 15 to 20 feet on some plays. Dewan estimates he's now only 60 percent of the way to fully measuring a fielder's ability.

2.5 Million Data Results

This is where Sportvision enters. Fieldf/x essentially automates and massively expands the work of Dewan's video scouts. Each game at AT&T Park last season produced files of about 2.5 million results, or 2 terabytes' worth of data. At that rate, eight baseball games would fill the memory bank of IBM's Watson supercomputer.

"It's almost overwhelming how much data we're creating," said Ryan Zander, the company's general manager of baseball products.

Much of it is extraneous: 20 records a second of players warming up between innings or milling around between pitches. Zander said Fieldf/x is accurate to within a foot. At AT&T, it would sometimes grab hold of seagulls and cotton candy vendors who came into the frame and begin tracking their movements. The slice of data that teams are most likely to want amounts to about one million results per game.

Paid For

Via major league's BAM, front offices are likely to get just that, and without paying a cent. In 2000, every club agreed to kick in $1 million a year for the first four years of running BAM, with the expectation that the project would eventually cost $120 million.

The idea was to manage a leaguewide website and figure out how to make money from baseball online. BAM became a moneymaker ahead of schedule in 2003. now gets 50 million to 60 million unique visitors per month during the season. Its mobile app, At Bat 2010, was the top grosser in Apple's online store last year. BAM's annual revenue is now nearly $500 million, and teams have already been paid dividends totaling three times their initial investment. The data is gravy.

For the first installation in San Francisco last year, Sportvision, whose labs are in nearby Mountain View, worked directly with the Giants, under BAM's oversight, to get permission to test the technology.

In return, the Giants received exclusive access to the data. BAM arranged this year's installations -- already in place at Yankee Stadium and in San Diego, and under way in Kansas City and Tampa.

'Every Park'

"Our plan is ultimately to put it in every park," said CEO Bowman.

First, he wants the commissioner and clubs to see how it works. (Bowman plans to install a competing technology, called PlayItOver, in one park "to keep everybody honest.") If teams like what they see, BAM will likely help shoulder the installation cost -- about "six figures per," according to Sport­vision CEO Hank Adams -- and then try to figure out how to make revenue from the technology.

"We think it's a project that may deliver value to our fans through the myriad of devices they use," said Bowman.

Sportvision, meanwhile, will go to work on broadcast products, such as overlaying the field with concentric circles illustrating a player's range.

Mountain of Data

Clubs will get a mountain of data and race to make use of it. The coming deluge reminds the Red Sox's Tippett of Project Scoresheet in 1984. Like Dewan, he cut his teeth on that new batch of data.

"I happened to be at the right age at the right time and got in on that early, and that's why I have a job with the Red Sox today," the 53-year-old said in the hallway, amid the crowd at the Sloan conference.

Fieldf/x, he said, has the potential not only to be a big step forward in how clubs evaluate players but also in opening the door to "anybody who wants to jump in and be among the leaders in figuring out what we can do with this stuff."

There's no shortage of people waiting to take him up on the challenge, as suggested by the 1,500 who showed up at the Sloan conference. Moneyball made analytics sort of sexy -- Brad Pitt will play Beane in the movie version to be released this fall -- and the market for number crunchers is glutted with talent.

The Internet is teeming with bloggers hoping to get noticed for their work at sites such as Baseball Prospectus and the Hardball Times. The Indians' Chernoff rattles off a list of four names the team has recruited from their ranks and said his team's analytics budget continues to grow.

Bloggers' Insights

Much of the insight gained so far from the Pitchf/x data came from such bloggers, who figured out how to gather the information from MLB's online Gameday service.

As a rule, baseball teams don't talk about their front- office spending, but according to sources familiar with their budgets, they now range from about $100,000 to half a million or more for analytics.

The teams at the top end of that range treat work done in public forums as tryouts. At the bottom, they treat it as free labor. And where they get their stats analyzed will influence each team's opinion about whether or not they want the public to see the Fieldf/x data.

"You hear stories from front offices about how much they are relying on free work from the Internet," said Robert "Voros" McCracken, a onetime baseball analyst who famously gave away one of the game's great statistical epiphanies to a small online group in 1999 (the only reliable measures for a pitcher are the outcomes that don't involve fielders: walks, strikeouts, and home runs).

Free Labor

Teams, according to Voros, are asking, "'Why do we need to hire this guy? He's giving us what we want for free.'"

Voros's work earned him a job devising systems to evaluate college players for the Red Sox for three years. The pay was less than $30,000 per year.

