Offshore News Digest for Week of December 3, 2007

THE EASTERN EUROPEAN HOUSING BUBBLE

An opportunity to lose one’s money in a new exotic location beckons.

As a student of speculative manias and bubbles, I have been lucky enough to witness two giant bubbles during my 10-year stay in the U.S. The dotcom-telecom bubble burst loudly and now the residential real estate bubble has grown too large and extended to support itself as well. Now we are once again witnessing another speculative bubble. This time, it is in Eastern European real estate.

When I returned back home to Bulgaria in late 2004, people everywhere told me that real estate was definitely the best investment. I also heard that real estate is the safest investment – real estate prices never go down, right? Anytime I tried to object, people informed me that I was just citing textbook stuff that did not apply to Bulgaria. This was not the time to be theoretical, but to make money in real estate. Average annual gains in previous years ran about 25-35%, and things were only going to get better. Bulgaria was to enter the EU in 2007, so Western Europeans were on the verge of rushing to buy our real estate at sky-high prices, thereby making us all rich.

Everybody was convinced that real estate prices in Sofia, the capital of Bulgaria, would reach those of Prague and Budapest, which in turn were supposed to reach those of Rome and Berlin in the not-too-distant future. Everyone was investing in real estate ... with borrowed money, of course. The smartest and most educated were buying two or more properties, using the first one as collateral for the second, and the second one as collateral for the third. They were the undisputed geniuses that invented the way to pyramid one financial asset on top of another. Many of them, however, had never heard of Charles Ponzi.

The ultimate objects of speculation were resort properties on the Black Sea, where the majority of Western and rich Eastern Europeans will spend their summer vacations. God has blessed our Black Sea with beautiful scenery, sandy beaches, and a perfect climate, and property prices proved it. Prices rivaled those in Florida’s Miami Beach. Everywhere, people assured me that this was not a bubble, but sound financial investing based on solid fundamentals. Fundamental analysis, however, indicates that that real estate in Bulgaria is indeed grossly overvalued. Let me explain ...

What constitutes a real estate bubble?

Real estate has two fundamental indicators that provide the serious analyst with guideposts: (1) the rent-to-price ratio and (2) the price-to-income ratio. Rent-to-price divides annual rent from the property into its purchase price, giving the yield or current return on the investment. 100 years of U.S. history suggests a normal yield of around 10-12%. Property gets cheap when yields approach 15-20%, while yields lower than 6-8% suggest overvaluation and bubble territory. Over the last 3 or 4 years, yields in Bulgaria hovered in the 3-4% range, suggesting a strong bubble.

The price-to-income ratio tells how many years of pretax annual earnings are necessary for a household to purchase a house. The historical rule of thumb is that one annual income indicates undervalued properties, two annual incomes normal valuation, and three annual incomes overvaluation and bubble territory. Currently, this ratio for most regional markets in the economy is around 7-9, which is once again indicative that real estate is extremely overvalued.

Thus, both indicators confirm that there is a real estate bubble across Bulgaria, although few analysts there would acknowledge the importance of these ratios. Interestingly, when many analysts consider the fact that real estate earns less than a bank deposit, they immediately respond that rising prices more than compensate for the low yield! This is bubble psychology at work.

Macroeconomic fundamentals look terrific from one point of view and terrible from another. With steady money supply growth rates of 30%, mainstream economists counter that a currency board manages the Bulgarian monetary system, so inflation is impossible, because the government does not print “unbacked” currency. Credit has been expanding steadily for many years at a phenomenal 50% rate, driving a wild boom destined to turn into bust. Mainstream analysts would counter that the initial credit base 5-8 years ago was abnormally low, so that the credit and banking system has a lot of catching up to do, and that these healthy credit growth rates indicate strengthening confidence in our banking system.

For many years, mortgage growth was 70-80%, which makes me firmly believe that a wild real estate bubble is in the making. I also worry that current account deficits have reached nightmarish proportions at 20% of GDP, so the collapse of the currency board and the economy is a certainty. Finally, I point to the crisis proportions of the foreign debt, currently standing at 100% of GDP. Mainstream economists claim that strong mortgage growth underpins growth in the real estate sector and the economy, and that trade deficits do not matter – we are now part of larger Europe. A sound analysis indicates that the economy is bound to collapse in the near future, while a government-endorsed analysis concludes that everything is great and will get even better.

This gets us to Eastern Europe. One may confidently claim that practically all of Eastern Europe, mostly for similar reasons, is in a giant real estate bubble that is beginning to crack. The big picture shows the real estate bubble slope runs from the U.K. to Bulgaria. The explanation: Early in the decade, the beginning of the bubble was in Great Britain. Weak German and French economies forced the European Central Bank to maintain abnormally low interest rates for many years.

This fueled real estate bubbles across the stronger Mediterranean economies – Spain, Portugal, France, Greece – and, later on, in Western Europe. These bubbles in turn spread across Eastern Europe, first in the Czech Republic, Poland, and Hungary, and later on in the Baltic countries (Latvia, Lithuania, Estonia) and the Balkans (Romania, Serbia, Bulgaria). For all practical investment purposes, the real estate bubble has not spared a single country in Europe.

Anyone looking at the U.S. real estate market before 2005 could have probably seen the same thing coming. Investors should steer clear of Eastern European real estate, unless of course they would like the opportunity to lose their money in a new exotic location.

THE COMING CHINA CRASH

While the Chinese stock market, as measured by the China Securities Index 300, is down 18% since October 16, that follows a period since January 1, 2006 during which the CSI 300 had soared 535%. Chinese economic growth is currently running at over 11% and the big money is convinced that it will continue, while the country’s foreign exchange reserves are $1.4 trillion, the largest in the world.

A crash would appear to be imminent!

Bears on China have been common for the last decade, and their track record has not been good. To take just one unfair example, Henry Blodget, the former Internet genius, wrote in Slate in April 2005, “You’ve probably been daydreaming about the fortune to be made in Chinese stocks. Well, keep dreaming ... you’ll eventually conclude that you could have done better selling insurance in Toledo.” That was about six months before the Chinese market took off.

To see why a crash may be coming, it is worth examining the behavior of the China Investment Corporation, the $200 billion sovereign wealth fund set up by the Chinese government in September. Now $200 billion is a fair chunk of cash. You could almost buy all but three U.S. corporations with that (at today’s prices, ExxonMobil, General Electric, and Microsoft – 4-5 others including Google barely top the bar.) Six weeks ago, the power of sovereign wealth funds was celebrated and China Investment’s moves into the market were awaited with bated breath.

So much for that. A third of China Investment’s portfolio is to be invested in Central Huijin Investment Company, a purchaser of bad loans from the Chinese banks, and another third will recapitalize China Agricultural Bank and China Development Bank, to shape them up for privatization. $3 billion of the fund was invested in the private equity manager Blackstone in May – that may have bought China useful political contacts, but it is now worth $2 billion. And the remainder is being invested very carefully, primarily in U.S. Treasury securities – which are also losing money steadily in yuan terms.

The lackluster investment strategy of China Investment exposes a central flaw in the Chinese economy, its lack of a rational system of capital allocation. For more than a decade, Chinese state-owned companies have made losses, and have been propped up by the banking system. Since 2004, loss-making state-owned companies have been joined by overbuilding municipalities, erecting white-elephant office blocks in attempts to turn themselves into the next Shanghai. None of these losses have resulted in bankruptcy. Instead the cash flow deficits have been covered by the Chinese banks. As a result, the Chinese banks have an enormous volume of bad loans – $911 billion at May 2006, according to a later-withdrawn estimate by Ernst and Young, which must surely have ballooned to $1.2-1.3 trillion now.

That explains why China Investment is somewhat un-aggressive in its international investment strategy. China’s $1.4 trillion of reserves are in fact almost all required to prop up the banking system, when the inevitable liquidity crisis occurs. If the banks are to survive, China Investment will have to be followed by six more sovereign wealth funds of equal size, each of which will have to abandon its attempts to take over Exxon or Google and pour its money down domestic rat-holes.

A $1 trillion problem in subprime mortgages has caused even the U.S. money market to seize up and has required frequent applications of salves by the Fed. Since China’s economy is around 20% the size of the U.S.’s, the Chinese banking system’s bad debt problem is in real terms about five times that of the U.S. – about 40% of its GDP.

We have seen this movie before. The Japanese banking system’s bad debts after 1990 totaled around $1 trillion, about 30% of Japan’s GDP. The result was the bursting of the 1980s bubble and a period of little or no economic growth that lasted well over a decade. Admittedly the Japanese authorities made matters worse, by refusing to face up to their bad debt problem and issuing more government bonds to fund witless Keynesian public spending schemes.

Nevertheless, we can have very little confidence that the Chinese authorities, once the same problem stares them in the face, would do any better. After all, at least one of the alternative policy mixes, that tried by Herbert Hoover and the Federal Reserve in 1930-32, proved very much worse. If China faces the choice between a decade of stagnation, as in Japan from 1990-2003, and a decade of economic collapse, as in the U.S. from 1929-1940, it will rightly prefer the Japanese alternative.

It may not have the choice. One of the factors that kept Japan out of real trouble in the 1990s was continued strong growth in the U.S. and world economies. Its magnificent export industries were able to continue growing, albeit at a slow rate, and provide a certain amount of traction for the economy as a whole. However, China will find it difficult to do the same, since the next decade does not seem likely to be a period of robust world growth. Far from it. The U.S. seems fated to endure at least a few years of very sluggish growth due to its housing market crash, and Britain appears to be in a similar mess, so even relatively robust growth in the resurgent economies of Germany and Japan may not be sufficient to keep Chinese exports growing.

