What the Goldman Sachs case really shows

The issues go beyond fraud and strike at the heart of how capital markets work

FIRST, a quick re-visit of subprime mortgages. These were packaged together and then resold as collateralised debt obligations (CDOs), which carried higher interest rates than the mortgages based on the principle that diversification reduced risk.

But when you diversify assets you must have different kinds of assets. You could diversify within property but concentrating assets in less than prime real estate where default risk is relatively high is not the best way to do it.

To make these instruments more palatable, investment bankers such as Goldman Sachs and others got the largest insurer in the world, AIG, to insure them, and why they agreed is anybody’s guess.

To make matters worse, what happened was the creation of synthetic CDOs which effectively gives a holder exposure to the CDOs without actually owning any of the securities issued in relation to the CDOs. This is done through the issue of credit default swaps or CDS, a derivative product.

While the actual operations of these are complex – even some of the bankers could not understand these - their effects are not difficult to understand. Basically, a large number of institutions took leveraged bets by buying these instruments both for capital gain and yield.

When the real-estate bubble burst, the loss was greater than the loss in the value of the real-estate assets because derivative instruments traded based on these assets far exceeded the value of these assets.

Not surprisingly, those who were left holding the assets and the derivatives collapsed – some of the biggest names in the US – requiring an unprecedented rescue by the US government, which effectively injected hundreds of billions of dollars directly.

The latest episode, where the US Securities Exchange Commission or SEC is filing civil action against Goldman Sachs for fraud may well be the tip of the iceberg and eventually other financial institutions may be similarly charged.

But really, for those who watch the financial markets and the predatory types of profits that hedge funds, investment banks and others were seeking by engineering all kinds of incomprehensible financial products and market manipulation in some cases, this action comes as no surprise.

That Goldman Sachs may have sold a financial derivative to one client while helping another client short the product is quite a clear example of how the company took money from both sides. The end result was the hedge fund that took the opposite bet made US$1bil at the expense of other investors.

It is pretty difficult to estimate how prevalent this practice was among other investment banks but this action by the SEC is going to put a lot of them under the microscope.

Public opinion is already against the financial shenanigans that brought the mighty US financial institutions to their knees and this latest episode will make it even more so.

One good thing that hopefully will come out of this is that the authorities in the US will no longer be duped by the capitalism mantra into believing that deregulation is the way to go.

Events in recent times clearly show that those institutions that take massive deposits from the public must be closely watched to see what they do with that money and what kinds of products they put on the market and the kind of risks they carry.

Profit is fine so long as it is within the limits of the law, is ethical, within the limits of acceptable risk and does not destroy the very fabric and functioning of the markets from which it comes. More than anything else, both individuals and institutions have to be held to greater account in their behaviour.

There, here and everywhere one thing must be kept in mind: the role of the capital markets is to efficiently intermediate the allocation of capital between those who have too much of it and those who have too little of it. Profits are merely the by-product of this.

A Question of Business
By P. GUNASEGARAM

● Managing editor P. Gunasegaram feels that too often we do not see the forest for the trees.

Productivity and talent management

Productivity growth can make the years ahead much more prosperous

FOR 50 years, sustained growth in Malaysia was based on ever-expanding use of manpower and accumulation of fixed capital assets. Basic economics tells us this business model will eventually give way to the law of diminishing returns, that is, when increasing injections of labour and capital lead to lower rates of additions to output with each passing year.

The message: We can’t be expected to grow efficiently by simply doing more of the same.

To become an increasingly higher-income nation, we need to shift from the “old” resource-based economy to one that is innovation led. Empirical evidence suggests that the old strategies have delivered steadily worse results.

On the other hand, innovation is known to have driven one-half of US productivity growth over 60 years. McKinsey Global Institute notes: “Those innovations – in technology as well as products and business
processes – boosted productivity.” For us, only innovation can be relied upon to drive exponential growth.

By innovation, I mean fresh thinking and approaches that add value to consistently create wealth and social welfare. In the end, innovation drives productivity, and productivity drives the flow of real income.

History teaches us that a burst of productivity growth can make the years ahead much more prosperous. With higher pay, workers can still save and yet have enough left over to spend more to raise living standards.

However, economics is unsure about the predictability of innovation and productivity. Investors are notoriously fickle and entrepreneurs’ serendipity, usually random.

Then, there is the speed with which new products and services can be rolled out and brought to market. It was Paul J. Meyer who said: “Productivity is never an accident. It is always the result of a commitment to excellence, intelligent planning and focused efforts.” Perhaps, this can help make productivity growth somewhat more predictable.

In the United States, studies by my econometrics professor at Harvard, Dale Jorgenson, pointed to technology advancing less fast than in the decade before the recent recession. Consequently, productivity can be expected to slacken to around 1.5% annually, yielding potential GDP (or gross domestic product) growth for the United States as a whole at about 2%–2.5% a year over the next few years.