Sportvision's Adams admits the passive approach to freelancers, is "probably not the best business model or even the most consumer-friendly, frankly."

For now, however, the company is focused on its broadcast products and its partnership with the league. The fate of the Fieldf/x data is unclear.

"I think we would make it public," said Bowman. "We live in an age where, if you've captured it somewhere, somebody's going to find it, so you're better off making it transparent."

But that decision will ultimately come from the commissioner and teams.

For Clubs Eyes Only

If Tippett has any say in the matter, clubs will keep the data to themselves.

"I want this to be adopted by Major League Baseball, made available to all the clubs, but kept within the industry," he said.

Tippett says that broad access to Pitchf/x data produced useful ideas and that as a fan he values open access, but he knows who signs his checks.

"We don't get paid to advance the state of the art in analysis," he said. "We get paid to put a winning team on the field."

If he could, of course, Tippett would keep the information exclusive to the Red Sox, but Fieldf/x only becomes truly useful as a leaguewide data set, so teams will have to share.

For the heavily analytical teams, the competition is not with other teams, but with bloggers. Those clubs, said Gennaro, will like their chances in a race restricted to a field of 30.

"A team at the bottom of the food chain," he said, "would benefit grossly from [Fieldf/x] being in the blogosphere."

Data Windfall

If it gets there, teams will get information potentially worth millions for free.

Tom Tango is the nom de plume of one of the most respected minds in sabermetrics, although he writes and posts anonymously. ("Tommy is pretty much the best out there," said Voros.) Tango, who consults for the Toronto Blue Jays and Seattle Mariners, estimates that getting a jump on the new fielding data could be worth an extra win or two per season for a major league team.

"Teams will spend a lot of money to purchase an extra win or two ($5 to $10 million)," he said in an e-mail.

That's for players. Spending on analytics has not caught up. While he is fiercely protective of his identity, Tango is an advocate for public access to Fieldf/x.

"MLB can hire the 30 best analysts," he said, "but the next 3,000 best analysts would be able to do better and faster work as a community than any single analyst can do on his own."

Wait and See

Companies such as Baseball Info Solutions and Bloomberg Sports are in wait-and-see mode.

"I would love to get my hands on it and use it in our stuff," said Dewan, "but how that's going to work in the long run, I don't know."

Bloomberg, which like Bloomberg News is owned by Bloomberg LP, already gets Pitchf/x data as part of a partnership with BAM and includes it in the analytics package it sells to 18 major league teams.

"We would certainly be interested," Squadron said of Fieldf/x. "We might be best positioned to make sense of that volume of data."

Last summer, Sportvision invited six analysts to see what they could find in 13 games worth of Fieldf/x data. Even with that small slice, they were able to begin unwinding the difference between the results of a play and its quality.

Soon teams will be able to distinguish between plays made because a fielder was already standing in the right place and those made because of exceptional quickness to the ball.

New Metrics

There will be new metrics -- such as degree of difficulty ratings -- and more precise coaching.

"There are going to be pregame meetings on where the shortstop is going to play exactly for each of the hitters," said Gennaro.

One way or another, the exhaustive data will also seep into the game's vernacular.

"We see center fielders make catches or shortstops make diving plays and we go, 'great range, great jump,'" said Bowman. "That's what it looks like to our naked eye."

Now fans will begin to see what they've been missing. Range will be described in numbers and not just adjectives.

"It's going to make the game more scientific," said Gennaro.

More science, Bowman assures, doesn't have to mean less poetry.

"The facts will not end the discussion, they will only enlarge it," he said.

Editors: Bryant Urstadt, Dex McLuskey

To contact the reporter on this story: Ira Boudway at

To contact the editor responsible for this story: Bryant Urstadt in New York at

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Friday, April 1, 2011

Why Marc Faber Is Such a Bear

Why Marc Faber Is Such a Bear

The thing about predictions is that if you make enough of them, eventually they'll start to come true. Being a good enough prognosticator to hold the investor community's attention most of the time is an entirely different matter.

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Thursday, March 3, 2011

US Standard of Living in Peril From Dollar's Weakness: Zell Article: US Standard of Living in Peril From Dollar's Weakness: Zell

The US standard of living could drop 25 percent if the dollar loses its standing as the world's reserve currency, investor Sam Zell told CNBC.

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Tuesday, February 15, 2011

Lawmakers Resist Bankruptcy for US States

US lawmakers have expressed opposition to the idea of allowing US states to seek bankruptcy protection to alleviate pension underfunding and other debt burdens. The FT reports.