At that point, China will have two alternatives. It can allow the banks to work their way out of their bad loans, condemning the domestic economy to probably a decade of little growth and extremely tight credit (high Chinese savings would alleviate this problem, but they will be trapped in the Chinese banks because the authorities foolishly do not allow Chinese citizens to invest abroad). Alternatively, it can inject more or less its entire foreign exchange reserves into the domestic banking system in order to recover its bad debts. That would allow the Chinese economy to continue expanding, but at a cost of devastatingly high inflation from the additional money pumped into the system.

We have seen societies with low economic growth, very high inequality (as China has now) and persistently high inflation. They are collectively known as Latin America. Since China also has much of the corruption that bedevils Latin America and its government lacks any genuine understanding of the free market and is increasingly dominated by special interests, it may indeed be fated to follow a Latin American growth path for the next few decades, with a tiny entrenched elite enriching itself at the expense of the disfranchised masses. That would be the worst possible outcome for the Chinese people, but it is not by any means impossible.

Many observers of the current U.S. financial market downturn comfort themselves with the thought that the world now has more than one growth engine, and that China, with four times the U.S. population, can because of its very high growth pull the world economy along sufficiently even when the U.S. stalls. However, if China is about to incur the inevitable backlash from its recent debt and equity bubbles, during which practices have flourished that have no place in a well functioning free market, then we may be entering a world in which the two main growth engines of the last decade are both broken. Growth in such a world will be truly sluggish and inflation high, as the world struggles to cope with the effects of an excess of cheap money now grown toxic.

Major recessions tend to produce foolish political reactions. In the U.S., it seems likely that a major recession would produce resurgent protectionism and an aversion to world trade, which to the voting public will appear to have been responsible for the loss of millions of good U.S. jobs without any corresponding gains to the living standards of the majority. Japan, bless it, remained admirably politically stable during its sluggish decade, and eventually found a leader in Junichiro Koizumi who was able to lead it back into renewed growth.

In China, there can be no assurance whatever that a populace whose living standards have suddenly stopped improving will not turn to violent nationalism and/or counterproductive economics. Since the country is not a democracy and not likely to become one, the authorities are likely to react to hardship as did Vladimir Putin to the chaos of late 1990s Russia, imposing even more draconian repression and seeking a military adventure abroad to occupy the masses of disaffected youth and distract the public from its new poverty. That too would produce a future in the West far worse than would be cased by a mere domestic recession.

Bears who weary of observing the chaos in the U.S. financial markets can cheer themselves up by looking at China. There will be more than one source of the oncoming world downturn.

TABLES TURN ON SINGAPORE’S PIONEERING SOVEREIGN-WEALTH FUND

Thanks for the help, now get lost.

Temasek’s Singaporean chairman, S. Dhanabalan, rarely gives interviews, so when he issued three golden rules on overseas investments in the Straits Times this month, it was worth paying attention. Temasek is one of the earliest and biggest of what are now called sovereign-wealth funds, and is watched closely by its peers. His message was not an uplifting one.

Mr. Dhanabalan said that as a result of the impact of rising nationalism on sovereign-wealth investments, Temasek would no longer seek controlling interests in companies outside Singapore, would use local partners and consider the “emotional sentiments” that may be aroused by its acquisitions. All sensible stuff, to be sure. The trouble is, he was speaking after an adverse Indonesian ruling that penalized Temasek even though the company’s investments met all three of those criteria.

Antitrust authorities charged Temasek with monopolizing Indonesia’s telecommunications market, even though it had indirect minority holdings, used a local partner (the Indonesian government) and the stakes were bought at a time, after the Asian financial crises in the late 1990s, when its money was more than welcome. If an appeal fails, the penalties include fines and a forced sale of its interest in either Indosat or Telkomsel, both prized assets. It follows another embarrassing struggle over a Temasek investment in a Thai telecommunications company purchased from the family of Thaksin Shinawatra, then the prime minister. For Temasek, political risk is on the rise.

The Indonesian investments were made in 2001 and 2002 through two Singaporean companies in which Temasek was the majority shareholder: SingTel, the old national carrier which is well respected for its management and technology, and a technology conglomerate, STT. Each bought a minority stake in an Indonesian mobile carrier. At the time, the country was still fighting its way out of a financial crisis. No longer. It is now booming, and the two assets are coveted jewels. Share prices in one of them, and those of the listed parent of the other, have quintupled. Indonesia adds 2 million new subscribers monthly, but there is still room to grow because of low penetration. To some degree, SingTel has replicated its success by buying stakes in mobile-phone firms throughout Asia.

The case against Temasek was hardly straightforward. Mobile phone calls in Indonesia are getting cheaper. Even though the companies in which Temasek has ties control 80% of the market, they are fighting off more than a half-dozen well capitalized competitors. The original plaintiff in the case against Temasek dropped out. One judge on the 5-person adjudication panel wanted the charges dismissed, but he was replaced.

However quirky, this may not be the last such case to bedevil sovereign funds. They like big, privatized assets, such as telecoms firms, and they like them cheap. Such assets, however, are also politically sensitive, as Temasek has learnt to its cost. The lesson is clear. In bad times its money was welcome. In good times, less so. Other funds with an eye on distressed markets in the West should bear that in mind.

INDIAN BANKS REFUSE DOLLAR LOANS TO EXPORTERS AS COST RISES, FUNDS SOURCES DRY UP

Credit crunch’s effects fan out.

MUMBAI: Banks have stopped giving dollar loans to exporters. According to banking industry officials, they can no longer afford to offer dollar loans as their own foreign currency credit lines have dried up.

Indian banks have been drawing foreign currency credit lines from international banks to lend to local exporters. Now, with the subprime fiasco severely impacting the global money market, high-street banks in the U.S. and Europe, even reluctant to lend each other in the term money market, are in no mood to extend credit lines to Indian banks.

And even if they do, it will be at a price that is higher than what local banks can charge exporters. Under the RBI norms, banks can charge a maximum of London inter-bank offered rate (Libor), plus 1% for dollar loans, commonly called packing credit in foreign currency (PCFC).

“Liquidity has become so tight that we would be losing money if we give PCFC loans to exporters,” says the head of trade finance of a private bank. Exporters use PCFC loans to process goods as well import raw materials. Since the interest on such foreign currency loans are significantly lower than rupee loans, PCFC helps them to save on cost.

WHAT WE CAN ALL LEARN FROM DISNEY WORLD

Over the years, your business correspondent has endured cross-country flights in coach, spent sleepless nights in four-star hotels where room service stopped at 11 p.m., and trekked to conference rooms all over Manhattan. I have just returned from what is likely to be the most harrowing investigative jaunt of my career, a 4-day slog through teeming streets filled with screaming children. For half a week I subsisted on unhealthy, borderline inedible fare and endured the torture of loud, repetitious music and unbridled sincerity.

Yes, I survived Disney World.

Critics charge that Disney’s parks are nothing more than some ersatz version of reality, carefully constructed capitalist fantasylands that shut out unpleasant realities. (In other words, they are a lot like Wall Street before the subprime mess hit the fan.) But Disney World, an immensely successful enterprise, clearly has a lot to teach about the realities of business. In fact, for 21 years the Disney Institute has offered businesses “the tools to apply proven systems and strategies to their own organizations.” Case studies show Disney has helped the accounting firm PricewaterhouseCoopers boost retention rates among interns and assisted General Motors’ efforts to improve customer satisfaction at dealerships.

But many businesses and other large organizations would be well-advised to just stop spending millions of dollars on the services of McKinsey and other management consultants, and instead drop $248 on a 3-day Park Hopper pass.

Airline executives should rush to the Haunted Mansion in the Magic Kingdom. Our heads sank when we approached and saw the sign advertising a 15-minute wait. Despair turned to elation when we were ushered into the spooky entry hall in just a few minutes. This experience was repeated time and again – at rides and restaurants – where promised delays of 20 minutes miraculously shrank in half. After a few days, it became apparent that this might be a conscious strategy of underpromising and overdelivering. Which is precisely the opposite of the tack airlines have taken lo these many years. The carriers continually promise that planes will leave or arrive at a specific time, when they know the probability of an on-time departure is only slightly greater than the probability of your suitcase being the first item to hit the luggage carousel.

The blanket assertion that government should be run more like a business is frequently unconvincing. (What if the FEMA were managed like Enron?) But the brass at the Department of Homeland Security, from Secretary Michael Chertoff down to the surly guards at La Guardia who single out 8-year-old girls toting pink backpacks for extra scrutiny, should spend a day at Disney’s efficiently managed borders. The land of Mickey tightly controls access to its 30,500 acres through a system of checkpoints and turnstiles that combines state-of-the-art technology and old-fashioned humanity. Disney’s border crossings, which in 2006 managed the flow of 49 million through the complex’s six principalities, are equipped with biometric identification. Adult guests cannot enter unless they first scan their index-finger print, which must match prints already on file. The border guards smile effusively at the foreigners who have come to spend money heedlessly on their shores.