Nothing spectacular, but much better than Japan during the recent lost decade. As of now, continuing high unemployment and rising US GDP growth in the fourth quarter of 2009 and the first quarter of this year means an abrupt 7% annual rate gain in productivity. This reflects in part a reluctance to hire given the uncertainties. There was a similar knee-jerk reaction during the 2001 recession.

A rebound in electronics demand suggests perhaps the wave of technology advances that fuelled productivity in the years prior to 2008 may have some steam left.

Most now see Asia reviving nicely this year. This year’s first-quarter results and forecasts for the year are rather robust, thanks to government stimuli. The Asian Development Bank (ADB) and the World Bank now talk about 7.5%–8.5% growth for the year (5.5%–6% ex-China). But India and East Asia (China, South Korea, Taiwan) display more impressive productivity growth. Within Asean, the underlying productivity profile remains anaemic, especially the more mature among them.

For Malaysia, productivity growth averaged below 1% a year over past 20 years. That’s a setback. Hence, there is resurgent talk of reform and rebalancing in search of new directions. The ADB suggests finding ways to “shift the drivers of growth”.

Today, China and India are where the action is – they provide the learning laboratory for innovative practices and processes.

As Professor Bill Fischer of IMD (Switzerland) puts it: Whereas Japan’s management revolution was all about “lean”, China’s is all about “speed” – faster to produce, faster to market, faster across markets, faster to expand.

Today, China uses its competitive advantage and “Chineseness” to do things better. But not through conventional blockbuster innovation.

Government as an enabler

There is no prescription for how a country can create a culture of innovation and competitiveness. According to Joseph Stigliz, the 2001 Nobel laureate: “…But government does have a role – in education, in encouraging the kind of creative and risk taking that the scientific entrepreneurship requires, in creating the institutions that facilitate ideas being brought into fruition, and a regulatory and tax environment that rewards this kind of activity.”

Ironically, the US prowess in innovation owes much to government support. As Harvard professor Josh Lerner tells it, the early development of the Silicon Valley emanated from Pentagon contracts. As did the Internet, which grew out of a defence project initiated in 1969.

In Malaysia, development of new industries and restructuring of old ones (creative destruction) often require a nudge from the government in terms of subsidies, loans, infrastructure and other support.

In order to be successful, the government needs to (i) create a conducive climate for public-private collaboration – or as Harvard’s Dani Rodrik puts it: It requires a government “embedded” in the private sector, but not in bed with it; (ii) incentivise innovations with “rental” rewards through a credible patent system; and (iii) ensure “public goods” serving society are promoted in a transparent fashion.

Venture capital

From Asean to northeast Asia and from India to Japan, the big risk to innovative ventures remains the lack of ready access to finance. The onset of the great recession and damage done to the financial system have exacerbated this risk. Firms which depend on bank credit and private equity have been particularly vulnerable.

A recent IMF (International Monetary Fund) study of North American manufacturers estimates that a 1% rise in the corporate bond rate can lead to a 0.25% fall in productivity. This is a big deal.

Worst hit is venture capital (VC). During the best of times, VC funds were already hard to come by. In recent years, reflecting big losses (by foundations and endowments) on hedge funds, private equity, and stocks and shares, venture financing has become more risk-averse.

The same story hits Asia since innovative ventures are forced abroad for financing, even in cash-rich Japan. Worst hit are angels, early start-ups and intermediate-stage start-ups.

In Malaysia, the situation is worse. The bulk of VC monies comes from the government and start-up funding is virtually non-existent in practice. Not only are governing boards and top management of VC funds risk-averse, their fear of loss on their watch scares them.

Furthermore, the environment is set in a culture that does not readily take on risk. As I see it, a government that takes no risk in promoting innovative ventures is one that is likely to make the bigger error of not trying hard enough.

All is not lost. Studies at Harvard Business School have shown that venture financing during and soon after recessions is more successful per dollar spent in practice, than during booms when money flows easily. Indeed, entrepreneurship is resilient to business cycles, partly because many turn to self-employment when laid off or offered a chance to take on risk.

I am told that 40%–45% of corporates listed in the Fortune 500 were born during recessions. As one involved with VCs, I find little comfort in this. I certainly won’t bet on it.

Talent management

Human capital lies at the core of innovation. Raising productivity requires a labour force of high calibre – committed, motivated and skilled enough to drive transformational change based on excellence over the long term. It’s about trapping potentials through acquisition of new skill sets in designing new products and services, and devising new processes and systems to do things smarter and more efficiently. That’s what talent management is all about.

In terms of outcomes, this simply means encouraging businesses to invest in R&D, design, automation, software, training and the accumulation (also acquisition) of intellectual property. Concomitantly, we also need to pursue initiatives on the flip side – promote angel investors and start-ups through an incentive regime that rewards risk taking.

Angels nurture start-ups very early. Their involvement goes beyond funding. They provide hand-holding, mentoring, coaching, and access to business networks. Indeed, this link turns innovative ideas into commercial propositions.

