EU Creditwatch: S&P - so what?

S&P put Eurozone on credit watch

Stephen Bartholomeusz' summation of the overnight news from Europe is worth reading.  He makes the following points (emphasis is ours):-

1. The reasons cited by S&P for putting 15 of the 17 core eurozone members on negative credit watch, which means they could be downgraded within 90 days, are very familiar to the markets, which had acted pre-emptively as it became apparent that the eurozone authorities were struggling to respond to the escalating crisis.
2. The ratings agency referred to tightening credit conditions across the eurozone. Credit conditions have been tight for months, to the point where European debt markets are effectively shut and bank lending has shrivelled.
3. The continuing disagreements between policymakers about how to tackle the crisis and ensure fiscal convergence in the longer-term has been the central factor in the market’s increasing fear and loathing of all things euro, although at least the agreement between Germany and France overnight provides a pathway towards the longer-term objective, with a mechanism for binding members to fiscal discipline and sanctioning those who stray.
4. The eurozone, as S&P noted, is awash with debt at both the government and household level, a situation compounded by the near-inevitability of a region-wide recession. It is that combination, and the apparent freezing under pressure of eurozone policymakers unable to respond to the complexity of the crisis, that caused the markets to take fright months ago.

The effect of a S&P downgrade?

1. It could...impact intra-eurozone holdings of sovereign debt and the pricing of any new debt issued. There are institutions that can, or will, only hold AAA-rated paper.
2. It may also affect the ability of the European Financial Stability Facility – which the eurozone authorities are hoping to leverage to help bail out and support sovereign debt refinancings – to raise funds itself. It would certainly adversely impact the EFSF’s cost of funds.

In summary:

The pact between Germany and France does provide a blueprint for a different and more effective pan-European fiscal regime in future, but doesn’t address the near-term issues and the need to reassure markets that the authorities have a plan to stabilise Italy and Spain, to re-open credit markets, stabilise the eurozone banking system and maintain some level of economic growth to blunt the severity of the austerity policies being imposed on the more indebted nations.
In the absence of a compact that deals directly with the immediate issues, the crisis will only deepen, destabilising not just the eurozone but the global economy and financial system in the process

Euro Crisis: unintended consequences?

International financial markets have experienced high volatility for months now as the European debt crisis continues to lurch from saga to soundbite, summit to parliamentary sitting.  Ireland, Portugal and now Greece have forced changes of government.  Italy is pushing seemingly closer to a change in leadership as its bond yield rises higher, towards an unsustainable level, whatever that may be. The European leaders summit at the end of October agreed in principle to changes ushering a market rally but the volatility continues and many commentators are of the view that the underlying problems remain (ie the debt rising and growth stagnating) and the measures are themselves not enough to achieve a resolution.

...too much debt (enhanced by little growth) is the source of Europe’s problems and the three ways of dealing with it is to write it off, pay it down or inflate it away, slicing Greek debt obligations to private bondholders in half is a real long term solution. It will still leave them with extraordinary debt levels relative to their small and stagnant economy but it’s a big start. Read the article from The Big Picture here 

What of the European leaders' resolution relating to the so called "50% haircut"? Aside from the immediate political casualties in Athens and Rome, we consider there are unintended consequences.

Peter Boockvar (for his Forbes profile, see) wrote on October 27:

...next will be those looking to hedge sovereign exposure, mostly banks, will then have to short sovereign debt or outright cut credit to the region. EU officials better be careful what they wish for the holders of Greek CDS

How can a "strong-armed" 50% "haircut" not constitute a default? How can this not have ramifications for the pricing of the next lot of debt needing to be refinanced by these deeply indebtetd European sovereigns?

In addition to the CDS issue, Bloomberg reports on 8 November here that BNP Paribas SA and Commerzbank AG are unloading sovereign bonds at a loss, leading European lenders in a government-debt flight that threatens to exacerbate the problem. The European Banking Authority is requiring lenders to boost capital by 106 billion euros after marking their government debt to market values. This trend may undermine European leaders' efforts to lower borrowing costs for countries such as Greece and Italy while generating larger writedowns and capital shorftalls.

Another voice on the CDS issue is John Mauldin whom you can follow here  I have reproduced a significant portion of his note written on 29 October, 2011 and I have italicised the central point:

Let's Just Change the Rules 

I've always had a soft spot for Bunker Hunt. Yes, I know, he was a voracious manipulator who tried (and did) corner the silver market back in 1980, but boys will be boys. Maybe it's a fellow-Texan thing. He went bankrupt because they changed the rules on him. Lesson for all of us: Never assumes the rules are what you think they are just because they are written down, if someone else can change them. You can only push so far and then the peasants revolt.And that is the final thing that happened at the summit. 

The banks "voluntarily" took a 50% haircut. Voluntary in that Merkel, Sarkozy, et al. told them that the alternative was a 100% haircut. "That's the offer, guys. Take it or leave it." Cue the theme from The Godfather.And because the write-off was voluntary, there would be no triggering of credit default swaps clauses. Because if it's voluntary it's not a default capiche?And that smooth move, dear reader, triggered a rather significant unintended consequence, which resulted in the market "melt-up." 

Let me see if I can walk you through this rather bizarre world of derivative exposure without exposing too much of my own ignorance.Let's say you bought credit default swaps on a certain bank's debt (let's use JPMorgan, but it could be any bank) because you think that Morgan is exposed to too much credit default swap risk. Just in case. Now, if (say) Goldman sold you the CDS, they could and would in turn hedge their risk by shorting some quantity of Morgan stock, or perhaps if the risk was sizeable enough, the S&P as a whole. It would depend on what their risk models suggested.But as of yesterday, the risk evaporated: there would be no CDS event. So why buy CDS? Time to cover. And then the shorts get covered.Further, the risk to financials was cut by a large, somewhat murky amount. But it was definitely cut, so buy some risk assets. Which puts any long/short hedge fund in a squeeze, especially those with an anti-financial-sector bias. But because of the nature of the hedge, the whole market moves. It involves rather arcane concepts that traders call delta and gamma. (Remember that the recent rogue traders had been at delta trading desks?) Guys at those desks can calculate that risk in a nanosecond. You and I take a day just to wrap our head around the concepts.And it just cascades. The high-frequency-trading algo computers notice the movement and jump in, followed quickly by momentum traders, and the market melts up. Because a significant risk was removed. But not without cost. 

