Last week the Deepwater Horizon, a Transocean Ltd. (NYSE: RIG) oil rig leased to British Petroleum (NYSE: BP), exploded and sank in the Gulf of Mexico, costing at least eleven lives, hundreds of millions of dollars in damages and great harm to the environment as its well leaks oil at a rapid rate. As I write this entry, the well is leaking 5,000 barrels (155,000 pounds) of oil per day into the Gulf. Even more frightening is the fact that if the well cannot be closed, the total leakage could amount to over 100,000 barrels (4.2 million pounds) of oil.
Many Americans are wondering why more safety precautions were not taken in anticipation of such an event, given the potentially catastrophic damage we are seeing now. Every oil well has a shut off valve, known as a blowout preventer, which cuts the flow of oil from a well when closed. Crew members of the rig were either unable to close the valve, or they tried and the shut-off process simply did not work. Still, the shut-off process should have happened automatically through the “dead man” switch, whose purpose is to sense catastrophe and close the valve. The Deepwater Horizon did have a dead man switch, but for unknown reasons it failed to close the valve. The last line of defense in this situation would be an acoustic trigger, a device that sends acoustic impulses through the water that can trigger a valve to shut down the well; however the Deepwater Horizon did not have one. Interestingly enough, BP was the main opponent of regulations proposed by the US that would have required acoustic triggers on deep sea rigs, citing unproven effectiveness and cost issues as their reasons for opposition. If it fails it fails, but it looks like it would have been worth the $500,000 (the cost of an acoustic trigger) to try – this incident alone is costing BP $6 million a day, not to mention the $560 million cost of replacing the rig.
The issue now is trying to stop the leak at its source, and then deciding how to move forward if that effort fails, which is very possible. Remote-controlled robots were dispatched to activate the blowout preventer, but so far those efforts have not proven effective. On Wednesday, BP conducted a “test burn” to measure the effectiveness of setting fire to the oil-filled water. While the test was successful, weather conditions deteriorated soon after, preventing any further burning from taking place. Other ideas for containing the leak include building a massive dome to be placed over the well, as well as drilling a second well at an angle to relieve the pressure of the leaking well, and intercept its contents. BP’s stock price has already fallen 13.8% since April 20th, the day of the explosion. But even more damaging to BP is that it is on the hook for the total cost of containment and cleanup, which is an unknown at this point but exceed $1 billion. Luckily for Transocean, it is insured for the total cost of the rig, $560 million, as well as $950 million in third-party liability coverage, but is responsible for any losses exceeding that figure.
It’s safe to say that we will see major changes in safety regulations for deep sea oil rigs, and eventually BP will be faced with fines and lawsuits related to the incident, but at this point the main concern is containing this massive leak and minimizing further damage. It also remains to be seen whether or not the government will scale back offshore drilling in general, mainly in the Gulf and off of the Atlantic.
Friday, April 30, 2010
Friday, April 23, 2010
Financial Reform Bill
All the focus this week is on two issues surrounding the financial industry – Obama’s efforts to push his financial regulatory reform bill through Congress, and the fraud lawsuit brought against Goldman Sachs by the SEC. While these two issues should be unrelated, it’s hard to overlook the convenient timing of the SEC’s accusation against Goldman. But since our President has assured us that he found out about the accusations from the news media, and that the SEC is an independent agency that does not report to the White House (and we know politicians always tell the whole truth), we can chalk it up to “coincidence.” And since I already discussed at length the charges being brought against Goldman and the likely effect on the company and stock market, I will spend more time focusing on the impending financial reform bill.
The financial regulatory debate has parallels with the recent healthcare issue. While most people understand why Washington is trying to implement these reforms, much like the healthcare reform bill, few people understand what reforms they are advocating, and how these reforms will affect Wall Street or anyone else. Additionally, both parties are taking such a strong stance on this issue that the facts have become secondary to partisan jabbing, leaving the American people clueless.
The goal of all the proposed reforms fall under four major categories: protecting individuals from banks and other large financial institutions, protecting these institutions from themselves, increasing the power of shareholders, and requiring more disclosure by financial institutions. The strongest opposition from Wall Street has been in response to the idea of a tax that would affect bank, thrift and insurance companies with more than $50 billion in assets, in order for the government to recoup its losses from the bailout. While this would generate more cash flow for the government, it would almost certainly lead to increased fees for these institutions’ clients. The law also seeks to heavily regulate the trading of derivatives, financial instruments whose value is dependent upon the price of an underlying asset. But too much regulation of derivatives could impede the ability of financial institutions and others to hedge against major losses (the intended purpose of derivatives trading). Other proposals include increased shareholder powers, a consumer protection agency, and the Volcker Rule which would require banks to be separate entities from hedge funds or private equity funds, and would also ban proprietary trading by banks except in certain cases.
Any future changes to our country’s financial industry will undoubtedly come with one major caveat – people will find a way around them. Congress needs to limit changes to things that have a high likelihood of achieving the above four goals without unpleasant side effects. Delaying full commissions for mortgage brokers until the loans have been refinanced or shown to be performing, and requiring banks to retain a stake in loans they securitize so that they remain on the hook for some of the losses, are both ideas that would provide positive incentives to do good while increasing accountability by financial institutions. These are the types of changes that might actually prevent another financial crisis. We could do without regulations that just create loopholes, encourage gaming the system and cause more distress to the American taxpayer.