All these need ready access to a talent pool of critical skills and expertise. They make the difference between success and failure; the difference between quality and quantity. In the end, they deliver products and services better, smarter and faster. That’s what productivity is all about.

The Economist Intelligence Unit’s August 2009 global survey on talent strategies identified critical constraints on talent in an enterprise’s capacity to innovate.

Externally these are (i) intense global competition, (ii) rapid turnover, and (iii) rising cost, whereas the internal limitations are (a) lack of collaboration and resource sharing within an organisation, and (b) business and talent strategy not aligned. They reflect the war on talent out there.

In today’s world, I believe competitive enterprises can’t afford to be insular. Indeed, they need to look outside for talent to survive. China and India are wooing their national talent from North America where they have been entrepreneurial drivers. Other parts of Asia are doing the same. Indications are that host advanced nations are fighting back.

They may not have to fight too hard. Between 1997 and 2002, I am told, close to two-thirds of foreigners who earned PhDs in science and engineering in the United States are still there. The “stay rates” are much higher among Chinese and Indians (80%–90%).

Talent scarcity is a global issue. It’s not confined to developed nations, where it’s very serious. By 2050, for the first time, sixtysomethings will exceed 15-year-olds or younger. Even populous nations like India and China lack skilled professionals. The high skills gap reflects inadequate quality education and education mismatch.

Malaysia is reported to have lost up to 400,000 (mostly professionals) to emigration over the past two years. We are told that one to two million Malaysians work abroad (again, mainly professionals).

In his book, The Flight of the Creative Class, Professor Richard Florida states that skilled immigrants gravitate to global “talent magnets” centred on major cities which are open, tolerant and liberal with attractive living lifestyle.

He argues that as a “third-tier” global city, KL cannot engage successfully in the war on talent. To evolve into a human creative hub, KL’s ecosystem and outlook on excellence need to be radically transformed to reflect the true spirit of the New Economic Model.

This will require strong leadership, steadfast political will, and lots of time. Until this commitment is translated on the ground, Malaysia’s success in the talent war remains a serious challenge. Yet, without an adequate talent pool, innovative-led growth can only be sub-optimal.

What Are We To Do
By TAN SRI LIN SEE-YAN

● Former banker Dr Lin is a Harvard-educated economist and a British Chartered Scientist who now spends time teaching and promoting the public interest. Feedback is most welcome at
starbizweek@thestar.com.my.

US spacecraft sparks arms race concerns

Space plane can 'help launch space weapons, be used for anti-satellite purposes'

 

BEIJING - The latest spacecraft launched by the United States has triggered concerns over a new arms race in space that could jeopardize world peace, Chinese military researchers said on Friday. 

The US Air Force launched unmanned spacecraft X-37B with a rocket from Florida's Cape Canaveral Air Force Station on Thursday evening local time, media reported. The spacecraft is designed to fly in low orbit for as long as nine months. 

The X-37B looks like a space shuttle orbiter, with a similar shape and payload bay for cargo and experiments. But unlike US space shuttles that can stay in orbit for only about two weeks and are costly to maintain, X-37B can reportedly be used repeatedly with less costs. 

The space plane is meant to serve as a test platform for unspecified experiments before gliding to an autonomous runway landing, the US Air Force said. 

The US military has only made the general description of the mission objectives of its latest space launch public - to test of guidance, navigation, control, thermal protection and autonomous operations in orbit, re-entry and landing, media reported. 

"This launch helps ensure that our warfighters will be provided the capabilities they need in the future," said Colonel Andre Lovett, a launch official and vice-commander of the Air Force's 45th Space Wing, in a statement on Thursday. 

However, the ultimate purpose of the X-37B and details about it remain a mystery. 

Experts said the spacecraft is also intended to speed up the development of combat-support and weapons systems. 

The spacecraft is the world's only reusable operational spaceship and "an important breakthrough of space technologies", said Zhao Xiaozhuo, a research fellow of military studies under China's Academy of Military Science of the People's Liberation Army. 

The space plane is considered to hold potential military value as it can serve combat-support systems and become a platform for launching space weapons, Zhao said. 

It can also be easily used for anti-satellite purposes, he said. 

"As a superpower, the US has been calling for nuclear disarmament all these years and urged other countries to be more responsible for world peace and safety," Zhao said.

"But in the meantime, its development of the space plane may lead to an arms race in space." 

Zhai Dequan, deputy secretary-general of the China Arms Control and Disarmament Association, said the impact of the space plane "may not be serious enough to trigger an arms race in space", but it has demonstrated US resolve to take a leading position in it. 

"The US has previously said that it would slow down the pace of developing the space plane project. But now with the launch, it shows the US has never really slowed down," Zhai said.

The space plane has the potential to destroy other nations' satellites, which will help the US take the lead in space, he said. 

"China has always insisted on the peaceful exploration of outer space," Zhai said.

"It is urgent for all countries to reach an agreement to avoid weaponizing outer space."

By Xin Dingding (China Daily)
Updated: 2010-04-24 06:46

AP contributed to the story.

CHINA DAILY