Reuters Columns

At long last, Dubai has admitted what has been obvious to everyone else for months: it can’t pay its debts.

This painful admission of reality, the signal to Dubai World’s creditors that they won’t see any of their money until at least next May, pulls the magic carpet out from under companies investors had thought would not default.

The straw that broke the Dubai camel’s back is a $3.5 billion sukuk bond. It had been due to be repaid on December 14. It won’t be.

The government’s argument will be scant comfort to bondholders. The plan is to restructure the emirate’s flagship firm and its sprawling portfolio, which includes plum assets like ports operator DP World, as well as a few dogs like the bizarre Palm developments built in the sea off the Dubai coast.

The task of unpicking this web falls to Deloitte partner Aidan Birkett. Sheikh Mohammed bin Rashid al Maktoum, Dubai’s ruler, may find himself making up the rules as Birkett goes along, since nothing as remotely embarrassing has been seen in Dubai before.

He will have his work cut out, and the indication that he can do this by next May looks like wishful thinking. Dubai World’s debts total $59 billion, including the borrowings of its Palm-owning subsidiary, Nakheel.

Dubai’s own restructuring is only just beginning. Some estimates put the emirate’s total external debts at almost $80 billion, money spent to finance its extravagant attempt to build a financial metropolis in the Gulf desert.

Dubai was already struggling to find external sources of new finance. Wednesday’s shock news will effectively close the markets, leaving it dependent on its petrodollar-rich neighbour Abu Dhabi. Abu Dhabi has already stumped up $10 billion. Only hours earlier on Wednesday, two of its banks had subscibed $5 billion for new bonds. Presumably, they did so in the knowledge of what was about to happen.

Investors are finding out the hard way about the risks of buying into a city state built on shifting sand that is not underpinned by oil. Dubai’s lot now rests entirely on the firmer foundations of its neighbours.

Financial regulation is turning into a bigger muddle than it was before the crisis.

Nearly six months after the Obama administration unveiled its blueprint for the biggest overhaul of the financial system since the 1930s, lawmakers are still, well, talking. Regulators, meanwhile, don’t appear to be doing enough talking — with each other.

The Miller-Moore amendment to the House bill is a case in point. Taking their cue from the Federal Deposit Insurance Corp’s Sheila Bair, the congressmen from North Carolina and Kansas have horrified some in New York who fear legislation holding secured lenders accountable could up-end the repo market, an arcane yet important source of financing in the bond market.

Perhaps the Federal Reserve should have been called in on this one. It is, after all, well versed in the world of repo and as a banking regulator should be part of the discussions anyway.

For its part, the Fed has been pushing the idea of contingent capital, the next big thing that will allow banks to increase their regulatory capital when they become distressed. But by doing so, they would introduce a new, untested security that will only theoretically better protect the financial system. Many said the same thing about credit default swaps.

A cap on leverage is one positive to come out of the House’s draft legislation.

There’s plenty of blame to go around when it comes to what caused the financial mess, but without excessive leverage there wouldn’t have been excessive risk taking.

Big banks are going to take risks. They are single-minded about making money. But when the taxpayer is the ultimate lender of last resort, they shouldn’t be allowed to do it with huge piles of borrowed money.

These are important issues, and regulators need to be talking more in public about them and coming to some sort of consensus quickly. Right now, it’s not clear whether turf battles or thoughtful discussions are influencing the shape of a financial overhaul.

There is plenty to be thankful for this Thanksgiving — the global financial system, for one thing, is no longer in freefall. But when it comes to meaningful financial reform, it’s not only hard to be thankful, it’s hard to be hopeful.

Prominent in most hedge fund literature are some impressive sounding figures. Since 1990, a weighted index of hedge funds has returned around 12 percent — about 4 percent higher than the S&P 500 — while offering half the volatility.

The figures testify not just to the superior performance of funds but suggests that most hedge fund managers “turn out to be relatively cautious,” as James Simons of Renaissance Technologies recently claimed.

The industry should not be allowed to get away with such misleading claims. This should be the starting point of any new regulation of hedge funds.

The seductive figures so assiduously promoted by the industry exaggerate returns for several reasons. The easiest to correct is that reporting results is purely voluntary.