Finally, every CEO should take at least three or four rides on It’s a Small World and then spend the rest of the day in Epcot. For years, the U.S. has been shrinking as a global economic force, a trend that is accelerating with the continuing boom in Asia and the domestic slowdown. For more and more companies, future growth and prosperity will depend on penetrating foreign markets. But Americans are not so much innocents abroad as ignoramuses abroad. A day at Disney can remedy all that. Epcot allows visitors to immerse themselves in the cultures and cuisines of 11 countries, from Mexico to Norway, in 40 compact acres.

Of course, it should be noted that despite the great efforts made to create authenticity, Epcot does not provide a uniformly realistic experience. In Epcot’s European countries, the dollar still retains some value.

BRITS HEAD FOR THE WILD BLUE YONDER

A study carried out by Datamonitor, on behalf of Overseas Property Professional magazine has found that British and Irish citizens now own 3.81 million properties overseas (excluding time share and fractional ownership), with 1.21 million of these properties being owned by permanent UK and Irish citizens and residents. The study, involving 4,800 consumers and 880 estate agents and property developers, was conducted in July and August 2007 and is the largest of its kind ever undertaken in the UK and Ireland into the overseas property market.

The report examines the market from the perspective of consumers, as well as industry players such as property developers and estate agents, and provides in depth analysis of the dynamics of the property market in the 30 leading destinations for UK property buyers. The study values the overseas property market in 2006 as being worth £44.4 billion, with UK and Irish based estate agents forecasting the market to continue to grow at an annual rate of over 13% between now and 2012 – almost doubling the total value of the market.

Spain, France and the USA remain the most popular destinations of choice, but younger buyers are looking further afield to markets including Brazil, Egypt and Croatia. Demand for overseas homes is increasingly being driven by buyers at the younger end of the age spectrum looking for a combination of investment and personal use. However, over 70% of property owners claimed that their purchase was driven by a desire to improve their lifestyle.

The OPP is a dedicated trade platform for those actively involved in the sale and marketing of overseas property. Its readership comprises agents and developers but also includes financial advisers, brokers, property consultants, media owners, PR and Marketing specialists, lawyers, etc.

Research recently carried out by property specialist Obelisk International confirms that overseas property investment is providing solid returns, in comparison to the continuing news of increased UK house prices, failing pension systems and short property funds. Obelisk has seen a huge increase in first time buyers investing in overseas property in order to get on the first rung of the property ladder, and an increasing number of investors are using this type of investment to fill a pension shortfall.

Kevin Prior, sales and marketing director at Obelisk International, said, “Inflated house prices in the UK have led to some financiers believing a crash in the housing market, coupled with a large number of first time buyers – who are taking out huge loans to meet these costs and therefore landing themselves into the negative equity trap - further adds to concerns.

“Overseas real estate is considered a safer asset with investors tending to behave more calmly than their counterparts on, for example, the stock market. The real estate arena is also less subject to the effects of panic selling than stocks and shares. Investors can benefit greatly from foreign currency and foreign mortgage rates, as these products allow borrowers to take advantage of the low interest rates and favorable exchange rates when purchasing real estate abroad.”

INTERNET KEY TO EXPATRIATE LIFE, SHOWS STUDY

According to a recent study by offshore bank Alliance and Leicester International, 83% of expats regularly shop online, 63% use the internet daily to keep in touch with friends and family, 47% check their bank balance online at least once a week, and 63% use the internet daily to email loved ones. The World Wide Web has revolutionised expats’ everyday lives with 70% now logging on daily and over 25% switching on every hour. The vast majority of expats now have broadband access with almost half of those surveyed owning webcams and one in three opting for cheaper international calls via VoIP (Voice Over Internet Protocol) technology.

Simon Hull, Managing Director of Alliance & Leicester International comments, “Our research shows that the internet has revolutionized the lives of expats, enabling them to go about their daily lives at the click of a button, any time of the day – helping them to stay in touch, do their shopping and manage their finances. Whether it is making purchases, or transferring money from accounts it is even more important that expats take the same precautions with their safety online as they do offline.”

Alliance & Leicester International’s eSaver Offshore savings account offers an online application process without the need for a “wet” signature, allowing customers to both start and manage their account online.

Another recent study from ALIL showed that almost a third of expatriates move overseas to land the jobs they want, and the expatriate community is becoming more diverse than ever. 40% are relocating to destinations such as the Middle East, Australia and the USA to further their careers. More recently, expatriate communities as far as Africa, Singapore, Thailand and Russia have been growing.

LONDON’S HEDGE FUND MANAGERS FLEE TO SWITZERLAND OVER TAX CHANGES

Dozens of London-based hedge fund managers are reportedly relocating to Switzerland to escape new tax rules affecting non-domiciled individuals residing in the UK. According to the Financial Times, David Butler, founding member of Kinetic, an investment management consultancy, stated that at least 40% of his hedge fund clients have expressed alarm at new tax rules affecting non-domiciles, announced in the pre-budget report, and Switzerland, with its favorable tax climate for wealthy investors, has emerged as the natural alternative for some managers.

Butler went on to claim that two-thirds of his hedge fund clients have already moved their entire operations to Switzerland, while others have moved at least 20% of their businesses, including research operations, marketing, distribution, and some fund management activities. Should this trend continue, Butler predicted that soon, the UK will be used by hedge funds for just finance and back office operations, with key value operations shifted offshore.

Under the shake-up of the non-domicile tax rules announced by Chancellor of the Exchequer Alistair Darling in October’s pre-budget report, UK residents who are non-domiciled will now also have to pay an annual charge of £30,000 to ensure that they contribute in respect of the foreign income and gains which they keep abroad, and on which they do not pay UK tax. The charge will apply if they have been resident here for more than 7 years. Users of the remittance basis will also lose their tax-free personal allowances. In addition, tax advisors are warning that companies and offshore trusts set up by non-doms are being targeted by the UK government as part of new anti-avoidance rules.

Presently, London remains the undisputed European hedge fund capital, and is second only to New York in the asset management stakes. According to International Financial Services London (IFSL), a private sector organization which promotes the UK’s financial services industry, London’s share of global hedge fund assets increased from 10% to 21% between 2002 and 2006, making London one of the fastest growing hedge fund centers. The 900 hedge funds located in London accounted for 80% of European based hedge fund assets in 2006, and if figures for funds of funds and U.S. hedge funds with a trading desk in Europe are taken into account, London’s share was more than 90%.

Factors underpinning London’s strong position include its local expertise, the proximity of clients and markets, a strong asset management industry and a favorable regulatory environment. But other European financial centers are beginning to catch up, especially in terms of their regulatory environment, Switzerland included. The Swiss Federal Banking Commission (EBK), an independent regulator of the Swiss banking industry, has expressed its support for changes to the Swiss tax and legal system to encourage more hedge fund managers to base their activities in Switzerland.

Moreover, Switzerland’s personal income tax system could be a strong lure for UK-based hedge fund managers. This system allows wealthy non-national investors and celebrities to effectively negotiate their own tax rate with Swiss cantonal governments, as long as they agree to reside in the country for part of the year.

The UK government says the new tax measures are targeted to protect competitiveness by ensuring that secondees to the City are not affected (the majority have left the UK by 7 years). However, Butler’s revelations in the FT are further evidence that the changes are not being well-received by the City. Tax and wealth advisors are warning that the new rules could be potentially disastrous for the UK finance industry, and are urging the Chancellor to rethink the proposals.

U.K. TAX MAN EMBARKS ON “FISHING EXPEDITION” FOR OFFSHORE ACCOUNTS DETAILS

HM Revenue & Customs is embarking on a “fishing expedition” to round up unpaid tax on offshore bank accounts by putting increasing pressure on banks to reveal customer details, a large accountancy firm says. Over the past 12 months HMRC has applied to the Special Commissioners for leave to issue Section 20(8A) TMA 1970 information notices to some of the largest UK financial institutions seeking documentation relating to offshore accounts where the holder is a UK resident for tax purposes.

Accountant KPMG says that these notices are unusual because they require documents that relate to the tax liability of an unnamed taxpayer or class of taxpayers. In other words, the taxman does not have any details of these bank customers and is simply fishing to find out who may have undeclared interest or income on offshore investments.

Last year HMRC won a case against Barclays Bank, forcing it to reveal the names of all its clients with offshore bank accounts. In June of this year HMRC issued an amnesty to those with undeclared offshore income, but of the estimated 400,000 or more liable to tax in the UK only 25,000 voluntarily disclosed income from offshore sources by the 7 July deadline. The tax man is now being forced to pursue the rest.

These Section 20(8A) applications have to be authorised by the Board of HMRC. Until recently this information power has been used very sparingly by HMRC. In each case where the Special Commissioner has granted leave, the decision has been published in anonymous form, KPMG explains.

But HMRC now appears to be trying to unearth information by what could be described as coercion on the banks and other financial institutions. The tax man is trying to obtain confidential information about customers’ offshore bank accounts by getting the banks to voluntarily divulge the numbers of offshore accounts where the holder has a UK address.

“Considerable doubts have been expressed about this approach”q KPMG says. “In particular there is some concern that HMRC is seeking to depart from a well established statutory information process which contains considerable legal safeguards for the recipients of such notices especially when, as in this case, they stand as an entirely innocent third party in relation to the potential compliance failure.

“Secondly it is unclear why potential recipients of a notice should undertake the assessment of whether they should be served with a notice when the statutory requirement is for the Inspector to formulate a reasonable opinion as to potential tax liability.”