Let's go back to where I noted that Italian interest rates are rising even as the ECB is supposedly buying. What gives? It is clearly the lack of private buyers, and a lot of selling. Because now you can't hedge your sovereign debt. If you ever need that insurance, they will just change the rules on you, so why take the risk? 

Destroying the credit default swap market will make it harder to sell sovereign debt, not easier. Those "shorts" were not the cause of Greek financial problems; the Greeks did it all to themselves. As did the Portuguese, and on and on. Now admittedly, rising CDS spreads called attention to the problem, much as rising rates did in eras long past. And that did annoy politicians. And clearly, banks that had exposure to that market got the "fix" in to make their problems go away.(OK, this is just my conjecture; but I have speculated before with reason that a major writer of sovereign CDS were German Landesbanks. Think Merkel didn't have that report? As did Sarkozy, on French exposure? It was a very high-stakes poker game they were playing this week. But one side of the table could rewrite the rules.) 

Now, I know I am greatly oversimplifying the CDS situation. Even so, a great deal of the volatility of recent times can be laid at the feet of the CDS market, because it is so opaque. There is no way to prove or disprove my speculations, because there is no source that can really plumb the true depths of the situation. And that is the problem.I am not against CDS. We need more of them. But they should all be moved to a very transparent exchange. If I buy an S&P derivative (or gold or oil or orange juice), I know that my counterparty risk is the exchange. I don't have to hedge counterparty risk. The exchange tells whoever is on the other side of the trade that they need to put up more money, as the trade warrants. Or tells me if the trade goes against me. The banks lobbied to keep CDS "over the counter." The commissions are huge that way. If they are on an exchange the commissions are small. This was a huge failure of Dodd-Frank. And we all pay for it in ways that no one really sees. 

As the Bastiat quote at the beginning said, there is what you see and what you don't see.Equity markets are supposed to help companies raise capital for business purposes, not be casinos. Investors want to and should be able to buy and sell stocks with a long view to the future. And increasingly there is the feeling that this is not the case. When I talk to institutional investors and managers, it is clear that they are very frustrated.I am not arguing against hedge funds here. There is a need for short sellers in a true market. But that selling should be transparent. In a regulated exchange, you can see the amount of short interest. Everyone knows the rules. But without an exchange, things happen for reasons that are not apparent. An event like the Eurozone summit changes an obscure rule with some vague clauses about triggering a credit event and the market reacts. This time it was a melt-up. Next time it could be a meltdown, as it was in 2008.CDS markets should be moved to an open regulated exchange. 

And while we are at it, high-frequency trading should be stemmed. This could be done easily by requiring all bids or offers to last for at least one second, instead of a few microseconds. You make the offer, you have to honor it for a whole second. What a concept. That would not hurt liquidity, but it would cut into the profits of the exchanges (especially the NYSE) but I thought these were public markets and not the playground of the privileged few. 

If it weren't so cold here in New York, I might just wander down and join Occupy Wall Street and see if I could enlighten a few minds. If those kids only knew what they really should be protesting.

Super Contributions: how can Australians be helped to retire with enough super?

Super Contributions - the future

A report from actuaries at Deloitte released 2 November studies the future of Australia's superannuation industry.

Dynamics of the Australian Superannuation System: the next 20 years 2011 – 2030, explores a range of scenarios that show the comparative growth in superannuation assets by market segment, in the demographic makeup of post and pre-retirement funds, and what longevity means for retirement adequacy.

To put the average balance at retirement in context, the authors turned to the current Association of Superannuation Funds of Australia (ASFA) Retirement Standard, which suggests that a single male requires $22,000 per annum for a modest lifestyle in retirement. That means to retire on a modest lifestyle a male will require a balance of $280,000. A female will need the higher amount of $310,000 due to greater longevity. But...the average balance for a male at retirement in 2030 will only be $217,000 in today’s dollars, and the average amount for a female will be even less - $139,000.

Given that 50 percent of the population is expected to live beyond the standard 85 years of age for a male and 88 years for a female...a single male retiring with an account balance of $217,000 and taking an income stream of $22,000 per annum has a 78% chance of outliving his retirement benefit.

The Report projects that recent strong growth in industry funds, master trusts and Self Managed Super Funds (SMSFs), will continue at the expense of corporate and public sector funds.

The Deloitte model projects that SMSFs will continue to remain a popular superannuation option overall with its assets reaching $2 trillion by 2030. This is however almost one trillion dollars lower than in their 2009 projection, which is almost entirely due to the introduction of lower concessional contribution limits.

Generational change is significant.  The report finds over the next 20 years, the share of assets held by Generations X and Y will grow from about 46% in 2010 to become the dominant superannuation customers with 84% of all assets in 2030.

The combination of longer life expectancy and volatility in the investment markets is raising the risk that retirees will run out of money before they die. The Deloitte report finds this presents an opportunity for the industry to think innovatively and find new solutions to what will become an increasing challenge.

The Australian Superannuation system is still dominated by lump sums, but we are seeing an increasing proportion of retirees opting for an income stream. It is expected that this trend will continue, presenting a challenge for funds to provide services and pension benefits for members as they approach and  transition into retirement.

The decision to increase the Superannuation Guarantee to 12% and lift the qualifying age for the age pension to 67 years, are intended to help Australians provide for their own retirement – by saving more and working longer.

Addressing adequacy in retirement is described by Deloitte as "a work in progress" see here.

A significant factor under consideration by industry about which the ATO/Government is aware is the possibility of increasing the limits for concessional contributions when a person is nearing retirement. 

This would go some of the way to resolving the question of adequacy of superannuation.