As research by Burton Malkiel of Princeton has shown, hedge funds tend to be quite happy to report results until they start to fail. In the six months before funds ceased giving data, funds produced an average monthly return of minus 0.56 percent, compared with an average positive return of 0.65 percent during their reporting lives.

Take this into account and aggregate hedge fund returns slide right back to the level of the S&P index.

Requiring funds to report results until their demise would help correct this — providing investors with a more realistic estimate of the risks and returns of funds overall. By allowing a delay — say three months — regulators could eliminate the danger of compromising the investment secrets of hedge fund managers.

This is not to say that hedge funds - still off limits to the average investor — should be as transparent as mutual funds; reporting to a regulator and to industry aggregators like Hedge Fund Research would be sufficient.

Regulators also need to address the backfill bias in fund figures. Managers should no longer be able to set up several incubator funds and then report only those that flourish. Not surprisingly, such backfilled funds produce the illusion of superior performance — 500 basis points higher than contemporaneously reported figures.

Hedge fund investors may be wealthier and more sophisticated than the average investor. But they are still entitled to accurate numbers. The current selective drip feed of results from the hedge fund sector cannot be allowed to continue.

Japan Airlines needs a new flight path. It has no hope of breaking even without jettisoning huge debts, massive pensions obligations and a bloated cost base. Even a last-minute deal with its pensioners will not solve its problems. JAL should opt for bankruptcy.

JAL’s troubles are not new. It has reported losses in four out of the five past years. And in the first six months of 2009 alone it was some 131 billion yen ($1.5 billion) in the red.

Its shares are in a downward spiral. They have lost more than half their value this year as investors have baled out rather than wait for a government-engineered restructuring plan to deal with the losses, debts of $15 billion in debts and a $3.7 billion pension shortfall.

The only reason JAL is still flying is thanks to a 100 billion yen credit line from the state-owned Development Bank of Japan. This is meant to tide JAL over until a state-backed turnaround fund decides whether or not to support it. This could take between one and three months.

JAL’s pension hole is a major sticking point, with JAL’s president Haruka Nishimatsu warning pensioners and staff that unless they accept an average 40 percent cut in their pension payouts, the carrier will be forced into a court-led restructuring.

Faced with inevitable opposition from 9,000 pensioners and 17,000 JAL employees, the Democratic Party government of Prime Minister Yukio Hatoyama is considering legislation to implement such cuts.

Even if such a change in the law were possible, JAL’s problems require more drastic action. With too many planes, too many routes and a heavy cost base, the airline desperately needs to slim down.

JAL had cash reserves of just 95 billion yen at the end of the first half. It has admitted to problems meeting its loan obligations and its ability to continue as a going concern. JAL’s biggest creditors include the country’s three top banks.

JAL is trying to cut costs, but this will not be enough to see it through one of the toughest periods in airline history.

While there is value in JAL’s network in Asia — it is being courted by Oneworld alliance partner American Airlines, rival SkyTeam member Delta Air Lines and private equity firm TPG — only once it has been freed from the weight of its pensions and debts, will it be able to take-off again.

Given the rate of descent of its shares, investors are right not to wait for a long-winded government-led restructuring.

Why is passing healthcare reform so difficult? A big reason is that Democrats are trying to pay for a broad-based new entitlement without enacting a broad-based new tax. As the joke goes, the only real difference between Republicans and Democrats is that the Rs don’t want to raise taxes on anybody and the Ds want to clip only the top 2 percent.

But some Democrats have finally found a cause worth taxing the middle class for: the war in Afghanistan. A group of powerful House committee chairmen are pushing a graduated
income surtax. (A Senate effort would tax only the wealthy.)

The twin goals, backers say, are fiscal probity and transparency, especially now that it looks like President Barack Obama will be sending up to $34 billion worth of new troops to Afghanistan. As Barney Frank, House Financial Services chairman, puts it: “It’s important for people to understand how these wars are adding to our deficits.”

Nonsense. The same lawmakers supporting the war surtax also support a healthcare reform plan that is structured to hide long-term costs. No accounting trick is spared. Taxes are front loaded. Some spending is back loaded, while other spending is shunted to a separate bill.