The financial regulatory debate has parallels with the recent healthcare issue. While most people understand why Washington is trying to implement these reforms, much like the healthcare reform bill, few people understand what reforms they are advocating, and how these reforms will affect Wall Street or anyone else. Additionally, both parties are taking such a strong stance on this issue that the facts have become secondary to partisan jabbing, leaving the American people clueless.
The goal of all the proposed reforms fall under four major categories: protecting individuals from banks and other large financial institutions, protecting these institutions from themselves, increasing the power of shareholders, and requiring more disclosure by financial institutions. The strongest opposition from Wall Street has been in response to the idea of a tax that would affect bank, thrift and insurance companies with more than $50 billion in assets, in order for the government to recoup its losses from the bailout. While this would generate more cash flow for the government, it would almost certainly lead to increased fees for these institutions’ clients. The law also seeks to heavily regulate the trading of derivatives, financial instruments whose value is dependent upon the price of an underlying asset. But too much regulation of derivatives could impede the ability of financial institutions and others to hedge against major losses (the intended purpose of derivatives trading). Other proposals include increased shareholder powers, a consumer protection agency, and the Volcker Rule which would require banks to be separate entities from hedge funds or private equity funds, and would also ban proprietary trading by banks except in certain cases.
Any future changes to our country’s financial industry will undoubtedly come with one major caveat – people will find a way around them. Congress needs to limit changes to things that have a high likelihood of achieving the above four goals without unpleasant side effects. Delaying full commissions for mortgage brokers until the loans have been refinanced or shown to be performing, and requiring banks to retain a stake in loans they securitize so that they remain on the hook for some of the losses, are both ideas that would provide positive incentives to do good while increasing accountability by financial institutions. These are the types of changes that might actually prevent another financial crisis. We could do without regulations that just create loopholes, encourage gaming the system and cause more distress to the American taxpayer.
Tuesday, April 13, 2010
Government Bond Yields Reflect More Than Just Default Risk
I’ve said it before and I’ll say it again – we (investors and non-investors alike) need something to worry about. So it shouldn’t come as too much of a surprise that members of the media are questioning the safety of US debt after three Treasury auctions were met with poor demand a couple of weeks ago, mainly from foreign investors. There are a lot of things we should worry about as investors, but the safety of US Treasury debt is not one of them. In the Wall Street Journal article entitled “Debt Fears Send Rates Up,” the reporter points out that during the prior week, U.S. Treasuries were yielding slightly more than U.S. corporate bonds, which is surprising but not unheard of. But her source, an economist at BNP Paribas, brazenly goes on to say that maybe investors are more comfortable with the risks of owning bonds backed by U.S. corporations than the government. This seems far-fetched considering our government just bailed out a number of our country’s most prominent banks and automakers to the tune of nearly a trillion dollars, and given the fact that the US has never even come close to defaulting on our debt. While it is a worst-case scenario, we could simply print more money, unlike many European governments—such as Greece—which depend on the European Central Bank to control the money supply in the Eurozone.
A rising yield for Treasuries, or any developed country’s debt issues, is only occasionally reflective of increased default risk, which is not the main determinant of bond yields and prices. Expected growth, inflation and changes in currency exchange rates are the major determinants of government bond prices; in many cases, they are more important than default risk in pricing a bond. Let’s look at current bond yields to illustrate this point. 10-year U.S. Treasuries and U.K. Gilts currently yield 3.63% and 3.75% respectively, while Japanese government bonds yield only 1.40%. However, according to the S&P, Japan’s credit rating is “AA” while the U.S. and U.K. both have the most secure rating of “AAA.” Whether this is caused by expected appreciation of the Yen against other currencies or assumptions about growth rates or inflation in Japan, it is clear that investors are willing to take a much lower interest rate on Japanese bonds despite their supposed higher default risk.
The decrease in Treasury prices and subsequent increase in yields (since prices and yields move inversely to one another) isn’t something to completely overlook. This could be problematic for the housing market, as it could lead to increased mortgage rates, or could be indicative of other impending problems for the U.S, such as higher inflation down the road. But it certainly does not mean U.S. debt is any less secure than it always has been for many decades.
A rising yield for Treasuries, or any developed country’s debt issues, is only occasionally reflective of increased default risk, which is not the main determinant of bond yields and prices. Expected growth, inflation and changes in currency exchange rates are the major determinants of government bond prices; in many cases, they are more important than default risk in pricing a bond. Let’s look at current bond yields to illustrate this point. 10-year U.S. Treasuries and U.K. Gilts currently yield 3.63% and 3.75% respectively, while Japanese government bonds yield only 1.40%. However, according to the S&P, Japan’s credit rating is “AA” while the U.S. and U.K. both have the most secure rating of “AAA.” Whether this is caused by expected appreciation of the Yen against other currencies or assumptions about growth rates or inflation in Japan, it is clear that investors are willing to take a much lower interest rate on Japanese bonds despite their supposed higher default risk.
The decrease in Treasury prices and subsequent increase in yields (since prices and yields move inversely to one another) isn’t something to completely overlook. This could be problematic for the housing market, as it could lead to increased mortgage rates, or could be indicative of other impending problems for the U.S, such as higher inflation down the road. But it certainly does not mean U.S. debt is any less secure than it always has been for many decades.
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