Radical Bank Reform | Alan Kohler | Business Spectator

Time for Radical Bank Reform

Excellent article today from Alan Kohler who references Andrew Haldane, executive director of the Bank of England. He explains the history of banking:

the risks from banking have been widely spread socially. But the returns to bankers have been narrowly kept privately. That risk/return imbalance has grown over the past century. Shareholder incentives lie at its heart. It is the ultimate irony that an asset calling itself equity could have contributed to such inequity. Righting that wrong needs investors, bankers and regulators to act on wonky risk-taking incentives at source.

A shift away from remunerating bankers based on return on equity instead looking to return on assets would lead to different risk assessments by bankers and outcomes for the banks, for the bankers and for society at large.

A valuable macro perspective on our financial system. Read it here

SGC boost to 12%, abolition of age limit for super contributions

Super Contributions Boost

Today the federal government introduced legislation into the House of Representatives to increase the superannuation guarantee from 9 per cent to 12 per cent. The objective is to try and provide for more Australians to self-fund their retirements from their superannuation funds.

 

The bill will also abolish the age limit for when people can make contributions to their superannuation. This significant change will mean Australians can make contributions throughout their whole working life.

 

The introduction of the bill is the first step for the legislation. The debate on the legislation has been adjourned and is likely to be resumed early next year, 2012.

Wall Street Protests

#OCCUPYWALLSTREET

The nascent demonstrations we have seen on the streets of New York and other US cities over the past month at first glance seemed to be comprised of people with a variety of grievances brought together with a general claim to having "lost out" in the wake of the bank bailouts of 2008-9 and the persistently high level of unemployment.

The declaration of the "NYC General Assembly" from 29 September 2011 sets out the range of grievances: http://nycga.cc/2011/09/30/declaration-of-the-occupation-of-new-york-city/ 

The media coverage and commentary continues to grow and now other theories are emerging:

Reuters today posits that the "unashamedly liberal" MSNBC television news network has "staked out" the Occupy Wall Street movement as a pet topic in the same way as the conservative Fox News network has dominated coverage of the Tea Party movement in US politics over the past couple of years.  To what end?  The theory is that such a popular issue will make viewers "turn on" and this leads to greater ratings particularly going into a Presidential election year: Reuters: 13/10/2011

(Fox is owned by Rupert Murdoch's News Corp. MSNBC is a venture of Microsoft Corp and NBC, the broadcast network controlled by Comcast Corp. CNN is a unit of Time Warner Inc and ABC is a unit of Walt Disney Co)

There are other issues here: TV news in the USA generally has lost ground as a news source particularly with younger people because of the availability of instant news via the internet.  Further, some commentators think that the liberal voters who traditionally supported MSNBC have split into two camps - those who think President Obama has hindered their cause/s and those who still support him.

Meanwhile other theories abound:

• that the "Arab Spring" which saw (relatively) peaceful regime change in the Middle East organised primarily through social media networks has inspired the US demonstrators seems quite clear;
• Canadian anti-establishment magazine "Adbusters" posted the original Wall Street demonstration for September 16, 2011 on the Internet, which spawned the last few weeks' activities (Adbusters, which features provocative essays and spoof advertisements challenging people to reject consumer culture, has about 20,000 subscribers and sells about 80,000 copies at newsstands and independent bookstores, mostly in the U.S. It sells no advertising, and funds itself entirely through sales and donations). 

The idea for wall street protests began with west coast magazine but NY activists made it real.

The magazine's founder, Kalle Lasn said today in an interview with the Washington Post:

The initial phase of the revolution, what we are seeing right now, is leaderless, and the protesters are not hopping into bed with any party, even the Democratic party. Everyone is trying to second-guess what they’re after. But nonetheless, they’ve launched a national conversation. As the winter approaches, I think there will be different phases and ideas, possibly fragmentation into different agendas. I think crystal-clear demands will emanate

and hinted at the possible establishment of a third political party:

I think people want a Robin Hood tax on all trades, they want to bring back the Glass-Steagall Act, to ban high-frequency flash trading, implement banking reform, clean up corruption in Washington, and down the road, a third party may spring up: Washington Post 13/10/2011

We shall watch with interest what comes of all this as the weather cools...

Super Gamble | Robert Gottliebsen | Business Spectator

Short-changed by a Super Gamble

SMSFs tailor their investments to suit their risk appetite. This is a key advantage over industry and other retail funds as shown today by Gottliebsen in the context of Australian equities' risk to commodity and financial stock prices: see
Short-changed by a super gamble Robert Gottliebsen Commentary Business Spectator

Economic Outlook - Global Economy - Das' view

www.imf.org

Satyajit Das is a writer with experience in Australian and international financial markets over 30 years. In a 2006 speech called "The Coming Credit Crash" – he argued:

...an informed analysis of the structured credit markets shows that risk is not better spread but more leveraged and (arguably) more concentrated amongst hedge funds and a small group of dealers. This does not improve the overall stability and security of the financial system but exposes it to increased risk of a "crash" during a credit downturn.

1.  European Debt: the risk is that the Greek bailout plan announced on 21 July 2011 can't be implemented due to claims by Finland for collateral leading to others' similar demands and German disaffection that they are not receiving similar collateral. Greece's fall in GDP is too large to successfully make requisite debt repayments: the Greek economy has shrunk by 15% since the start of the crisis. Debt contagion to other European nations remains a real risk and concerns regarding US and Japanese national debts are increasing.
Last week Das wrote "From green to red: is Credit Crunch 2.0 imminent?" which has been reproduced on blogs around the world from The Drum on ABC online to Ritholtz' The Big Picture. He makes four excellent points which we now summarise:

2.  Bank Problems: Global banks are facing serious issues; French and German banks have very large exposures to Greek, Irish, Portuguese, Spanish and Italian debt. Das notes:

If there are defaults, then these banks will need capital, most likely from their sovereigns. As they are increasingly themselves under pressure, their ability to support the banking system is unclear. The pressure is evident in the share prices of French banks; Societe Generale’s share price has fallen by nearly 50% in a relatively short period of time.