No, the goal of the surtax is to drain public support for a war many Democrats think should be downgraded. And no doubt if this legislative effort proves successful, it would be tempting to eventually make the temporary surtax permanent.

Indeed, the whole effort could be laying the groundwork for a broad value-added tax that many centrist and liberal economists think necessary to shrink America’s long-term budget gap.

But why not take this opportunity to help pay for the war through spending cuts? It’s inside-the-Beltway wisdom that Congress won’t cut spending. But eventually spending will need trimming to deal with the long-term budget deficit without resorting to currency devaluation or inflation or huge tax increases.

Time for Congress to prove the common wisdom wrong and do the unexpected: Cut spending.

The "too-big-to-fail" amendment offered by Representative Paul Kanjorski has good intentions, but fatal flaws.

One I wrote about on Monday. Another is a section (see page 7) that gives systemically dangerous institutions (SDIs) the right to appeal regulatory orders in a federal district court. If they don't like the corrective actions that regulators instruct them to take, they could delay them indefinitely.

With bank resolutions, the key issue is speed. We learned that the hard way during the savings and loan debacle. Allowing banks to deteriorate until they have no capital left is like waiting for an infection to turn gangrenous before treating it.

With most companies, that's not a problem for anyone but shareholders and creditors. But banks aren't like other firms. Society provides them a strong, and expensive, safety net. And that safety net has expanded significantly in the last year.

In exchange, we rightly subject them to more stringent regulations. We guarantee their liabilities, after all, so we've the responsibility to control their assets.

As Ed Kane of Boston College told me: "We support them the way parents support children. It's our responsibility to discipline them."

So that regulators have the power to act quickly against plain-vanilla banks, Congress established the Prompt Corrective Action doctrine in 1991. It gives bank regulators extraordinary power to put the screws to banks before they dig themselves too deep a hole.

Banks may consult with regulators on what needs to be done. But the only judicial review available to them is through the court of appeals, which must review the administrative record of corrective actions that regulators have already instructed banks to take. And it must do so in an expedited manner, typically 30 days.

A similar doctrine to break up SDIs proactively is what many had hoped Kanjorski would propose. But the judicial review process it envisions would turn corrective actions into the SDIs' shield, rather than the regulator's sword.

For one thing, it would allow SDIs to challenge their regulator in a district court, not the court of appeals. A district court's review wouldn't be limited to the administrative record; it would likely include a trial by jury. First of all, this would involve a lengthy discovery process. And systemically dangerous institutions typically have the best, most expensive lawyers in the world. While regulators are tied up, they would have an even stronger incentive to engage in morally hazardous behavior, to shift losses to the safety net while looting whatever value is left in the institution.

Just look at the billions in bonuses that Wall Streeters paid themselves last year after their balance sheets were rescued by taxpayers.

Professor Bill Black of the University of Missouri Kansas City worries Kanjorski's judicial review process would effectively turn the district judge and jury into the regulator, a position for which they have no expertise. Would a North Carolina jury instruct Bank of America to take corrective actions that could lead to thousands of lost jobs in their area? Probably not.

Black says Kanjorski can improve his amendment by limiting SDIs' judicial recourse to an expedited review of the administrative record in front of the court of appeals.

Kanjorski's head is in the right place, even if his legislation is flawed. We need a new regime that encourages regulators to break up big banks before they threaten to bring down the system.

But his amendment makes the process too difficult. Already it erects a big roadblock by telling regulators they can only take action if an SDI "poses a grave threat to the (nation's) financial stability or economy."

By the time regulators realize a firm poses a grave threat, it's probably too late to do much about it. And if the firm can delay action indefinitely by going to a district court, then what's the point?

One residual from Timothy Geithner’s rough confirmation back in January — “Turbo Tax Tim” and all that — is that his political position is probably a bit more precarious than that of the typical newbie treasury secretary.

Not only has Geithner been a frequent target of late-night comedy shows, he’s the public face of the unpopular bank and automaker bailouts. High unemployment rate isn’t helping either.