KPMG says it “supports the approach that recipients should be reluctant to engage with the informal process because of the considerable risks that may arise from damage to customer relationships and confidentiality problems.” In other words, why should the banks do the tax man’s dirty work for him?

If the banks go ahead and comply with HMRC’s request, it will simply increase the flood of individuals opening offshore accounts in areas like Singapore and Hong Kong. These jurisdictions have not signed the European Savings Directive which requires overseas banks to either deduct withholding tax from interest payments or inform the account holders’ home tax authority of interest paid.

HMRC ANNOUNCES DETAILS OF £51 MILLION VAT FRAUD

A self-titled “peer” last week received two prison sentences totaling 10 years or his role in a massive “missing trader” VAT fraud. Malcolm Edwards-Sayer, who worked as a law lecturer and a lay preacher and bought the title of Lord Houghton, was jailed for his part in a major conspiracy to steal £51 million from the public purse in a sophisticated VAT fraud.

An intense investigation by HM Revenue & Customs uncovered his role as the main player in the elaborate scam, in what has become known as carousel or “missing trader” fraud, and in plans to launder the proceeds of crime. This involved the dishonest manipulation of the VAT system through the import and export – principally of mobile phones – over an 18 month period.

Nick Burriss Director of Operations, Criminal Investigation, for HMRC explained following the verdict, “Missing trader fraud is not merely a paper fraud but often features links to other forms of serious and organized crime which brings devastation to our communities.”

The fraud involved the purported import of mobile phones and computer chips from various EU countries, VAT free. The goods would then be sold on more cheaply, but with VAT added, through a chain of companies. Once the goods had been sold on a number of times they would be exported back to EU countries. The companies would then default or go “missing” before making their VAT repayments to HMRC.

IRISH OFFSHORE ACCOUNT HOLDERS SET TO SUE BANKS OVER DISCLOSURES MADE TO REVENUE

The Revenue Commissioners and the banks are facing a legal backlash following a High Court ruling in relation to their offshore assets investigation. The High Court has ruled that the tax authority had no right to force Irish banks to hand over financial details of overseas bank accounts held by Irish residents. The Revenue said it was appealing the decision to the Supreme Court.

The judgment paves the way for Irish residents who held offshore accounts to sue their bank for breach of confidentiality, according to senior legal sources. Many were forced into making settlements after the Revenue was given details of their bank.

The judgment rejected an application by the Revenue to compel National Irish Bank to hand over details of accounts in its Isle of Man subsidiary. The High Court said that granting the application “would be downright disrespectful to a foreign jurisdiction.”

In a statement, the Revenue said, “NIB was unique in having a branch in that jurisdiction, as opposed to a directly owned subsidiary, as was the case with all other financial institutions. The judgment, therefore, does not have wider implications.”

However, several legal experts said the judgment could apply to other jurisdictions. The offshore assets probe relied on information obtained from subsidiaries of Irish banks in jurisdictions such as the Isle of Man, the Channel Islands, Hong Kong and Andorra. A key part of its success was the tax authority’s ability to obtain details of overseas bank accounts held by Irish residents.

“The case is extremely significant,” said tax lawyer Suzanne Kelly. “The Revenue’s wings have been clipped and its powers curtailed.”

In his judgment, Mr. Justice William McKechnie said it was an implied term of any contract between a bank and its customers that the bank would not divulge details of accounts without the customers’ consent. The Revenue had contended that it had jurisdiction over subsidiaries of Irish-domiciled banks, so was entitled to the documents. However, the court found said that the “branch in question could never have existed unless authorized by Manx law.”

McKechnie said that NIB and account holders must have presumed that the applicable law would be Manx law, not the law of Ireland. “Otherwise it makes no sense for a person with an Irish address to open an account in the Isle of Man, rather than in Ireland,” he said.

IRS ISSUES STATISTICS OF INCOME BULLETIN

The IRS has released the Fall 2007 issue of the Statistics of Income Bulletin, featuring data from 134.4 million individual income tax returns filed for tax year 2005. U.S. taxpayers reported $7.4 trillion of adjusted gross income less deficit in tax year 2005, up 9.3% from tax year 2004, when 132.2 million returns were filed.

Certain types of income posted strong gains between 2004 and 2005. Net capital gains climbed 41%, and taxable interest rose 29.5%, while net partnership and S-corporation income gained 27.3%.

Taxable income totaled $5.1 trillion in tax year 2005, up 10% from the prior year. Total income tax increased for a second straight year, rising 12.4% to $934.8 billion. Between tax years 2003 and 2004, total income tax rose 11.2%, the first increase in 4 years. The alternative minimum tax (AMT) grew 33.7% between 2004 and 2005 to $17.4 billion. Four million taxpayers paid the AMT in 2005, compared to almost 3.1 million in tax year 2004.

This edition of the quarterly Bulletin also included articles about:

• Growth trends in partnerships. Between tax years 2004 and 2005, the number of partnerships rose 8.5% to about 2.76 million. The number of partners increased just 4.2% to about 16.21 million in tax year 2005. Meanwhile, income rose at a much faster rate. Total partnership net income climbed 42% to $546.2 billion in tax year 2005.
• A look at private foundations. The number of private foundations that filed Form 990-PF remained nearly the same between tax years 2003 and 2004, while the number of nonexempt charitable trusts treated as private foundations that filed the return increased by 12%. In tax year 2004, private foundations distributed $27.6 billion in contributions, gifts, and grants and other outlays for charitable purposes, while nonexempt charitable trusts distributed $314 million.
• Recent data on charities. For tax year 2004, nonprofit charitable organizations exempt from income tax under Internal Revenue Code Section 501(c)(3) filed more than 276,000 information returns, an increase of 5% from 2003. These organizations held more than $2.0 trillion in assets, a real increase of 5% from the previous year and 52% over the past decade.
• Corporate foreign tax credits. For tax year 2003, U.S. corporations claimed $50 billion in foreign tax credits. Corporations that claimed a foreign tax credit paid $140.5 billion in worldwide income taxes on $424.5 billion in worldwide taxable income.

UK’S NEW MONEY LAUNDERING REGULATIONS TO BITE

Many new businesses will be enlisted.

HM Revenue and Customs is advising businesses to be ready for the new Money Laundering Regulations (MLRs) that come into effect on December 15, 2007 and which require many types of business to register or re-register with HMRC including Money Service Businesses, Trust or Company Service Providers, High Value Dealers and Accountancy Service Providers.

HMRC’s Business Director of Money Laundering Regulations, Melissa Tatton, said, “Businesses that are affected by the money laundering regulations will need to have the right processes in place so they can hit the ground running. From 15 December, businesses that have to take action under the Money Laundering Regulations need to put anti-money laundering controls in place.’

The new regulations also require that if such a business is not already supervised by the Financial Services Authority, or a professional body listed in the regulations has not agreed to supervise all relevant activities, they will need to register with HMRC. In addition, any person who runs or owns the business, and any nominated officer or money laundering reporting officer, will need to apply for a new fit and proper test designed to make it more difficult for criminals to get access to this sector.

The MLRs 2007 require Trust and Company Service Providers (TCSPs), which have not previously, to put in place anti-money laundering controls starting December 15. This means businesses will have to be able to:

• Carry out checks on their customers’ identities.
• Identify the risk of money laundering posed by a customer.
• Report suspicious activity to the Serious Organized Crime Agency (SOCA).

TCSPs include:

• Recruitment agencies, involved in arranging for someone to act as either a permanent or interim director, shadow director, or company secretary or partner of a partnership.
• Company formation agents.
• Suppliers of accommodation or correspondence addresses.
• Telephone answering services for businesses other than sole proprietors.
• People acting or arranging for others to act as professional trustees, including will writers and family offices.

HMRC estimates that as many as 10,000 TCSPs will need to familiarise themselves with the new regulations, so is urging anyone who is likely to be affected by these changes to start preparing now.

GUERNSEY ON COURSE FOR COMPREHENSIVE TRUSTS LAW UPDATE

Guernsey is on course for a comprehensive update of its trusts law to ensure that it remains user friendly for the 21st Century. On 25 July 2007, the Trusts (Guernsey) Law, 2007 was approved by Guernsey’s legislature and is expected to come into force in January 2008. The Law will replace the existing Trusts (Guernsey) Law, 1989 in its entirety. The underlying objective is to ensure Guernsey remains attractive in an increasingly competitive market. The main changes are as follows.

Purpose Trusts. The Law permits the establishment of so called purpose trusts for non-charitable purposes. Any legal purpose will be permissible and a valid trust can be created even though there is no ascertainable beneficiary. This is a significant variation from the long established principle of trusts law that requires the “three certainties” to be present in order for a trust to be valid – of intention, of subject matter, and of objects, i.e., there must be beneficiaries who are certain or capable of being rendered certain.

Purpose trusts facilitate the use of trusts for commercial transactions and offer increased flexibility when structuring complex commercial transactions. There are various potential commercial uses for trusts and reasons why a trust may be chosen over other entities, such as a company, in a commercial transaction.

Reservation of powers. The Law expressly allows the reservation of certain powers by a settlor. Such powers include the power to advance, appoint or apply income or capital of trust property and give direction to the trustees in connection with the management of trust property. The reservation of powers, however, may well open the trust up to accusations of sham in other jurisdictions.