This problem is not confined to Europe. Das comments:

Bank of America (“BA”) has recently emerged with analysts suggesting that the bank requires significant infusions of capital. The major concerns relate to BA’s investment in US mortgage originator Countrywide including continuing litigation losses, exposure to European banks, loans to commercial real estate and the quality of other assets, such as mortgage servicing rights and goodwill resulting from its acquisition of Merrill Lynch.

BA claims that its exposure of $17 billion to European sovereigns was hedged. As the world discovered in 2008, it wasn’t whether you were hedged but who you were hedged with and whether they were financially able to perform that was the issue. BA shares have fallen by roughly 40% price over the past month, compared to a 15% decline in the S&P 500. The cost of credit insurance on BA risk has also increased sharply.

BA decision to issue $5 billion in preference shares to Warren Buffett’s Berkshire Hathaway, now confirmed as the market’s lender of last resort, at distressed prices was not a statement of strength but weakness. BA needs more capital in any case and Buffett is betting on both BA and if things go wrong that the US taxpayer will bail him out as they did with his investment in Goldman Sachs.

3.  Money Markets: Banks and financial institutions are finding it increasingly difficult to raise funds. Costs have risen sharply. Spanish and Italian banks have limited access to international commercial funding. Like Greek, Irish and Portuguese banks, they are heavily reliant on funding from local investors and central banks, including the ECB.

4. Deteriorating broader economic environment: It is impossible to state it more succinctly than Das, as follows:

• Reduced exposure: American money market funds, which manage around $1.6 trillion, historically invested around 40-45% ($600-700 billion) with European financial institutions. Over the last few months, the money market funds have reduced their exposure to European entities, especially Spanish and Italian banks. The funds have also decreased the term of their loans to the European entities that they are willing deal with to as little as 7 days at a time, in an effort to limit risk. European banks are having to pay higher interest rates, if they can attract funds. 
• Flow on effect to Australia: Despite limited known direct exposure to European sovereigns and their relatively strong financial positions, Australian banks’ credit costs in international money markets have increased by more than 1.00% in less than 3 months. As a result, non-financial institutions are finding finance less readily available and more expensive. Anecdotal evidence suggest that businesses are having difficulty financing normal commercial transactions, recalling the credit problems of late 2008/ early 2009.
• Strong economies showing signs of slowing: Germany and emerging market economies, like China and India, which have contributed the bulk of global growth since 2008, are showing signs of slowing. The effects of the excessive credit expansion in China and India are showing up in bank bad debts. 
• Feedback Loops: Tighter money market conditions feed into lower growth, increasing the problems of government finances. Falling tax revenues and rising expenditures push up budget deficits, requiring greater borrowing. Lower growth feeds into greater business failures that increase bank bad debts, feeding further tightening in lending conditions and the cost of finance. 

The rapid and marked deterioration in economic and financial conditions means that the risk of a serious disruption is now significant.

Government policy options are severely restricted. Government support is restricted because of excessive debt levels and the reluctance of investors to finance indebted sovereigns. Interest rates in most developed countries are low or zero, restricting the ability to stimulate the economy by cutting borrowing cost. Unconventional monetary strategies – namely printing money or quantitative easing – have been tried with limited success. Further doses, while eagerly anticipated by market participants, may not be effective.

The outlook according to Das is decidedly bearish - if not verging on apocalyptic! However, his world view is firmly based on the interconnectedness of markets, about which we in Australia must forever be mindful. There are those who say "as long as China is ok, then so are we", but our opinion is that the economic situations in both the USA and Europe are of primary significance to China as they represent China’s major export markets and consequently the global picture must be borne in mind by us all, wherever we may be.

Death Taxes & Super Pension Accounts

Death Taxes & Pensions

The Australian Taxation Office has issued a draft ruling in July (TR/2011 D3) which provides that assets in the pension accounts of deceased fund members are not exempt from capital gains tax when they are sold to pay death benefits - this has relevance to all superannuation funds. This ruling is a clarification of the ATO's established position

The main points to note for SMSF trustees are:

1. Income and capital gains in pension accounts are tax exempt.
2. The disposal of assets from a pension account does not attract CGT.
3. When the pension account holder dies, the law treats the pension as having ceased.  From that point the tax exemption is lost.
4. When pension assets are sold or realised to pay a death benefit then CGT may be payable.

One way to deal with this situation is to actively manage the fund's assets such that the cost base of the assets in the fund is updated.  Consider selling assets which have built up large unrealised capital gains during the life of the pension account holder.

There is also the possibility of dealing with valuable assets by having  unsegregated pension accounts. 

Specific structuring advice should be sought with regard to this point.

The Debt Cycle, consumer spending and inflation

A very interesting macro perspective piece by Jessica Irvine in the Fairfax press today here. 

Irivine reviews bank lending patterns, interest rate history and Australians' spending since the early 2000s and notes that consumer spending statistics contained a significant proportion of debt. She gives cogent reasons why these spending patterns will not be repeated in the current and near future.

The bottom line for retailers is that they must get used to permanently lower sales growth. This is bad news for shareholders and bad news for retail employees.

But for the economy as a whole, this deleveraging by households is a good thing. It's something households across the rest of the developed world are desperately trying to achieve but that only we have the ability to do effectively, thanks to the income boost from the mining boom. The Reserve Bank is happy to see some weakness in retail spending to make room for increased spending by businesses in the mining sector.

And if households can reduce their debts and build a buffer for future international financial turbulence, that is no bad thing

"Living Wills" for Banks

APRA calls for Big 4 Banks to provide "living wills'

The ABC yesterday broke this story view here.  To deal with the notion of "too big to fail", the banks are being asked to give the regulator their plans in the event of another global financial crisis so as to minimise systemic risk; part of a global regulatory process reviewing capital requirements.

Macquarie Bank - profit downgrade ahead?

Ian Verrender writes yesterday in The Age "The Labour of Nicholas" that the future of Macquarie Bank's traditional investment banking operations is uncertain in the post-GST global market against much bigger players.

He details how its strategy of creating, selling to, and reaping management fees from, satellites is no longer a viable part of its investment banking business - an illustrative read.