No surprisingly, a new Rasmussen poll finds that 42 percent of Americans think Geithner has done a “poor” job handling the economy versus 20 percent who rate him “good or excellent.” And
the furor over his handling of the AIG bailout has yanked the competence issue back to the forefront.  So there is little political risk from calling for his resignation, as Representative Peter DeFazio, an Oregon Democrat, and several Republicans have done. But there seems to be little White House appetite at this moment for ousting Geithner, who certainly has no plans of his own for a fast exit.

And why would Obama cut him loose when doing so would be tantamount to a vote of disapproval in his own economic policies?

No one has charged Geithner with going rogue, after all. So blame the model, not the man, if you must. Not to mention a quick hook would stink of panic. Top cabinet secretaries of first-term presidents rarely leave before the midterm elections.

Nor does Geithner have much to fear from a whisper campaign to put JPMorgan CEO Jamie Dimon in the job. Despite the rumors, Dimon doesn’t want the gig. What banker would, given the current populist political climate?

It seems unlikely that radioactive Wall Street will be supplying Geithner’s eventual successor. More likely candidates: Rahm Emanuel, White House chief of staff; Janet Yellen, president of the San Francisco Federal Reserve; Lawrence Summers, director of the National Economic Council; and Roger Ferguson, CEO of TIAA-CREF and former Fed vice chairman.

But the calls for Geithner’s resignation, as well as stunts like the Congressional Black Caucus blocking a key House committee vote on financial reform, indicate a degree of desperation among congressional Democrats. They see high unemployment and dissatisfaction with Obama’s scattered focus on the issue as driving the anti-incumbent mood.

Unlike in sports, in government it’s the players, not the coach, who gets fired. And that’s why some Dems think one way to save their jobs in 2010 is by suggesting that Geithner lose his today.

The amendment is not very long: only 24 lines in the House’s mammoth draft legislation aimed at saving the financial system from itself. Still, it threatens to make an outsized impact on a critical source of market financing.

Representatives Brad Miller of North Carolina and Dennis Moore of Kansas have proposed putting secured lenders on the hook, should a failed big bank need more capital than it has on hand. On paper, it’s perfectly reasonable — after all, shareholders and creditors should be first in line to pay for some of the losses, not taxpayers.

Under the proposal, any assets pledged to back a secured loan “may be treated as an unsecured claim in the amount of up to 20 percent as necessary” to cover any losses of a bank in receivership that the government or resolution fund would incur.

That means a secured lender can only be sure to hold onto 80 percent of the collateral, with the remainder dependent on the going recovery value for unsecured debt. Lehman Brothers’ unsecured debt was worth less than a dime for every dollar, while Washington Mutual’s fetched only 57 cents, based on the settlement of credit default swaps following their respective failures.

Yet applying this broadly to all banks would also ensnare the repo market — $2.7 trillion worth of financing that greases the wheels of such mainstay markets as U.S. Treasury debt and mortgage bonds backed by housing finance giants Fannie Mae and Freddie Mac.

The repurchase agreement, or repo, market is a critical source of financing for dealers, hedge funds and others who use leverage to finance short-term trading positions. It’s a source of extra income for those holding virtually risk-free securities since they can squeeze out extra return by lending them out.

Such financing makes for a deeper and more liquid market that gives investors confidence that if they buy a Treasury note, for example, they can quickly sell it if they want to. When financial markets sour, investors pour into Treasuries not just because they believe the government will repay its debts, but because they can.

Under the Miller-Moore amendment, repo lending could also be vulnerable to a sizeable haircut should a financial institution fail. Blogger and colleague Felix Salmon has done some math here and says why he thinks it’s not such a bad idea here.

But introducing the risk of any such loss undermines the market, since the collateral backing the loans is supposed to be risk free. To be sure, this isn’t a completely safe market. At the height of the financial crisis, investors borrowing the securities didn’t return them when the loan expired, resulting in an unprecedented number of so-called fails.

The amendment also raises the possibility that it will create exactly what it’s hoping to stop: a run on a big bank. Joe Abate of Barclays Capital notes that secured lenders will hardly wait around for a bank to enter receivership; they’ll start cutting their repo transactions with a bank at the first whiff of trouble.