Duration. The Law abolishes the 1989 Law’s provision that restricts a trust’s duration to 100 years. The change will not be retrospective but the contents of an existing trust could be transferred into a second trust, subject to the terms of the existing trust.

Liability of directors of corporate trustees. The 1989 Law provides that directors of corporate trustees may be deemed to be guarantors of the trustee in respect of any damages and costs awarded against the trustee for breach of trust. This provision clearly acted as a deterrent to new business entering Guernsey and has consequently been abolished.

Information to be given to beneficiaries. The Law recognizes that there may be very good reasons for denying beneficiaries access to information or documents, e.g., in the case of an employee benefit trust where privacy is paramount. It therefore clarifies the circumstances in which information may have to be given to beneficiaries and that the terms of the trust may expressly exclude the beneficiaries’ right to such information, subject always to any order of the Court. The burden of proving the need for the information remains with the beneficiary.

Letters of wishes. The 1989 Law provided that, subject to a trust’s terms or a court order, a trustee was not obliged to disclose documents which revealed the trustee’s deliberations or reasons for any decisions and any material upon which such decisions were based. The Law amends the position to make it plain that letters of wishes or documents which reveal the intention of the settlor or any beneficiary of the trust are preserved from disclosure, subject to the terms of the trust or any order of the Court.

Limitation period for breach of trust. The Law clarifies when an action for breach of trust must be brought by introducing an absolute long-stop date of 18 years from the date of breach, regardless of the whether the beneficiary had actual knowledge or not. This clearly promotes certainty and is to be welcomed.

Exclusion of foreign law. The Law also introduces an exclusion of foreign law provision, which should address the concerns of the trust industry regarding the apparent willingness of the Family Division to ride rough-shod over the concept of trusts law in offshore jurisdictions and of the local courts to give effect to foreign judgments. In numerous cases, the Family Division has either varied offshore trusts or held that the assets of a discretionary trust are the resources of a spouse, notwithstanding that there are numerous other beneficiaries and the trustee has no obligation to make any distribution to the spouse whatsoever.

Several offshore jurisdictions have legislated to exclude the operation of foreign laws, including Bermuda, Cayman and Jersey. Notwithstanding the intention of these provisions, subsequent case law has raised serious questions as to how effective these provisions actually are. The provisions of the Law are expressed in broader terms than Jersey’s and mirror similar legislation in Bermuda, where the courts have been more robust in their approach than Jersey’s. It may therefore be that the provisions of the Law will have the effect that they were intended to. However, Guernsey’s court usually considers Jersey authorities highly persuasive and is likely to cooperate with the courts of England and Wales unless it is absolutely clear that the legislature’s intention is to the contrary. It therefore remains to be seen what level of protection the provisions of the Law will afford Guernsey trusts when the issue comes before the Court.

GET THE STATE OUT OF MARRIAGE

Draw up your own contract to fit your personal situation.

How often do you have knock-down, drag-out fights with your neighbors about what church to attend or what car to buy? Never, right? The reason? You are free to attend any church you choose or buy any car that you prefer. So is your neighbor. In a world of free choice, you might have a friendly or even heated argument at the picket fence over systematic theology or the virtues of Hondas vs. Mazdas. But, at the end of the day, it does not matter who wins the argument. Your neighbor cannot force you to become Catholic, and you cannot force him to choose an S2000 over an RX-8. You each do as you please.

Now compare that situation to the world of government action and politics. For some reason, many folks believe that decisions made in a democratic manner, i.e., by voting, are preferable to those made in the world of private transactions. But political decisions entail one side winning and imposing its will on the other side. When 55% of your city’s voters choose to float a bond measure to fund a community center, the other 45% of the voters also are forced to endure the traffic and pay for the project. It is a winner-takes-all situation.

That win-or-lose nature of the process becomes even more contentious when we are dealing with deeply held social, religious and cultural issues. Religious conservatives like to talk about (and wage) what they call the “culture war”. I have no interest in fighting any type of war with my neighbors. But in their view, they are the guardians of traditional values who are battling it out with leftist elites who want to impose a new set of cultural values on the nation. In the view of their opponents, the conservatives are trying to cram their sectarian values down everybody else’s throat. Both sides have a point, as each side does use the government to promote certain values.

The latest ongoing culture-war battle involves gay marriage. Conservatives, who claim to believe in states’ rights, are promoting federal bans on same-sex marriages. Liberals, who tend to favor federal solutions, are claiming that pro-gay-marriage states such as Massachusetts have the right to set their own marriage terms.

There is one way to keep this battle from becoming as nasty and divisive as other such battles. In a New York Times column, Evergreen State College Professor Stephanie Coontz revived the sensible libertarian argument for privatizing marriage. “Why do people – gay or straight – need the state’s permission to marry? For most of Western history, they didn’t, because marriage was a private contract between two families. The parents’ agreement to the match, not the approval of church or state, was what confirmed its validity.”

It was not until modern times (the late 1800s) that the state began to dictate the terms of marriage, Coontz explained. In the 1950s, she added, the state used the “marriage license as a shorthand way to distribute benefits and legal privileges.” But these days, with so many prevalent family situations and obligations, a marriage license no longer is the easiest way to sort out financial and familial obligations. The easiest way to sort out such matters is through private contracts, not by having the state impose one particular vision of marriage on everyone.

Why not just let individuals choose their own terms of marriage, based on the dictates of their religious group or their conscience? Advocates for state-sanctioned marriage argue that marriage is a public good that needs to be protected. Well, good marriages are good for the nation, no doubt, but it is not as if states can make people more moral by imposing certain rules on them. People already live in every sort of moral and immoral way, inside and outside of marriage. That is the nature of humankind. I would argue that the best way to encourage solid marriages is to let individuals choose the terms of them.

I am a traditionalist on such matters, but it is not up to me to decide how other people should live. My marriage is not dependent on the state, but on my church (I am Eastern Orthodox), which would never approve of gay marriage. But some other religious groups do. What they do is not my business, as I am not a member of them. Public “benefits” and legal responsibilities should be handled by contract, not state decree.

As Anthony Gregory wrote, “If people wish to consider themselves married to each other, let them do so, draw up any relevant private contracts to handle the details of the arrangement and live their own lives in peace. If third parties wish to consider any given pair (or larger number) of people married, that should be their choice. No one, heterosexual or homosexual, would have any special rights under the law. Hospital visitation rights and other such matters would be handled contractually, and decided by the private individuals and institutions involved – not the state. No one would have to see the government give marriage licenses to some but not others, and no one would have to see the government legitimize any marriage he or she doesn’t personally approve.”

Given changing cultural attitudes, it is only a matter of time before gay marriage is approved by the government. Is it not better to embrace the private route than to let the Left use the state to transform another cultural institution? Then again, modern conservatives have become as accustomed as modern liberals to viewing the state as the arbiter of all things moral. And although privatization is the right idea, too many people have too much vested in continuing the culture war.

THE GREAT FIRE SALE HAS BEGUN

Abu Dhabi deal for piece of Citigroup the first batch of America’s seed corn to go.

On November 27, the Dow Jones Industrial Average rose by 215 points. The next day, it rose by 330 points. Why? The financial press had an immediate answer. The news had broken that morning of the offer by the government of Abu Dhabi to pay $7.5 billion for 4.9% of America’s largest and most prestigious bank, Citigroup.

The news reports failed to explain the 4.9% figure. It has to do with U.S. government rules against allowing any single purchaser of stock to buy more than 4.9% without getting permission from the U.S. government. Abu Dhabi bought the limit of what it was allowed to buy. I have no doubt that it could have negotiated more than 4.9% for its $7.5 billion without that limit. The participants on both sides recognized that the bank was facing an emergency. It had squandered at least this much money and possibly much more in its ill-fated subprime mortgage lending schemes.

Without warning, the bank in August suffered horrendous losses. There is no way that Citigroup would have sold 4.9% of the company last July. Citigroup was fat and sassy. Its president, the now-departed Charles Prince, was riding high. The stock fund managers started buying as soon as the news hit. The official interpretation: “This decision by Abu Dhabi indicates that America’s largest bank is in good shape. This is the end of the subprime crisis.” Here is my interpretation:

A small percentage of a gigantic pool of oil-generated capital, which is managed by government bureaucrats in a city-state whose nation did not exist as recently as 1970, was used to buy 4.9% of the largest bank in the U.S. because this purchase was perceived as a better deal than buying T-bills denominated in a falling dollar.

The net worth of each of Abu Dhabi’s 420,000 citizens is $17 million. Of course, they cannot actually get their hands on this money. It is administered on their behalf by salaried bureaucrats. These bureaucrats are in charge of allocating billions of dollars worth of oil revenue. They have decided to get into the banking business, a profession that is prohibited by Islamic law – usury taking. They have no experience in banking. But they thought, “Gee, let’s buy part of a bank that is suffering major capital losses.” Why does Abu Dhabi have this kind of money to invest? Because oil is up, and the world’s economy is repeating the experience of 1973–79 – a massive transfer of wealth to Arab, Iranian, and other oil kingdoms. To this group, add Russia, which now has almost $500 billion in foreign currency reserves, third only to China and Japan.

In 1988, Gorbachev went begging to the West for money. Today, the West is at the mercy of the good graces of Putin. The only thing that will send oil back to 2006’s level ($55) is a worldwide recession. Supply and demand favor the oil exporters from now on. This is permanent. The world’s economic power will shift inexorably to the oil kingdoms and to China.

