Published on the Business Today, issue Wednesday, 14 October 2009
When the going gets tough and international business hits rock bottom, these islands cannot expect to avoid their share of flak. We are inundated with national statistics showing a drop in imports with a corresponding drop in export performance of our main industries. This does not mean that productivity has plummeted. Its the recession.
A report by the European Commission on the government’s fiscal policy has commented unfavourably that this year the government deficit is likely to deteriorate further to 4.6 per cent of the Gross Domestic Product. Unemployment is also rising, albeit slower than the EU average. Yes, Malta’s business cycle is showing signs of overheating and its engine is spluttering in an uphill climb. The finance minister is in consultation with business leaders on how to recover almost €80 million in revenue shortfall. Thousands of letters have been recently mailed to taxpayers offering an amnesty of up to 90 per cent of penalties and interest if they square up by 15 January, 2010.
The letter is addressed directly to alleged defaulting taxpayers, who according to the Inland Revenue Department have outstanding balances for the years of assessment 1999 to 2008. A smart deal, if ever there was one, to collect more revenue in a year when our deficit is over four per cent. Good news for older arrears, since they will now benefit from a reduction of 75 per cent and thus save 25 per cent in tax arrears up to 1998. All this, still calls for belt-tightening.
Recession has also badly hit the construction industry, not to mention also the famed ICT Smart City project, daubed as the elixir to create thousands of jobs to replace the close down of hotels, factories and of course the shipyards. Economic stagnation and rising government expenditure is being more and more linked with extravagant waste, cushioned in the burgeoning public sector coupled with rampant tax evasion. Many expected higher productivity gains following the signing earlier of a collective agreement which this year cost an unprecedented €23 in salary increases.
Lately the civil service has taken a lot of flak from various commentators that its’ engine is not firing on all cylinders while pockets of idle human resources languish in departments not giving a full day work for their pay. On the international scene, we notice how the G20 event has come and gone and the world leaders who gathered in Pittsburgh tried their best to put some sense back into the financial markets. They have acted in unison to call for better regulations particularly on hedge funds to promote a more balanced economy. But here in Malta we all remember how the Minister of Finance promised a full guarantee for any investor losses of up to €100,000 in the eventuality of bank failures, and so far the going was good and no bailouts resulted.
Not the same can be said for the turmoil that engulfed US banks with the shocking collapse last year of Lehman Brothers and of course the funding of AIG and the twin mortgage sisters Fanny Mae and Freddie Mac. Wall Street’s big bet on securities based on risky home loans went sour. With hindsight although some are optimistically talking about grass shoots, doom-mongers still strive to remind us of the naughty bankers namely a bête-noire that resulted in the subprime mortgage meltdown. This labeled the end of 2007 as a disastrous year for many banks who dipped their fingers into the never ending jam jar of securitised assets.
One can never forget the classical debut of the famous Bear Stearns, who daubed heavily as one of the America‘s largest underwriters of mortgage bonds. It was one of the most high-profile victims of the credit crunch, which was triggered by bank losses linked to the US housing market. Many may ask what went so wrong so quickly when such bulwarks of the financial world have suddenly collapsed. Typically we notice how while there were rumblings about the weakness of the subprime mortgage last quarter of 2007, it heralded the demise of the two internal hedge funds that had been heavily invested in mortgage securities. These two funds were hosted by Bear Sterns.
Yes one can remark that when the mighty fall, their reverberations are colossal. As I stated earlier, the accelerated housing slowdown has ruined many financial institutions starting from the US and spreading to Europe and to some extend in Asia. Bear Stearns has stood as the prime example of an acute subprime infection. Bear, one of Wall Street’s five leading investment banks, played a major role in the subprime mortgage mania that lead to a meltdown, a precursor to the global financial crisis. To explain better the operation at Bear, it consisted primarily of converting sub prime loans into securities that were later spoon fed to millions of investors.
Naturally its own hedge funds took a nice dollop of such securities. Such funds worked wonders up until the day when the kettle over-boiled and the subprime market began to show deep fissures in 2007. With hindsight, one notes that the unexpected collapse of such funds in July 2007 cost investors $1.4 billion and helped spark the demise of Bear Stearns (among others). As can be expected the funds’ implosion sent shudders through the market with investors suddenly questioned whether more earthquakes are in store which can topple other investment banks.
For instance, it comes as no surprise to hear that Bear lost so much capital in the horrible year of 2007 that forced it to form a partnership with China’s Citic Securities. The financial press reported at that time, that Morgan Stanley announced a $5 billion stake sale to China’s sovereign wealth fund, and both Citigroup and UBS made similar deals with Middle Eastern and Asian governments to shore up their weaknesses. In December 2007, Bear had announced it lost about $854 million for the fourth quarter, compared to a profit of $563 million, for the same time last year.
The firm also said it had written down $1.9 billion of its holdings in mortgages and mortgage-based securities. With all this high profile collapse of Bear Stearns one would have expected a major inquiry on the culprits who high jacked the bank’s finances and caused its momentous crash. In fact Federal prosecutors allege that two managers Ralph Cioffi and Matthew Tannin were acting in a frantic scramble to save their skins and to keep their mortgage bond funds from collapsing. Definitely both are small fish in shark infested waters and that sunk the bank.
This week the trial of two alleged rogue managers will commence in the federal court. Both men face up to 20 years in prison if convicted. They have denied the indictments. While prosecutors are not seeking criminal charges against one of the defendants for his handling of the loan, since they want to use the evidence to show he had a strong motive to commit insider trading when he withdrew $2 million from the fund whose assets he had pledged before it collapsed in the summer of 2007.
With hindsight one recalls how unwary investors lost more than $1 billion when the funds were liquidated in July 2007. Lawyers representing Ralph and Matthew defend their client’s actions saying that they did nothing illegal or criminal but merely had poor judgment and made investment mistakes at a time when the markets were crumbling in a free fall. Sadly this is the only major criminal case to emerge thus far from the global cataclysm which hopes to explain the hedge funds sclerosis. For the downtrodden hedge fund investors there is no consolation just eat your hearts out.
George Mangion Partner at PKF – an audit and business advisory firm