If lawmakers want to make the financial system stable when trouble strikes again, they should start with the basics — require bigger capital cushions at banks that need to be much smaller. Then let markets sort out the minutiae. If they still want to tinker, take up a hobby instead.

For all the fear that bankers have expressed about Representative Paul Kanjorski's amendment to end "too big to fail," the final text shows that they don't have much to fear. While the amendment gives regulators new power, it's unlikely they'd actually use it.

The Pennsylvania Democrat neuters his own legislation with a single line, which stipulates that for regulators to take action against a systemically dangerous institution (SDI) it must "(pose) a grave threat to the financial stability or economy of the United States."

But if the point is to break up systemically dangerous institutions pre-emptively, then we want regulators to tear them apart before they pose a grave threat. SDIs tend to fall into that category only after they're in trouble. By that point it's too late.

"There's no political constituency for bank soundness regulation until it's too late," says Professor Richard Carnell of Fordham. "Regulators will tend to do what's politically expedient. During good times that means carrying on business as usual."

I don't suspect any regulator today would say that Goldman Sachs poses a grave threat to financial stability. Yet the complexity of its operation and its interconnectedness with the rest of the financial system means that it clearly has the potential to. That may be a fine distinction, but in practice it's one regulators will be likely to hide behind.

Another problem with Kanjorski's amendment is that it pollutes bank regulation with politics. The Treasury secretary would have to sign off on resolutions over $10 billion and the president on resolutions over $100 billion.

Walker Todd, a bank expert at the American Institute for Economic Research recently told me: "It's been my experience over the last 35 years that examiners in the trenches identify the problems in banks quickly. They dutifully pass their concerns up the line, but their criticisms often get wiped away or tamped down for political reasons."

Examiners do their job well, but politicians get in their way.

I'm torn. At a visceral level, I like the idea of using TBTF status as a hammer to shatter SDIs into pieces. But if this is the best we can hope for, then perhaps it's better to focus on other structural reforms that will make banks safer and less complex.

Putting OTC derivatives onto exchanges, strengthening capital (the Miller-Moore amendment is a good start), splitting commercial from investment banking, establishing some sort of exposure rules so that SDIs can't have too much exposure to any single counterparty. But that's a wish list that will never get done. In the end, I suspect the only way we'll rebuild a sound financial system is after the one we have blows itself up.

It may be fantasy M&A, but little GFI Securities has a suggestion for putting Cadbury and Hershey together without bankrupting the buyer. Compared to the blunderbuss approach from Kraft, it’s elegant and at least provides some food for thought.

The idea is the dual listed company (DLC), a corporate structure that allowed Carnival, the world’s largest cruise line, to take over P&O Princess. Like Cadbury, P&O was a FTSE100 company, and, through the DLC, has been replaced by Carnival in the index.

It’s obvious that Hershey is culturally and philosophically the best partner for Cadbury, assuming it is obliged to find one. But Hershey is too small to pay cash, while a Pennsylvania law requires the Hershey Trust to retain control of the business.

GFI proposes that Hershey tenders for 11 percent of Cadbury shares at a big premium, followed by a merger of operations, with existing Cadbury shareholders owning 55 percent of Cadbury-Hershey. The vexed issue of control might be tackled by special provisions in the DLC, or by differential voting rights between Cadbury-Hershey plc and Cadbury-Hershey Inc.

This is head-banging stuff, even before the little matter of constructing a tax-efficient DLC, something GFI admits would be “highly complex”. In practice, the firm can expect little more than an acknowledgment of its letter to Todd Stitzer, the Cadbury chief executive.

Yet it should not be dismissed out of hand. The argument in this takeover battle so far has all been about what price Kraft needs to pay to win, but few doubt what would happen to Cadbury if it did so. The UK employees are right to be apprehensive.

Kraft cannot afford an all-cash offer, and UK shareholders tend to sell foreign equity issued in takeovers. Besides, Cadbury is the only way sweet-toothed British investors can find exposure to the sector, and the bulls believe it will be eventually worth much more than 820 pence, the price at which many expect Kraft to win. There is a long way to go with this bid, but something like GFI’s proposal might produce a happier ending than death by cheese slices.