Back then (2007), Nick (Moore) and his lieutenants had convinced the world that they had invented the financial equivalent of the perpetual motion machine. It was devilishly simple. Establish your own buyers, your very own set of clients in the form of listed satellites.
Then, buy assets at outrageous prices, sell them on to the satellites, for a handsome fee, and install your own management, again for a handsome annual fee. Each year, all you had to do was revalue the assets and borrow ever more cash to pay the dividends. Simple!
So impregnable seemed the model, that Macquarie's much bigger global rivals couldn't understand why they hadn't thought of it first and tried to get in on the act.
When debt suddenly dried up in 2007 and asset prices crashed, the machine ground to a halt, forcing Macquarie to cut loose all the satellites and return to a traditional business.
That was always going to be a hard slog.
While Macquarie never abandoned traditional investment banking, its operations had become addicted to the easy money to be made from the satellites. And they no longer exist.

It will be interesting to see what happens next week at the Macquarie AGM.

Stevens' take on the Two Speed Economy: we need "Resilience and Adaptability"

In his speech widely reported yesterday, RBA Governor Glenn Stevens gave the following three insights to "make sense" of the phenomenon:

while everyone understands that there is a ‘mining boom’, many people would say that they themselves cannot directly feel the effects. We have seen widespread re-emergence of talk of ‘two speed’ or ‘multi speed’ economies.

The first point is:

the impact of the resources sector expansion does get spread around, in more ways than might immediately be apparent. Obviously mining employs only a small share of the workforce directly – less than 2 per cent. But to produce a dollar of revenue, companies spend about 40 cents on acquiring non labour intermediate inputs, primarily from the domestic sector. Apart from the direct physical inputs, there are effects on utilities, transport, business services such as engineering, accounting, legal, exploration and other industries. It is noteworthy that a number of these areas are growing quickly at present.

This flows through to shareholders and more generally to superannuation schemes in which most Australians have a stake.  Stevens describes this effect as "geniune income and genuine increase in wealth"

Secondly,

...a complex interaction of forces – the commodity price cycle, the financial cycle, population flows, endogenous responses of housing prices that then feed back to population flows and so on – has been occurring. The ebb and flow of these forces has made for differences in performance, first in one direction, then the other.

The example Stevens gives of this "complex interaction" is:

Take housing prices and population growth, which are of course quite closely related...It surely is no coincidence that the two state capitals that have had the clearest evidence of declining house prices over the past couple of years – Brisbane and Perth – are the two that previously had the highest rate of population growth and that have since had the biggest decline in population growth. Moreover, it is hard to avoid the conclusion that changes in relative housing costs between states, while certainly not the only factor at work, have played an important role.

Thirdly, he notes the industry make-up of our economy is continually changing, which is a fact we have known for a long time.  But the significance of this, he says, is:

The point about long term shifts reminds us to look beyond the immediate conjuncture, and to think about the magnitude of the event through which we are living. For a good part of the change in our terms of trade is a manifestation of a large and persistent change in global relative prices. Let me be clear here: there is a cyclical dimension to the China story, and it is important that we remember that. But there is also a structural dimension. And the associated change in relative prices constitutes a force for significant structural change in the economy.

He notes the high exchange rate is exerting a powerful force for structural change, citing the retail industry as the leading example of this.  The "structural adjustment" to which the Australian economy needs to respond is  "inherently income-increasing for Australia", and most postively he concludes:

this is a much better problem to have than those we see in many advanced countries...we do not carry the legacies of the past several years in our banks' or public sector balance sheets that are such an impediment in other places.

and

Resilience and adaptability are among the characteristics we will all need in order to cope with a global environment that is growing more complex rather than less, and that presents both economic challenges and opportunities greater than those we have seen for many years.

We can see by the length and nature of Stevens' speech that it is meant to educate the Australian people about both the economic climate and the RBA's view of its role.  Most commentators have interpreted Stevens' speech as an indication that interest rates will rise in the latter part of 2011, probably August.  It certainly had an immediate effect on the Australian dollar which rose against the $US by 0.53 cents yesterday. The speech is doing more than that however, in that it is clearly an attempt to explain the RBA's position so as to take the people with them, or massage sentiment.  Its success in that regard remains to be seen if and when rates are hiked.

For the full text of Stevens' speech click here.

The Economist's view of Australia today

To read the full piece click here mentioned in the Australian media by many commentators this week including Terry McCrann who savaged the piece in the Murdoch press as:

a unique combination of the libertarian leftism of capital city - read: Sydney and Melbourne - elites that we can read every day in the Fairfax press and the pompous condescension of a fly-in fly-out visitor from 'the old country' click here

We like many of the observations made in the Economist article.  Of great interest to us is the following graphic which lends context to WA's current dispute with the Commonwealth over GST receipts and mining tax revenues:






Of course we all like to see the "good news story" such as the following chart entitled "Where the Aussies Score" (with the exception of the gambling table):

 

NAB Federal budget summary webcast 11 May 2011

I went to the Budget Breakfast yesterday hosted by NAB at Crown, Melbourne.  Whilst there weren't any BBQ stoppers the presentation/economic update given by NAB's Chief Economist, Alan Oster was useful.  His main message is that NAB's economic modelling is much the same as Treasury's.

Here is NAB's webcast: watch Alan Oster present his summary

View webcast (link opens in new window - you'll need to enter your name)

Budget 2011 - Based on Optimism & Tough as Tofu

The federal government’s anticipated return to Budget surplus in fiscal year 2012-13 is built on optimistic assumptions about the short-term strength of the economy that may not be achieved, says the Institute of Chartered Accountants in Australia.