Abu Dhabi’s purchase points to the future. America’s economic crown jewels will be sold to foreign owners. The profits from American-based companies will then flow to foreigners who own the companies. This scenario is unlikely to change in my lifetime or yours. Yet this purchase caused a 215-point rally in the Dow. Investors are short-sighted. They regard as a cause of celebration the most visible private transfer of American capital to foreigners in our lifetimes.

On November 28 the Dow climbed 330 points. Why? Because of a vague remark by a member of the Fed’s Board of Governors in a speech to the Council on Foreign Relations. He said that the Fed should be pragmatic. So what? This has been the Fed’s position since 1933.

The comment was interpreted to mean that the Fed will lower the target rate for overnight bank loans by another .25 percentage points. Other than serving as a symbol of the Fed’s commitment to liquify the banks by a small percent, such a decline will have no impact on the massive, multi-billion dollar losses that have been sustained by the financial sector and which will continue, everyone admits, through 2008 and maybe into 2009. And the actual speech was anything but reassuring.

The investing community wants to believe that the Fed and Abu Dhabi can change the fundamentals of the economy, thereby restoring confidence in the stock market. In other words, the fund managers believe that symbols are more fundamental than the reality of the highly leveraged, self-monitored debt market which has created so many liabilities that the solvency of some of America’s largest banks is at stake.

The stock market will need many more interventions by Abu Dhabi and other Arab oil states, which now control the flow of funds America’s capital markets.

The great fire sale has begun. Senior American managers have begun to sell the nation’s seed corn to the Arabs. They will continue to do so as the economic agents of American people. The sale of 4.9% of Citigroup is a visible turning point.

Stock market investors cheered. They bought. Why? Because they expect to be able to sell later on to the Arabs. This is the greater-fool strategy. “Buy now, sell to a fool later.” But the greater fools are the American buyers who are planning to sell their claims to the future of America’s productivity. The only way that the Arabs will turn out to be greater fools is if America ceases to be productive.

Without thrift, this is a real possibility. American households have been in a net negative position for two years. They are borrowing their way to the good life. In short, they are imitating the U.S. government.

This is not going to turn out well.

REGULATORY DEBAUCHERY

A step on the road to currency debauchery.

Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. Debauching the regulatory apparatus is a step along the same road. Current problems in credit markets are attributable, in part, to failures on the part of central banks and regulators. The response to the credit crisis also contains fundamental deficiencies.

Central bankers fueled the liquidity bubble through excessive monetary growth and low interest rates. The “Greenspan Put” repeatedly bailed out banks and investors from poor decisions, or irrational exuberance underwriting excessive risk taking. Asset price bubbles rolled merrily along, waves of risk mispricing moving through different markets. The current credit crisis has its origins in the Federal Reserve’s interest rate cuts of the early 2000s that helped engineer the housing bubble. This bailed out the markets and economy from the the excesses of the internet bubble.

Bank regulators have presided over substantive changes in financial institution balance sheets and risks. The balance sheet of large banks and investment banks now hold high levels of risky and illiquid assets, such as private-equity investments, bridge loans, hedge funds investments, distressed debt and exotic derivatives. Derivative transactions with and loans to hedge funds through their prime broking operations are substantial. Assets and exposures outside regulated bank balance sheets have increased. A recent OECD analysis shows that while major banks have increased capital and reduced reliance on short-term funding the risks have increased faster.

Regulators have been uncritically accepting of financial innovation. The benefit of dispersion of risk through the final system has become the accepted orthodoxy. The risks of a diffuse, opaque, globally inter-linked, highly leveraged financial system have largely been ignored. Belatedly, in its 2007 annual report, the Bank of International Settlements admitted that “our understanding of economic processes may be even less today than it was in the past.”

Recent events show the risk transfer has been largely cosmetic. In excess of $300 billion of risk in the form of Asset backed Commercial paper (“ABS CP”) has returned to bank balance sheets as ABS CP investors have gone on a buyer’s strike. Financial institutions have already incurred losses of over $50 billion. A substantial volume of assets is likely to return onto bank balance sheets as off-balance sheet structures and hedge funds are forced to sell. The total amount that will be reintermediated by banks may be in the range of $1 to $2 trillion. Weaker banks have been forced to forage down the back of the sofa for any loose change to add to their dwindling liquidity to meet these commitments. This has led to sharp rises in inter-bank lending and borrowing rates as well as general shortage of funds, especially for riskier borrowers.

Central banks have reverted to type in dealing with the crisis. There is no difference between a run on a bank and shutdown of access to funding from the capital markets. U.S. mortgage lenders have faced old-fashioned runs. Northern Rock found itself requiring central bank support in excess of £20 billion ($40 billion) as it was unable to raise required funding in money markets. The Chancellor of the UK Exchequer was forced to effectively guarantee the UK system of bank deposits to restore confidence. Central banks, including the Fed and European Central Bank, have pumped money into the system in an effort to ease the liquidity crunch.

In further regulatory debauchery, the Fed recently allowed banks to pledge ABS CP as well as highly rated asset-backed securities, corporate bonds and mortgage-backed instruments as collateral for funding at the discount window. Funding has been extended from overnight to 30 days. Other central banks have followed suit. Traditionally, only government securities are eligible for discounting. A fundamental principal of the discount window is that it is designed to provide short-term liquidity against instruments of unimpeachable credit quality. The regulatory spin is that this is “temporary” ... “in the light of market conditions” and “recognizes innovation in the market.”

There are profound practical and policy issues in this development. There are unconfirmed suggestions that the central banks are placing a value of 85% on AAA CDO securities. Given that there is significant uncertainty about the value of the security and even how they should be valued, the entry into this debate by central banks is curious. There is also the question what happens if the bank cannot redeem the borrowing at the end of the 30 days and the value of the securities is below the level of the amount advanced. This is precisely the problem confronting lenders who have lent against these securities. In widening the eligible assets, central banks are effectively underwriting the credit risk and the liquidity of the financial system with public money.

The moves have also done little to ease liquidity or credit market concerns. Following the cut in the discount rate, four major U.S. banks used the discount window “to encourage its use by other financial institutions.” They did not need cash. It was a sign of strength. In the words of financial historian, Charles Geisst, it was “like someone from the Upper East Side being seen in ... Wal-Mart.”

In other cases of “déjà vu all over again,” there have been suggestions that Fannie Mae and Ginnie Mae step in to buy mortgages to support liquidity as they have done in past crisis. The two institutions have assets and guarantees of almost $4.0 trillion supported by stockholders’ equity of around US$60 billion. Both entities have also reported recent losses and have been forced to raise capital. The scope for liquidity creation by this route is likely to be difficult.

Socialism for Wall Street.

In good times, financial markets embrace capitalism. In bad times, financial markets rediscover socialism. Currently, the U.S. Federal Reserve is engaged in a dangerous strategy to look after its Wall Street friends.

The Fed has cut the fed funds and discount rates. The markets cheered the Fed decision to cut rates in September and then again in October. “This is manna. I am blown away. These guys get it I could hug these guys. This is what we wanted.” Jim Cramer, CNBC’s markets pundit, was at the forefront of the cheerleading.

The relief has been short lived. In recent weeks, the differential between inter-bank rates and the central bank targeted rates has widened to levels not seen since August. This points to further potential cuts in both rates by the end of the year. Lower cuts are inconsistent with above-target inflation levels resulting from high oil prices, higher food prices, increasing cost pressures in emerging economies such as China and the potential inflationary effect of a weaker U.S. dollar.

The U.S. central bank’s strategy is clear. The current credit problems require a substantial reduction in the level of borrowings and leverage in the global financial system. Asset prices ramped up by excessive debt need to adjust. The adjustment could take place via a “crash”. This would be destabilizing and would wreak further havoc on already weakened banks. Alternatively, the deleveraging and price adjustment can be achieved by creating inflation through loose monetary policy. If asset prices remain at current levels, higher inflation allows values to fall in real terms. Higher inflation also reduces the value of the borrowings that must be paid back allowing the required reduction in leverage.

The Fed strategy also assists affected banks. The large writedowns in risky assets and the expected reintermediation of assets means that some banks need large infusions of capital. Given recent performance and subdued profit outlook, it would be difficult for them to raise this capital at acceptable prices.

Lower short-term interest rates allow banks to borrow cheaply. The money can be used to purchase government bonds that provide higher returns than the cost of borrowing. This generates profits for the bank without the banks having to hold capital against their assets (banks generally are not required to hold capital against government securities). The profits help recapitalize the bank.

In the 1980s, U.S. manufacturers looked to Japan as the source of ideas to improve efficiency. Remember “just-in-time” manufacturing, “zero defects”, etc. Now, it seems U.S. regulators are borrowing ideas from their Japanese colleagues. The Bank of Japan used the same strategy to recapitalize the loss-making Japanese banks after the collapse of the “bubble economy” in 1989.

Higher inflation expectations are already evident in higher gold prices, the steeper U.S. yield curve (long-term rates are higher than short-term rates) and the weaker U.S. dollar. Foreign investors, especially large sovereign investment funds, are switching from financial assets (bonds) to “real” assets (companies with real businesses) reflecting higher inflationary expectations.

The strategy is dangerous. Inflation can lead to a significant transfer of wealth from investors to borrowers. Inflation once embedded in the economy distorts economic activity such as investment and savings. The experience of the late 1970s and early 1980s highlights the difficulties in recapturing the inflation beast once uncaged.