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Thursday, January 13, 2011

America: Paydown problems

America: Paydown problems

It was the most startling of warnings. If the US does not get its finances in order "we will have a European situation on our hands, and possibly worse", claimed Paul Ryan, the new Republican chairman of the House of Representatives budget committee.

The consequences of not tackling the country's mounting debt burden would be dire, he last week told an audience of leading budget experts and economists at a gathering in Washington. "We will have the riots in the streets, we will have the defaults, we will have all of those ugliness problems," he said, referring to "French kids lobbing Molotov cocktails at cars, burning down schools because the retirement age will be moved from 60 to 62".

As it stands today, the US borrows about 40 cents of every dollar it spends. Curbing the budget deficit has been the stated mission of Mr Ryan, a rising Republican star, for several years. But such calls for action have multiplied in Washington in recent months, igniting what some say is the fiercest debate over fiscal and budgetary policy in decades.

The risks are big. If the government rushes into austerity, cutting too much and too quickly, it could stunt economic recovery. But if the political system cannot forge some kind of consensus on steps to restore US deficits to sustainable levels, the danger is potentially even greater: a sovereign debt crisis in the world's largest economy.

"It's a weak period for the economy, so I don't think you want to do serious deficit reduction anyway, but we are playing a dangerous game and we will start to pay a price for fiscal irresponsibility," says Ethan Harris at Bank of America Merrill Lynch.

The big fear is that if no action is taken, investors might eventually punish the US for its fiscal laxity. That would raise borrowing costs for businesses and consumers, force severe austerity measures and risk social unrest. Not only America's triple-A credit rating could be threatened; some point to consequences in foreign affairs and defence as well. Mike Mullen, chairman of the joint chiefs of staff, last year warned that the debt pile could limit the flexibility of the US in funding its military – in his eyes the "most significant threat to our national security".

So far, capital markets have not reacted much to the dismal long-term outlook. The 10-year Treasury yield, for instance, has been trading this week well below 3.4 per cent, close to historical lows although it has risen in recent months. Still, a growing number of voices are calling for a deal to address America's strained public finances, even if it means tackling programmes such as retirement benefits and healthcare for the elderly that have long been protected.

Yet whether this anti-deficit rhetoric translates into a meaningful turn towards austerity in the coming months – and leading into the 2012 presidential election – is much in doubt, for two main reasons: severe political divisions and the continuing fragility of the economic recovery.

"It's not urgent but at some point it's going to become more urgent," says Phillip Swagel, who was a senior economic official in the George W. Bush administration. "Clearly the markets don't think we're Argentina, but we should send them a signal that they are right, that we will address the issue."

A deal extending Bush-era tax cuts and unemployment benefits in December failed to send that message, adding $858bn to long-term deficits without any commitment to reductions in the future, even though supporters argue that if the measures boost growth, America's budgetary position will improve too.

But more big tests of America's commitment to fiscal discipline are looming. On January 25, President Barack Obama will lay out his legislative priorities for 2011 in his State of the Union address to Congress, and measures to reduce long-term deficits are expected to be on the agenda.

Some policies have already been flagged. In December, the president announced a two-year freeze on pay for civilian government workers, a nod to the need for budget cutting to begin at some point. The Pentagon has also been trying to get ahead of the game: last week it announced that it would trim its annual budgets of more than $500bn by a combined $78bn over the next five years compared with earlier projections.

These measures will be incorporated into the White House's proposed annual budget, to be presented in mid-February. Other steps could also be included, such as possible additional plans to cut discretionary spending across government agencies, start tackling social security reform and set a framework for tax reform.

Much attention will be paid to both the scope of these proposals and how specific they are, and to signs of the seriousness of the administration's commitment to deficit reduction.

Mr Obama's new economic team certainly bodes well for fiscal hawks, including as it does Jack Lew as budget director and Gene Sperling as head of the National Economic Council. The two are back in the same roles they held under Bill Clinton in the 1990s, when the US reduced its deficit through negotiations between a Democratic White House and a Republican Congress. Mr Clinton left office with a budget surplus.

Few expect the administration to take the aggressive approach sought by some prominent Democrats such as John Podesta of the Center for American Progress, a think-tank with close ties to the Obama White House. This would involve cuts to large programmes such as Social Security and Medicare, followed swiftly by a move towards tax reform. But it is unlikely to happen, because it could expose the administration to a barrage of attacks from both its Democratic base and from Republicans.