The Institute’s tax counsel, Yasser El-Ansary, says the government is expecting the health of the non-mining sectors of the economy to rapidly improve over the next two years, but based on current indicators, there’s no guarantee that will happen. 
http://www.charteredaccountants.com.au/News-Media/Media-centre/2011/Return-to-surplus-built-on-optimistic-assumptions

A useful summary of the budget provisions has been prepared by the Institute together with Thomson Reuters:  https://www.charteredaccountants.com.au/~/media/Files/Industry%20topics/Tax/Current%20Issues/Federal%20budget/Weekly%20Tax%20Bulletin%20Special%20Budget%20Report%202011ICAA

"Tough as Tofu": Stephen Long, economics correspondent for the ABC commented on Budget night: 

The Government's found savings of $22 billion over the four years of the forward estimates, but there's only about $17 billion or so in genuine cuts to expenditure - the rest are tax increases and levies.
The reality is that, over the course of the forward estimates, the genuine cuts to expenditure are pretty much offset by increases in expenditure

See:  http://www.abc.net.au/news/stories/2011/05/10/3213131.htm?section=business

Actuary analyses Australian Residential Housing market

Anthony Street (ex Macquarie Bank) presented this paper to the Institute of Actuaries in Australia at their biennial convention, 10-13 April 2011.

In my opinion it is the best statistical evidence showing why there is a property bubble in Australia.

I commend this paper to you: it is quite readable and Street does not have a vested interest in the field unlike almost all other commentators.

Presentation slides:

http://www.actuaries.asn.au/Library/events/Conventions/2011/HouseOrHome-Presentation.pdf

Audio:

http://www.actuaries.asn.au/Library/events/Conventions/2011/HouseOrHome-Audio.mp3

Paper:

http://www.actuaries.asn.au/Library/events/Conventions/2011/Con2011_Paper_Street.pdf    

Investment Allocation: SMSFs increase holdings in ASX listed shares

Popularity of listed instruments on the rise - but the real shift is to cash

Investor Daily reports today the latests ASX research into share ownership has shown self-managed super funds (SMSFs) are allocating a larger proportion of their investment portfolios to listed investments.

Also of note:

• the proportion of SMSF investments in unlisted managed funds have dropped to 16% from 46% in 2006 and 38% in 2008
• residential property holdings are down from 19% in 2008 to 12% in 2010; commercial property made up 14% of SMSF portfolios in 2008 down to 8% in 2010
• SMSF holdings in real estate investment trusts and listed property trusts fell from 20% in 2008 to 4% in 2010.

Australian equity holdings have stayed steady at 52% but SMSFs have shied away from overseas shareholdings, down from 9% to 3% allocation in 2010.

Where has all the money gone?  The underlying assumption in this piece is that investors have largely gone to cash - secured returns of around 6% proving to be very appealing to SMSFs' risk appetite.

See article by Darin Tyson-Chan: http://www.investordaily.com/11558.htm 

The Carbon Tax - Aussies fear the cost

Flat prices/fear of declining house prices are affecting the political "sell"

The Labor Government is having a hard time convincing ordinary Australians of the need to price carbon now.

Business and the union moverment are vocal in their opposition (van Onselen calls them in "lockstep": http://www.theaustralian.com.au/business/opinion/carbon-tax-is-like-a-bad-smell-that-wont-go-away/story-e6frg9if-1226041792769

Rob Burgess in today's Business Spectator considers this is due to three main factors:

1. Australians are not spending - the retail sales figures show dismal results for the first quarter 2011;
2. Wage rises have been only in a few industry sectors, largely mining and resources, not retail, manufacturing, tourism, education and other struggling sectors; and
3. Household debt: the RBA's aggregate data shows a dramatic and continuing decline in [discretionary income] due namely, [to] the debt we took on via housing finance...over the past decade: http://www.businessspectator.com.au/bs.nsf/Article/house-prices-carbon-price-ACTU-Jeff-Lawrence-pd20110420-G3SEK?OpenDocument&emcontent_Burgess

Burgess reflects:

In the mortgage belt, the voters Julia Gillard needs to win over for the next election are increasingly aware that their houses are no longer appreciating as they used to, and in cities such as Perth and Brisbane they may well be depreciating. Equity withdrawal and the wealth effect that flowed from it are all but over.

In this environment, the immediate effect of upping the cost of everyday goods makes for difficult politics.

"Debt" - the new 4 letter word

Inflation, currency devaluation and low to negative real interest rates: the US Picture

PIMCO's pullout from US Treasury Bonds: a harbinger of inflation, low/negative interest rates & currency devaluation?

Further to our earlier post Bill pops Ben's Bubble, we now read Bill Gross' April Investment Outlook which states http://www.pimco.com/Pages/Skunked.aspx:

• Medicare, Medicaid and Social Security now account for 44% of total federal spending and are steadily rising.
• Previous Congresses (and Administrations) have relied on the assumption that we can grow our way out of this onerous debt burden.
• Unless entitlements are substantially reformed, the U.S. will likely default on its debt; not in conventional ways, but via inflation, currency devaluation and low to negative real interest rates.

This indicates the reason behind PIMCO's February pullout.  It's a significant vote of no confidence in Bernanke's policy of quantitative easing, due to conclude in June 2011.  He's not alone.

 
Famed investor Warren Buffett joined the discussion recently when he said in a speech in New Delhi that investors should stay away from long term fixed-dollar investments because of his forecast for weakness in the U.S. dollar. Apparently Mr. Buffett is also reducing his long exposure to the long bond market and focusing on what he seems to love to do best, which is buying companies around the world. http://www.marketwatch.com/story/what-do-bill-and-warren-know-that-we-dont-2011-04-04?reflink=MW_news_stmp

Bill Gross said Treasuries “have little value” because of the growing U.S. debt burden.

PIMCO “has been selling Treasuries because they have little value within the context of a $75 trillion total debt burden,” Gross wrote in the report published on Newport Beach, California-based company’s website. Congress “must make ‘debt’ a four-letter word.”

PIMCO reckons the Fed has been responsible for 70% of recent Treasury purchases, with foreigners buying the other 30%. “Who will buy Treasuries when the Fed doesn’t?” asks Mr Gross, adding that the danger is of a spike in bond yields as private investors demand a higher return to compensate them for the risks of inflation or dollar depreciation. http://www.economist.com/node/18396156?story_id=18396156&fsrc=rss

Which leads to the question - what will happen when the current round of Quantitative Easing finishes?  In what circumstances would investors be most keen to buy more government bonds? When the economy is struggling. But central banks will be highly unlikely to reverse QE at that stage. In any case, cynics suspect the problem with QE is that there may never be a moment when central banks feel confident enough to unwind it. After all, American GDP grew by a respectable 2.8% last year and growth of more than 3% is forecast for this year. Yet the mid-March Fed policy meeting indicated that the second round of QE would still be completed: as noted in The Economist piece "Stopping quantitative easing may be harder than starting it" referenced above.

