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THE STANDARDISATION OF CORPORATE ACTIONS ISSUE NINE • SEPTEMBER/OCTOBER 2005

Kerkorian’s New play for GM

Lampert’s revival of Sears Holding Inc. Killinger takes WaMu into a bigger league The GCC Report: Let the good times roll

TRANSITION MANAGEMENT: MERRILL LYNCH RAISES THE BAR

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Outlook EDITORIAL DIRECTOR:

Francesca Carnevale, Tel + 44 [0] 20 7074 0008, email: francesca@berlinguer.com CONTRIBUTING EDITORS:

Karen Jones, Neil O’Hara, David Simons.

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Andrew Cavenagh, Rekha Menon, Tim Steele, Bill Stoneman, Angela May Ward, Paul Whitfield, Ian Williams, Benedict Mander, Michele Carnevale FTSE EDITORIAL BOARD:

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Paul Spendiff OVERSEAS REPRESENTATION:

Adil Jilla [Middle East and North Africa], Faredoon Kuka, Ronni Mystry Associates Pvt [India], Harold Leddy & Associates [United States] PUBLISHED BY:

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FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2005

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inancial institutions are under closer scrutiny than ever before as investors and regulators ask increasingly challenging questions about corporate governance, the social and environmental impact of operations and investments and ways in which financial institutions support local communities. Easy answers to these questions cannot be found.

Furthermore the search for lasting answers often requires organisations to change policies and practices wholesale, across a spectrum of activity. In the first of three connected articles we look at the emerging role of the Public Company Accounting Oversight Board (PCAOB), created by Congress in the United States to counter rising criticism of accounting standards and, in particular, auditing firms in the wake of financial reporting scandals at Enron and WorldCom. Neil O’Hara talks to PCAOB chairman William McDonough about the agency’s approach to its supervisory responsibilities. O’Hara finds an agency imbued with “admirable bureaucratic restraint”, a rarity these days when public institutions are constantly on the lookout for new worlds to conquer. We then take a look at the work of the United Nations Environment Program Finance Initiative (UNEP FI) which since 1992 has helped signatories to understand stakeholder concerns and exchange best practice. Membership in UNEP FI, it seems, is not only about surviving public scrutiny but also about learning how to turn it into an opportunity for growth. In the last element of the trilogy we look at the work of Transparency International and the growing global effort to stem international money laundering Waves of petrodollars are washing over the Gulf Cooperation Council (GCC) countries, whetting a local boom in investment in infrastructure and private sector consumption. Privatisation and deregulation are supporting a spurt of initial public offerings, with telecommunications and natural resources extraction companies figuring large on local exchanges as demand for shares from both retail and institutional investors continues unabated. Naturally, liquidity is very high indeed—private wealth alone in the region, for example, is estimated to account for some $1.3trn of investible money. The special GCC Report covers the rise of the local equity markets, the impact of deregulation on the local banking markets and the growing importance of local financial hubs in attracting and keeping money in the oil-rich states.

This edition’s sector report covers the US auto industry from two widely differing perspectives. Dave Simons examines the vicarious fortunes of the Ford, General Motors and Chrysler companies as they come to terms with changing consumer tastes and growing competition from foreign manufacturers. In our cover story, Ian Williams hones down on one particular company as he takes a considered look at the investment rationale of superinvestor Kirk Kerkorian as he ups his stake again and again in General Motors.

In June Washington Mutual chairman Kerry Killinger unveiled a deal to acquire Providian Financial, a Visa and MasterCard credit card issuer with nearly 10m customers and $18.4bn in receivables. Art Detman introduces us to an emerging force in US retail banking.

Francesca Carnevale, Editorial Director September 2005

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Contents COVER STORY KERKORIAN’S INSIDE STRAIGHT

........................................................Page 46 Reportedly mega-investor Kirk Kerkorian has now put around 20% of his reputed $5.8bn fortune into General Motors shares. Has he bought celestial futures? Or is he throwing away a significant chunk of his hard-earned wealth on a lost cause?

Ian Williams reports.

REGULARS WHAT PRICE SECURITY? ..........................................................................Page 6 Robert Leverich explains why investors still choose bonds over equities.

IN THE MARKETS

BSX GAINS RECOGNITION ..................................................................Page 10 Bermuda’s stock exchange builds a momentum of recognitions.

NASDAQ PARTNERS WITH FTSE ON NEW INDICES ....Page 12 FTSE Group and NASDAQ create four US domestic indices.

US RETURNS TO THE 30 YEAR BOND

....................................Page 14 The US Treasury has decided to relaunch semi-annual 30 year bond auctions.