The strategy may also not work. The cuts in rates do not appear to have had the desired effect in improving market liquidity conditions. Default risk concerns continue to inhibit lending and other routine financial transactions. Lower rates may set off further bubbles, e.g., in equities and emerging markets. Asset prices may fall sharply anyway.

Central bankers have stated that “errant” banks and investors will not be “bailed out”. Actual actions suggest otherwise. Banks have played their “nuclear” option well. The specter of “systemic risk” is one a central banker cannot ignore. The banks continue to privatize gains and socialize losses.

These moves have attracted remarkably little scrutiny or comment. Central banks are effectively underwriting the credit risk and the liquidity of the financial system with public money but without any transparent political debate. Socialism for Wall Street prevails, once again.

Central banks and regulators bear a serious responsibility for safeguarding the functioning and integrity of financial systems. At the moment they are being exposed like the Wizard of Oz – old desperate men (they are mainly men) behind the curtain running from one lever to another in a desperate attempt to maintain illusions.

U.S. HOUSE VOTES 404 TO 6 TO PASS THE BILL THAT LEGALIZES COINTELPRO?

Fast-tracked bill legalizes spying against U.S. citizens of almost any kind.

One month ago a bill passed almost unanimously in the House. This bill has received no mainstream news coverage. So it must not be that big of a deal, right? It is just a bill that will soon to go to Capitol Hill and since the Democrats are in control we are all safe from further infringements up on our civil rights, right? Well, maybe that is not totally correct since this bill is a lot more than meets the eye. But indicator number one should be the title, and indicator number two should be how fast it is moving through Congress.

On October 23rd, the Violent Radicalization and Homegrown Terrorism Prevention Act of 2007 passed 404 to 6 in the House. This bill is proposing an expansion of Homeland Security with the objective of spying on citizens whose political or religious beliefs might lead them to commit violent acts. And we are not referring to the attack of Megan Williams or the numerous police murders of non-threatening civilians. No this is solely about spying on political dissidents whose politics were shaped through a critical analysis of U.S. Foreign or Domestic policies.

The stated purpose of this bill is to first assemble a National Commission on the Prevention of Violent Radicalization and Ideologically Based Violence. Secondly, they will create a university-based Center of Excellence to study radicalization and homegrown terrorism.

Their definition of what defines radical and terrorism are very vague, and can be manipulated to serve several purposes. In the bill itself, it says homegrown terrorism means “the use, planned use, or threatened use, of force or violence” by a native citizen of the U.S. It is this definition that is leaves so much of this bills purpose, open to interpretation. Unfortunately, the interpretation by the same ole “powers that be” is the only one that really matters because it is them who will have the use of this bill at their disposal.

It is far too easy to point the finger at an individual or a group of individuals, and claim that they are “planning” or “threatening” the use of violence to achieve their objectives. If activists and concerned citizens congregate at a building to protest or demonstrate, could it be claimed that they are “planning” the use of violence or getting ready to riot? Take it one step further. If there is an act of civil disobedience, in the form of blocking the entrance to that building (a non-federal building) during the political protest, and that blocking is done with the use of a minimal amount of force (people physically locking arms), will this new bill turn a simple misdemeanor trespassing into a felony punishable through the federal court system? And who has the discretion to make that determination?

“Planned” or “threatened” use of violence is a vague term, and we have seen it used before. How many times have you heard of a cop beating, shooting, or killing an individual because in the officers opinion they “posed a threat” or were “planning” harm towards the officer? This situation is no different, yet now it decriminalizes police actions at a time when we are experiencing more police killings of unarmed civilians.

What is feared by the activist community is a general crack down on social justice activism and civil disobedience, or any dissent for that matter, because it now takes on a new and legal form. Being that it is so easy to point the finger, anybody willing to speak out will be in the scope of this proposed commission. Including many Hip Hop artists who have been the most critical of the government and its agencies. In J. Edgar Hoover’s time, this type of spying and repression was illegal and later became known as the Counter Intelligence Program (COINTELPRO). Currently these and similar practices are legal in regards to non-citizens under the heading of the “Patriot Act”. Did you really think that the government was only after those who sneak into the country to commit acts of violence?

Its defenders claimed that this bill will not “violate the constitutional rights, civil rights, or civil liberties of United States citizens or lawful permanent residents.” It is interesting that the criteria for members of this commission are individuals with expertise in “juvenile justice,” “local law enforcement,” and “Islam and other world religions.” I would think that sociologists, social workers, academics and social justice advocates have a better grasp on why individuals or organizations gave up on working “within” the system to seek other alternatives to achieve justice and equality? Why is it that social critics are not the primary targets for this commission membership? Is it because these social critics are the primary targets of this commission?

This bill, and its provisions, looks like ideological profiling of potential “trouble makers” national, and especially on the university campuses. This commission and its “studies” will be used to begin surveillance on suspected dissidents and those who might associate with them, but it will not end there. The commission’s purpose is to not analyzes the critics of the government policy and suggest reforming the policies to avoid the development of “homegrown terrorists” but rather to identify and neutralize those critics.

For those that know their history, this bill should sound familiar. Back in the ‘50s, J. Edgar Hoover, Head of the F.B.I., started the Counter Intelligence Program (known as COINTELPRO). This program was meant to, in Hoover’s words, “neutralize political dissidents,” and used thousands of illegal and covert operations to achieve its means. Though COINTELPRO claimed to watch the actions of all potentials threats, it seemed to focus all of its efforts on leftist and liberal political activists. They kept their eyes on the likes of Malcolm X, Dr. Martin Luther King Jr., and many others in order to quell the Civil Rights and Black Power Movements.

This new bill that is being fast tracked through Congress is nothing but a legalized COINTELPRO. And anybody that cherishes the right to speak out for their rights should keep an eye on this. If violence is already against every law of every state in the union, why exactly does there need to be a group that will spy on citizens and then possibly take actions against those whose “threat of violence” have a political undertone? And who is to be the targets? Well if history is any indicator, we know that the FBI did not use its resources to eliminate the KKK and other White Supremacy organizations, but they did do everything they could to eliminate, kill or jail the leadership of Black, Brown, Red, Yellow and White left organizations.

One of the most disturbing aspects of this bill is how fast it is moving through Congress. You would think such a monumental bill would be debated and discussed to no end. At least by the few progressives left in the House of Representatives. But the actions of the House show anything but concern.

When this bill came to House it was given certain provisions specifically to reduce debate time. Such an important bill as this was given little serious debate time, and was rushed to be passed. And it did pass, with a 404 to 6 vote. Of the notable votes, Presidential Candidate Dennis Kucinich voted against the bill. Ron Paul was not present to vote on the issue. This bill was hardly debated, it was passed almost unanimously, and now it is on its way to the Senate, and then the President.

There is no doubt that this bill will have the same results in the Senate, and will be signed by the President. At the speed it is moving, this bill may be a law by February, just in time for the primaries. And all of this is happening with almost nobody noticing. The news outlets are not mentioning it. It is slipping right in under our noses, like most laws of this nature do. And chances are, if you were not reading this you would still think that you had the right to defend yourself against government oppression or at least the right to demonstrate at the next Democratic and Republican national conventions.

As for those of us who are concerned about our individual civil liberties, what more can we do besides sit back and shake my head in disgust. Looks like protesting will lead to federal charges. 2008 is an election year, and every candidate promises change for the future and to correct the abuses of the current administration. Yet read their congressional voting records and you will see where some of these candidates actually stand. Most are for the war in Iraq and Afghanistan, and keep funding it. And, as evident in this new bill, almost all of the House or Representatives are for the war against your civil and political rights. It kind of makes you wonder, why these fear mongers and ideologues run around saying, “They hate of for our freedoms.” What exactly are those freedoms that we are hated for?

WHAT DO THE COPS HAVE ON ME?

Drew Peterson, a former Bolingbrook, Illinois, police sergeant suspected of murdering his 3rd and 4th wives, is now also under investigation for police misconduct. New evidence suggests that Peterson used official law-enforcement databases to check up on his 4th wife and her associates before she disappeared. Peterson’s attorney says it was common practice for Bolingbrook police to run checks for friends and family, and to run prank names to alleviate boredom. What can the police learn about you from these database queries?

Your name and aliases, your Social Security number, where you live, and when you were born. The color of your skin and eyes. Any scars or other identifying marks. Your height, vision, and gender. What kind of car you drive, whether it is a stolen vehicle, your license and plate numbers, and your traffic violation history. Your local, state, and federal criminal history. And your fingerprints.

Local police gather this information from five main databases. A search of records from the state registration agency (called the “Department of Motor Vehicles” in most places) yields information on your car and to whom it is registered. There is another archive of driver’s license records, kept in some states by the DMV and in other states by a separate licensing agency, which has facts on where you live, your driving record, and sometimes a digital copy of your license photo. Outstanding arrest warrants will show up in a third database, and a person’s criminal history can be found in either the local police records or the federally operated National Crime Information Center database, which culls from local, state, and federal files. (Some police agencies also subscribe to research tools that are available to the general public, like LexisNexis and credit reporting services.)

Access to the databases works a little differently in every agency. In general, police have unrestricted access to the DMV, driver’s license, and warrant databases, as well as the local police records. The information retrieval process works a lot like searching for a book at the library. Officers click a shortcut on their computer desktop to open a window that will let them search by name, license number, date of birth, or Social Security number, and return all matching records. Looking up a person’s federal and state criminal history is more complicated, though this also varies from local agency to agency.