The real point to Gross' observations of the domestic budgetary issues in the US is the reality of inflation, currency devaluation and low to negative real interest rates: that is why PIMCO has got out of bonds.

Family trust or SMSF? Which vehicle best provides for your retirement?

HOW DO FAMILY TRUSTS WORK COMPARED WITH SMSFs?

Both family discretionary trusts and SMSFs are established in Australia by deed and controlled by trustee/s according to the rules laid down in the trust deed.  SMSFs are also subject to the rules in superannuation laws.  Why would you choose one over another?

Government policy has successfully spawned the growth of the superannuation industry since Paul Keating was Treasurer.  The philosophy of the system is that we need to create a system to self fund our retirements because Australia has a burgeoning old age population which will otherwise overburden the public purse's ability to pay old age pensions as was previously the experience.  SMSFs have been developed in this country to allow for concessional contributions to be made by individuals up to a certain age and by their employers.  Whilst you are working, the whole fund is "locked up" until you reach a certain age - so as to operate as a source of income in retirement.  Flexibility remains as to the investment decisions of the fund (subject to legislative restrictions) and, once the age thresholds have been met, discretionary allocations may be made to fund members.

Discretionary trusts or family trusts derive from the law of equity and describe a situation where a family member shares wealth with other famliy members of a family group usually including grandparents, parents, children, grandchildren and their children.  Other beneficiaries may also be included in the deed.  Discretionary trusts have great flexibility, no contribution limits and no restrictions on the nature of the trust's investments (unless limited by the deed) and no borrowing limits.  They also are effective as asset protection for an individual and small business - they can be beyond the reach of creditors.  Perhaps their greatest advantage is the ability to "stream" distributions of income and realised capital profits in a tax effective way away from the main income earner of the family to lower-taxed beneficiaries.  The main condition applying to distributions is that all trust income and realised profits for the year must be distributed otherwise the trust faces tax at the top personal rate of 45% plus 1.5% medicare levy.  Assistant Treasurer Bill Shorten has said recently that the Commonwealth Government is going to make an announcement regarding the tax treatment of discretionary trusts arising from the decision of the Federal Court in the Bamford case.  Hopefully this will provide tax advisers with clarity.

If you desire asset protection and think you might need to access your assets before retirement then there are arguments in favour of a discretionary trust structure for your investments.  Similarly, the timing of receipt of your (high) income in relation to your age may be a factor given the contributions caps which apply to SMSFs ie if you receive large amounts of income into your 60s and 70s. 

There may be pitfalls in using trusts and care and professional advice should always be sought.

The US Fed TARP props "Toxic Cocktail" of "Too Big to Fail"

An excellent article by Simon Johnson professor at MITs Sloan School of Management, has been plublished today on Bloomberg.

Johnson restates the view that "the very effectiveness of US Treasury actions and statements in late 2008 and early 2009 had undeniable side effects, by effectively guaranteeing these institutions against failure, they encouraged future high-risk behaviour by insulating the risk-takers who had profited so greatly in the run-up to the crisis from the cosequences of failure.  And this encouragement isn't abstract or hard to quantify. It gives an unwarranted competitive advantage, in the form of enhanced credit ratings and access to cheaper capital and credit, to institutions percieved by the market as having an implicit Government guarantee."

The most interesting point of this article is that the Dodd-Frank financial-reform legislation was supposed to end too big to fail in some meaningful sense. But what has changed?   Johnson says:

"at the end of the third quarter of 2010, by my calculation, the assets of our largest six bank holding companies were valued at about 64% of gross domestic product - compared with about 56% before the crisis and about 15% in 1995."

"Our largest banks are now bigger, in dollar terms, relative to the financial system, and relative to the economy, than they were before 2008. So how does that make it easier to let them fail?"

For the full article click on this link: http://www.bloomberg.com/news/2011-01-27/banking-toxic-cocktail-is-too-big-to-forget-commentary-by-simon-johnson.html

Pimco pops Ben's bubble

Karen Maley for Business Spectator reports that PIMCO, globally the biggest bond trader, has dumped all of its investments in US government-related debt including US Treasury bonds and agency debt.

PIMCO’s founder and managing director, Bill Gross, has made little secret of his concerns that bond yields could rise sharply – and bond prices fall – when the US central bank’s $US600 billion bond buying program expires in June.

PIMCO’s flagship Total Return Fund slashed its holdings of US Treasury bonds and agency debt to zero at the end of February. A month earlier, such investments made up 12 per cent of the fund’s investments. 

At the same time, the $US236.9 billion fund boosted its cash holdings. The fund held $54.5 billion in cash at the end of February, a sharp rise from $11.9 billion it held a month earlier.

This is a stunning vote of no confidence in the policies of the US central bank by PIMCO.

For the full article click on the link below.

http://www.businessspectator.com.au/bs.nsf/Article/PIMCO-Bill-Gross-bonds-Ben-Bernanke-QE2-pd20110310-ESSLW?OpenDocument&emcontent_Maley

David Murray: "the relationship between house prices and incomes is uncomfortably high"

High Australian house prices have made our economy "vulnerable" to overseas events

Future Fund Chair, David Murray made some interesting comments yesterday at a Sky News panel which have been picked up in various papers today.

http://www.theaustralian.com.au/business/house-prices-seen-as-vulnerable-says-future-fund-chairman/story-e6frg8zx-1226022788109

Murray said that a rise in global interest rates would prompt Australian commodity prices to fall (cutting the income flowing into Australia) and would leave our economy exposed with high house prices.  He hoped:  "that won't happen and we can work it through," however, he observed: "But, by any normal set of measures, house prices in Australia are high."