MARKET LEADER

DEFINING MATERIALLY RESPONSIBLE INVESTMENT....Page 20 The search for common ground between investor returns and the sustainable development criteria of the UN.

WHEN BRIBERY AND CORRUPTION COUNTS ................Page 22 Enhancing FTSE4Good company inclusion criteria.

FACE TO FACE

RESTORING INVESTOR CONFIDENCE

......................................Page 16 Neil A. O’Hara talks to William McDonough, PCAOB chairman.

RUSSIAN IPOs PICK UP PACE

REGIONAL REVIEW

............................................................Page 24 Why Russian companies are rushing to list overseas.

TAKING THE MEASURE OF CHRISTOPHER COX ..........Page 27 Karen Jones assesses the new chairman of the SEC.

PANICKED IN DETROIT

SECTOR REPORT

............................................................................Page 49 What next for the US automotive industry? Dave Simons reports.

IF THE SHOE FITS?

........................................................................................Page 62 Can wunderkind Edward S. Lampert pull off the revival of Sears?

WHO’S AFRAID OF THE BIG BAD ALGORITHM?

INDEX REVIEW

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....................Page 81 Adam Sussman and Wendy Garcia of the TABB Group explain the dynamics of the relationship between brokers and their clients.

Market Reports by FTSE Research ................................................................................Page 86 Companies in this issue ..................................................................................................Page 85 Calendar ............................................................................................................................Page 96

SEPTEMBER/OCTOBER 2005 • FTSE GLOBAL MARKETS

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429.5 -1.4 12:26:08

SELL ORDERS PRICE QTY 4 17 12 75 103 101 1 2 2 2

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429.6 -1.3 12:26:08

SELL ORDERS PRICE QTY 10 13 35 123 203 202 3 1 2 1

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Contents FEATURES THE GCC REPORT

LOCAL LIQUIDITY OILS GULF EXCHANGES ......................Page 30 Welcome to the Middle East, where stock markets have been transformed over the last five years by rising liquidity and a new breed of investors coming to the markets.

TRANSPARENCY, INTEGRITY, EFFICIENCY ..........................Page 36 Page 36

Three new financial centres have been established with the purpose of attracting international and regional financial service firms in order to become the Middle East’s premier financial hub. Can they all succeed?

GCC BANKS RAISE THEIR GAME ..................................................Page 39 Page 39

Until recently banks in the GCC zone lived protected lives. All that has changed now as liberalisation and competition from foreign banks eager to leverage high levels of local liquidity.

MERRILL LYNCH SETS A NEW BAR ..............................................Page 54 The highly competitive transition management business now has a new force to contend with. Merrill Lynch has created a hybrid offering that promises to comprise the best of the broker/dealer and asset management approaches to the business. Will it set a new standard?

EUROTUNNEL: THE SEARCH FOR A NEW TRACK ..........Page 57 Eurotunnel is weighed down by £6.5bn worth of debt. But it’s not really Eurotunnel’s fault and it is now seeking a new refinancing package. Will it succeed?

ALL SHOOK UP ..................................................................................................Page 70 Third party lending agents are shaking up the cosy world of securities lending in the United States forcing traditional lenders to change their ways. Neil A. O’Hara reports from Boston.

THE BIG SQUEEZE ..........................................................................................Page 75 Brokers are feeling the pinch as commission rates continue to drop although higher trading volumes offset lost revenue. But it still comes at a price—more trades to process.

ASSAILING THE LAST BASTION..........................................................Page 78 Corporate actions is one area where standardisation has been successful. The credit for this goes to the ISO 15022 messaging standard. By Rekha Menon.

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In the Markets ASSET ALLOCATIONS

Photo: iStockphoto.com, June 2005

Early this year, publicly traded companies in the EU shifted to a single, new accounting standard. This requires them to mark-tomarket investment portfolios every year at current market value rather than valuing them at historical cost. This rule has caused many of Europe’s largest insurance companies, long the mainstays of the region’s equity markets, to allocate far more assets to fixed income investments. Even though pension funds seek the best long-term returns, this new regulation is forcing managers to sacrifice higher historical returns offered by equities at the regulatory altar of financial transparency and reduced volatility.

This increased demand for bonds is one reason bond yields are so low in Europe – unnaturally low some say. Robert Leverich, chief research analyst at Swiss American Securities in London reports.

WHAT PRICE SECURITY? OW INTEREST RATES worldwide have prolonged a global rally in real estate values that began when investors sought safe haven after the equity market collapse in 2000. Valuations in this sector appear to be extended by most measures, but with ample financing readily available and few attractive alternatives, demand for properties appears to continue unabated.

In the United States, 10 year Treasury notes are yielding 4%.

This is equivalent to a stock trading at 25 times earnings.