AMERICA IS GOING FASCIST

The signs are all there for anyone to see, and time is getting short for action.

Reading Naomi Wolf’s The End of America: Letter of Warning to a Young Patriot, I realized the hour is later than I thought. Many of us have watched the Bush regime’s actions with a growing feeling of horror intertwined with a sense that somehow we have seen all of this before, but we are not sure where. We are confused because what we are seeing conflicts with unexamined and deeply held assumptions we have about American freedom. Wolf’s short but meticulously documented book shows that what is happening in America has indeed happened many times before, not in the U.S., but rather in places like Chile, Italy, Russia, and Germany. In each case, people could not understand why they did not recognize where they were heading before they passed the point of no return.

Wolf argues that the United States is undergoing a “fascist shift” from an authoritarian but still relatively open society to a totalitarian society. The techniques for forcing this shift have evolved over the last century and are now studied by aspiring tyrants the world over. These methods are even part of the formal curriculum in places like the Western Hemisphere Institute for Security Cooperation, previously known as the School of the Americas, in Fort Benning, Georgia, where thousands of Latin Americans have been trained by the U.S. government in the most savage techniques of insurgency and counterinsurgency.

Fascists use 10 basic strategies to shut down open societies.

1. They invoke an external and internal threat in order to convince the population to grant their rulers extraordinary powers.
2. They establish secret prisons that practice torture, prisons that are initially few in number and only incarcerate social pariahs, but that quickly multiply and soon imprison “opposition leaders, outspoken clergy, union leaders, well-known performers, publishers, and journalists.”
3. They develop a paramilitary force that operates without legal restraint.
4. They set up a system of intense domestic surveillance that gathers information for the purposes of intimidating and blackmailing citizens.
5. They infiltrate, monitor, and disorganize citizens’ groups.
6. They arbitrarily detain and release citizens, especially at borders.
7. They target key individuals like civil servants, academics, and artists in order to ensure their complicity or silence.
8. They take control of the press.
9. They publicly equate dissent with treason.
10. Finally, they suspend the rule of law.

All of these strategies are being employed in America today.

Consider the evidence. The Bush administration and its supporters have consistently portrayed the security threat posed by international terrorists as a threat to the very survival of Western civilization in order to justify permanent war and to keep the American public in a state of panic and paranoia.

The prisons at Guantanamo and God-knows how many CIA “Black Sites” torture their inmates, even though human rights organizations have demonstrated that the majority of at least Guantanamo’s inmates are innocent victims of mass arrests. The inmates are designated as “enemy combatants” who have no rights under international or American law. And there is nothing stopping American presidents from filling these prisons with American citizens.

In an April 24 2007 article for the Huffington Post, Wolf writes that thanks to the Military Commissions Act of 2006, “the president has the power to call any U.S. citizen an ‘enemy combatant’. He has the power to define what ‘enemy combatant’ means. The president can also delegate to anyone he chooses in the executive branch the right to define ‘enemy combatant’ any way he or she wants and then seize Americans accordingly. Even if you or I are American citizens, even if we turn out to be completely innocent of what he has accused us of doing, he has the power to have us seized as we are changing planes ... tomorrow. Or have us taken with a knock on the door, ship you or me to a navy brig, and keep you or me in isolation, possibly for months, while awaiting trial.” She points out that while currently Americans in such situations will be spared any torture except psychosis-inducing isolation and can look forward to eventual trials, these rights typically evaporate in the final stages of a fascist shift.

They are called “mercenaries”.

Military contractors are the regime’s paramilitary force. Blackwater’s mercenaries, many of whom were trained by Latin America’s most horrific police states, have operated in Iraq outside of Iraqi, American, and military law, and have murdered uncounted innocent Iraqis with impunity. Domestically, Blackwater was contracted to provide hundreds of armed security guards in the wake of Hurricane Katrina in New Orleans, and there is evidence that they fired on civilians. Blackwater’s business plan calls for their use in future disasters and emergencies throughout the U.S., and it is supported by some of the biggest powerbrokers in America.

American intelligence agencies are now bypassing court orders to wiretap citizens’ telephones, spy on their e-mails, and monitor their financial transactions, and the USA Patriot Act forces corporations, booksellers, librarians, and doctors to turn over previously confidential information about Americans to the state.

Political opponents listed.

Thousands of human rights, environmental, anti-war, and other citizens’ groups have been infiltrated by government agents, many of whom have clearly acted as agent provocateurs in order to undermine the groups’ solidarity and to legitimize police actions against them.

America’s Transportation Security Administration maintains a terrorist watch list of tens of thousands of Americans who are now subjected to security searches and arbitrary detention at airports. The list includes people like Democratic Senator Edward Kennedy and respected constitutional scholar Walter F. Murphy.

U.S. Attorneys, CIA agents, military lawyers, and other civil servants who have disagreed with the Bush administration have been threatened and fired. The regime’s supporters have organized campaigns to damage the careers of artists like the Dixie Chicks for criticism of the president and his policies.

The administration has Fox News in its pocket, it has paid journalists for positive coverage, it has disseminated misinformation through the media, and it is ferociously attacking critical journalists. Arrests of U.S. journalists are at an all-time high. Independent journalists appear to be marked for death by American forces in Iraq. In her Huffington Post article, Wolf writes, “The Committee to Protect Journalists has documented multiple accounts of the U.S. military in Iraq firing upon or threatening to fire upon unembedded (meaning independent) reporters and camera operators from organizations ranging from al-Jazeera to the BBC. ... In some cases reporters have been wounded or killed, including ITN’s Terry Lloyd in 2003. Both CBS and the Associated Press in Iraq had staff members seized by the U.S. military and taken to violent prisons; the news organisations were unable to see the evidence against their staffers.” The goal of these tactics, as she writes in The End of America, is to create “a new reality in which the truth can no longer be ascertained and no longer counts.”

In recent years, prominent Republicans like Ann Coulter, Melanie Morgan, and William Kristol have accused liberal journalists of treason and espionage for publishing leaked material damaging to the administration, and in February 2007, Republican Congressman Don Young said “Congressmen who wilfully take actions during wartime that damage morale and undermine the military are sabateurs, and should be hanged.” This would be amusing, were it not for the Bush administration’s revival of the draconian 1917 Espionage Act after half a century’s slumber.

And finally, the Bush administration shows contempt for the law. Wolf writes that Bush has used more signing statements than any previous president, and by doing so has relegated “Congress to an advisory role. This abuse lets the President choose what laws he wishes to enforce or not, overruling Congress and the people.” He has also gutted the Posse Comitatus Act, which was created to prevent the president from maintaining a standing army for use against American citizens. Wolf writes that the 2007 Defence Authorization Bill lets the president “expand his power to declare martial law and take charge of the National Guard troops without the permission of the governor when ‘public order’ has been lost; he can send these troops out into our streets at his direction – overriding local law enforcement authorities – during a national disaster, epidemic, serious public health emergency, terrorist attack, or ‘other condition.’” On its own, this is an incredible expansion of presidential power, but when combined with the use of military contractors like Blackwater it gives the president almost dictatorial authority.

Shifts do not happen overnight.

Wolf shows that fascist shifts happen over a course of years during which the fascists’ plans unfold at an accelerating pace. Germany in 1933 was further along this path than it was in 1931, and Germany in 1935 was farther along than it was in 1933. Similarly, America in 2007 is farther along the path than it was in 2005, or will be in 2009, provided that a massive pro-democracy movement, complete with impeachment proceedings, does not reverse the shift while there is still time. A simple Democratic victory in the 2008 presidential election will not do the job unless the institutional and legal environment created by the Bush administration is thoroughly dismantled. Regardless of whether the next president is a Republican or a Democrat, he or she will inherit a legacy of centralized power that a democracy simply cannot tolerate.

During the shift, opposition politicians and activists still tend to perceive the world through a democratic frame of reference, and this prevents them from seeing that their opponents are no longer operating within this frame. As the opposition is tying its boxing gloves, the fascists are breaking out the machetes.

Wolf’s work has its problems. She does not acknowledge that Black and Indigenous Americans have long lived under quasi-fascist rule. She does not examine the role that previous administrations have played in setting the stage for the Bush regime. And she does not acknowledge the roles played by corporatism, widespread social dislocation and the radical Christian right in the rise of a fascist American zeitgeist. Despite this, The End of America needs to be read by as many people as possible.

Wolf writes about America, but Canadians do not have any cause for comfort. Canadian and American military forces are already deeply enmeshed. Canada is tied at the hip to the American economy, while the Security and Prosperity Partnership is integrating the countries’ security forces and harmonizing thier no-fly lists. The Harper government is eager to kowtow to the Americans, even to the point of refusing to advocate for Canadian citizens on American death rows. More than any of this, once the shift is complete the American government will act even more irrationally and belligerently than before. Canada has resources like oil and water the U.S. is going to need, and the Canadian border is less defensible than the French border was in 1940.

Americans and Canadians have to fight back more fiercely than ever before, to organize and lobby and fill the streets with mass protests, to raise awareness and forge alliances with anyone opposed to totalitarianism regardless of whether they are liberals, socialists, or conservatives. We have to take all the steps that have rescued dying democracies in the past, and to take them immediately, in the desperate hope that it is not already too late.