NSW stamp duty law amendment affects SMSF trustees

Following on from the previous post, a classic example of the advantage of the "perpetual succession" characteristic of a corporate trustee is the July 2010 amendment by the NSW Government of its stamp duty laws.


The NSW Government has removed the $50 duty concession in respect of changes of trustees of a SMSF.  Accordingly if the trustees of a self managed super fund are changed and cannot meet the criteria set out in s.54(3) of the act, full ad valorem duty will be payable on the transfer of any dutiable property as a result of the change.  Ad valorem means the duty is levied in proportion to the value of the property which is subject of the tax.


These changes affect super funds based in NSW or based elsewhere but with dutiable property in NSW.  "Dutiable property" can generally be summarised as land, private company shares, units in a unit trust, business assets, statutory licences, an interest in a partnership and a number of other specific matters.  If you are not sure whether a specific instance qualifies then you need to contact us.


To enjoy the $50 stamp duty concession and not pay full ad valorem rates of duty there are three criteria which must be met and which can generally be summarised as:

• non of the continuing trustees (remaining after the retirement of a trustee) can be or become a beneficiary under the trust;
• none of the new trustees can be or become a beneficiary under the trust; and
• the transfer is not part of a scheme to avoid these provisions.

The only way that a SMSF can meet these criteria is if the new trustee is a company and therefore the only trustee of the fund.


You can see the argument in favour of using a corporate trustee for your SMSF - given the state based stamp duty laws this could turn into a really significant issue for SMSFs with individual trustees holding assets in a number of states in Australia with different laws applying.

Self Managed Super Funds - which kind of trustee is right for you?

SMSFs need a trustee - should it be a company?

Self Managed Super Funds are governed by legislation which dictate that a fund must have a trustee/s: this may be real people (at least two) or a proprietary company.  Many clients ask us: what are the reasons for deciding to use a company?  Isn’t it simpler and cheaper to have individuals as trustees?

The advantages of establishing a corporate trustee in most cases outweighs the additional costs of establishment and compliance.

A couple of basics:

• With individual trustees, all members must be trustees and each trustee must be a member.
• If the fund is a single member fund then the sole member can’t be the only trustee – another individual must be appointed as trustee (not an employee of the member, unless they are related).
• If using a corporate trustee, all members must be directors of the trustee company and all directors must be members of the fund.
• If a single member fund has a corporate trustee, the member can be the sole director of the trustee company or there can be another director (not an employee unless related).

There are disqualification rules relating to both individual and corporate trustees.  The policy is that a trustee must have the legal capacity, solvency and good character to fill the role.

Succession

As a company and an SMSF can continue indefinitely, certainly beyond the lifetime of a member, a corporate trustee can provide greater certainty and continuity over control of the fund in the event of the death or incapacity of a member.

Single member funds

A sole member is permitted to be a sole director of a corporate trustee or there can be another director (not an employee, unless related).

A company may not act as trustee if:

• A responsible officer (including a director, secretary or executive officer) is a disqualified person
• The company has commenced the insolvency process; or
• Action has started to wind up the company.

Lump Sum Payments

In 2006 the Australian Tax Office confirmed the power of individual trustees to pay lump sums out of a superannuation fund (without first starting to pay a pension).  It had been previously questioned whether individual trustees had this power as a matter of Constitutional law.

Now there is no difference between companies’ and individuals’ legal authority to make lump sum payments.

Change of membership

When a new member is introduced to a SMSF with individual trustees, that person is required to also become a trustee.

Trust assets must generally be held in the trustee/s name/s.  This therefore means a new trustee will require the transfer of title to all trust assets (eg property, managed funds, listed securities) to include the new trustee.  This process requires significant time in administration and transaction costs.

Similar administrative issues (and costs) arise when a member leaves a fund on death, retirement or for another reason.

By contrast, when members come in or out of a fund with a corporate trustee, they only need to become or cease to be directors of the trustee company.  ASIC must be notified of the changes but otherwise, legal title to all assets remains with the company.

A corporate trustee can save significant time and effort particularly where the fund has significant assets.

Trustee protection from litigation

Individual trustees carry joint and several liability which may expose an individual trustee’s personal assets to risk if litigation arises eg a personal liability action in relation to a property of the fund.

With a corporate trustee an action will usually be limited to the assets of the company, not exposing the company directors’ personal assets.  The risk of litigation will depend on what activities the trustees undertake.

Cost

ASIC establishment costs of a company are in the order of $600. A change of trustee deed may also be required. There are annual ASIC fees and accounting costs to consider as well.

Family company v dedicated trustee company

Sometimes our clients ask us whether they can use an existing family company as the trustee for their super fund.  We tell them it is possible so long as the company’s other roles are kept separate to ensure the assets of the fund are protected.

A dedicated trustee company can provide a clearer separation of assets and director interests and can further reduce the chances of mistakenly mixing fund assets with company assets and reducing the possibility of trustee conflicts of interest, and is often a preferred course of action.

Also, you need to remember that the family company directors must be restricted to the SMSF members which may not suit all situations.

Voting rights and decision making

A dedicated trustee company has the opportunity to control voting powers in proportion to individual members’ accounts.

It is possible to structure directors’ voting rights based on their account balances, giving those with higher balances more control.  This can make trustee resolutions smoother if there is an even number of votes or there is a relationship breakdown among trustees.

Members with smaller holdings in the fund should consider whether this approach suits their objectives and take advice on this issue.

Death of a director

The articles of association of a company may provide for the executor of a deceased member to be appointed as a director of the trustee company until the time death benefits are paid from the fund.  This is permissible under the SIS Act.

Some companies’ constitutions provide for this to occur automatically – and this may be very important in circumstances of complex family relationships to prevent disputes and the perception of unfair treatment.

We recommend our clients consider this issue on incorporation of their corporate trustee.  If you already have a corporate trustee of your super fund, you may wish to consider this issue afresh to avert problems down the track.

Conclusion

An SMSF with individual trustees may be simpler and cheaper at the outset. 

However, you should consider all these issues and from our experience we find that in many cases, a corporate trustee is the better option despite some additional costs.