Nevertheless, Mr Lew maintains that the administration's resolve on deficit reduction is clear. "We need to have a bipartisan effort, which will address the serious fiscal challenges before us while at the same time promoting an agenda that will build the foundation of the American economy in the future, which to us means continuing to invest in education and innovation even while we make reductions in other places," he says.

But Republicans, who gained control of the House of Representatives in elections last November, partly on a message of fiscal rectitude and opposition to government spending, have other things in mind. They envisage spending cuts on a much larger scale than what is palatable to the White House or many congressional Democrats – and could resist any attempt by the administration to press ahead with new stimulus measures.

Many Republicans have shown little willingness to consider tax increases as part of any deficit reduction package – which many economists believe to be an essential component of a deal. The result could easily be gridlock, with both parties and the White House trading accusations, and investors and businesses growing increasingly nervous about America's ability to deal with the debt problem.

Meanwhile, a deadline that will force the two parties to engage – and probably battle – on fiscal issues is close. Any time between March 31 and May 16, the Treasury estimates, US debt will hit its congressionally mandated limit of nearly $14,300bn. If the administration and Capitol Hill cannot agree on a deal to raise that threshold, the US would have to shut down the government and default on its international debt obligations – potentially triggering the debt crisis that for the moment seems so distant.

Many Republicans have insisted that a higher debt ceiling should be tied to their aggressive spending cut targets, setting the stage for a big political showdown as the date approaches.

The administration does not believe the debt limit should be used as a bargaining chip to extract concessions. "Our view is a clean debt bill is the only responsible thing to advocate – and we're clearly going to have to engage in Congress on this," says Mr Lew. "We have no alternative but to raise the debt ceiling and it would be irresponsible to use the need to raise the debt limit as a way to force a crisis that could undermine the US economy and its standing in the world very severely."

Lawmakers as well as analysts expect in general that over the  next few months a limited  agreement – possibly on its own, and possibly involving the enactment of some deficit reduction measures proposed by the administration plus some new ones – will be reached. But while such an accord could placate investors in US debt for some time, it will probably only delay America's reckoning with its unsustainable public finances rather than correct the course.

America's budget deficit in the year to last September amounted to about $1,300bn – the second highest on record. Over the next several years, as the economic recovery advances and the impact of emergency spending measures taken during the recession start to wane, the country's deficits are expected to shrink naturally.

But the relief will be temporary: because of the retirement of the baby-boomer generation, which starts in earnest this year, the cost of government healthcare and pension programmes is projected to soar. According to a report issued last month by an 18-member bipartisan commission on fiscal responsibility, by 2025 tax revenues will be sufficient to finance only interest payments – which are projected to soar from their current $200bn a year to more than $1,000bn – and entitlement programmes, with no room for anything else.

"Every other federal government activity – from national defence and homeland security to transportation and energy – will have to be paid for with borrowed money," it warns. By 2035, rising debt could reduce gross domestic product per capita by as much as 15 per cent. That would imply a harsh reduction in Americans' standard of living.

This gloomy picture is what could eventually cause a crisis in international capital markets. It is also what drove the commission, led by Erskine Bowles, former White House chief of staff under Mr Clinton, and Alan Simpson, former Republican senator from Wyoming, to attempt what had rarely been tried before in Washington: to craft a detailed template to solve the country's budget woes, offering Americans and their lawmakers a concrete glimpse of what it would take to correct the problem.

The plan recommended a total of $3,900bn in deficit reduction by 2020, with a three-to-one ratio of spending cuts to tax increases. The commission proposed raising the state pension age, curbing government healthcare and limiting popular tax breaks such as the ability to deduct interest paid on mortgages.

Some potential options to cut the deficit – such as a consumption or value added tax, or a tax on carbon – were sidelined as politically infeasible. That contributed to a surprising level of agreement on the recommendations, with 11 panellists voting in favour of the package, including six sitting lawmakers. Still, this was not enough to force a vote in Congress on the measures, which would have required a 14-member majority.

The failure of the Simpson-Bowles commission to reach the required threshold is what left America's fiscal fate in the hands of the ordinary political process, from the White House to congressional leaders such as Kent Conrad, chairman of the Senate budget committee, as well as Mr Ryan. Turning back to Europe's debt woes, Mr Ryan declares: "This is not who we are, and this is not the fate that we want to have."

However avoiding that fate – and ushering in a new era of US fiscal responsibility – will require a level of political harmony that, in spite of a growing awareness of the problem, still seems elusive.