Right now, US benchmark indices are at 16 to 18 times earnings (depending on your earnings estimates). Real estate values have also skyrocketed over the last five years for similar reasons as in Europe. The tremendous growth in the mortgage origination market has fostered a huge volume spike in mortgage-backed derivatives, the building blocks for which are fixed income securities.

Therefore demand for real estate and mortgage products is contributing, in a big way, to creating the low interest environment that abets more demand.

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But this current cycle of ultra-low interest rates and ever-increasing real estate values will also plateau. That is because asset class performance is cyclical. Equities have disappointed over the last five years – left in the dust by bonds, housing and commodities.

As the dollar has resumed leadership, we expect Europeans to accelerate capital flows into dollar denominated assets and US equities appear cheap compared to other asset classes. As the hangover from corporate scandals and excesses of the 1990s recedes and highly efficient US companies continue to drop more revenue to their bottom lines, more of the capital drawn to dollar denominated assets should find their way back into US equities.

Corporate balance sheets in the US are in their strongest position in decades and cash is piling up at a record pace. With a dearth of clear investment alternatives, it is likely these companies will be forced to buy back shares, drastically increase dividends, or agree to be taken out at a price. This last option is already

happening, as witness recent activity in Neiman Marcus Group, SunGard Data Systems Inc. and others. With the huge flow of funds into private equity and hedge funds, pressure will continue to grow on public companies sitting on large cash hoards.

Consider that cash on balance sheets of S&P 500 companies has increased 54% over the last two years; this, even considering Microsoft’s $33bn dividend payout last year.

These cash balances represent nearly 8% of the S&P’s market value and roughly one-third of the companies in the index have more cash than debt, up from only 17% five years ago. One explanation for these large cash balances is above average risk aversion by corporate leaders in the wake of numerous corporate scandals and the ensuing regulatory requirements imposed on public companies. Rather than increasing risk by deploying cash to make an acquisition or a significant investment, corporations are more interested in minimising downside

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© 2005 Northern Trust Corporation.

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of GDP in line with historical average surprises, even considering the of the last 40 years. This happy opportunity cost of foregone growth. surprise is the result of sustained While such risk aversion may take economic growth which is producing years to dissipate, it seems clear that greater than expected income tax relative valuations are pointing revenues. Through June of this year, strongly to US equities. As the Robert Leverich, corporate tax receipts are running outlook for the US dollar continues senior vice president 41% ahead of last year. The federal to strengthen compared to the Euro it and director of deficit is often cited as a key risk factor seems increasingly likely that as a institutional sales vis-à-vis US equities, but this risk is strengthening dollar acts as a magnet and trading at Swiss being consistently overstated. for foreign capital, one of the biggest American Securities Earnings momentum may have beneficiary will be US stocks. With in London peaked, but the growth rate is still the aforementioned strong balance Photo: SASI August 2005 healthy, at or near double digits for sheets, solid earnings expectations the balance of 2005. Core inflation and growing dividend yield, one Corporate balance appears to have peaked at less than expects equities to appear sheets in the US are in 2% and it is likely that the Fed is increasingly attractive, especially their strongest position in nearing the end of the tightening cycle versus bonds. Some tactical asset decades and cash is given the slowdown in global growth, allocation models peg equities as piling up at a record pace. especially in Europe. It looks like any undervalued by as much as 70% slowdown in the US, however, is verses bonds using different With a dearth of clear merely a mid-course correction variations of the “Fed Model.” investment alternatives, it similar to 1985 and 1995. In both Thomson Financial, estimates that is likely these companies instances, the yield curve flattened, equities are 35% undervalued based will be forced to buy back the Fed stopped raising rates and on Thomson’s version of the Fed shares, drastically equities rallied. We expect a similar Model. This compares to a 70% increase dividends, or progression this time. overvaluation reading in early 2000.

So what of the bond market? While Such valuation distortions set the agree to be taken out at institutional asset pools such as stage for companies to buy back a price. This last option is pensions will continue to overweight stock (their own and others) until already happening, as bonds to match future liabilities, in a things come back into balance. witness recent activity in low interest rate world, some greater What will be the causal factor Neiman Marcus Group, portion will have to be allocated to tipping the marginal dollar from fixed equities. That’s the only way to ensure income to equities, ultimately SunGard Data Systems an acceptable average growth rate so bringing the Fed model back to and others. these pools can achieve their own equilibrium? It will have to begin with actuarial assumptions. a gradual recalibration Global demand for dollarof risk premiums. Like Are US equities on the cheap compared to other asset classes?

275 based, fixed income securities the Fed model, today’s 250 will remain strong as the US US equity risk premium 225 continues to be the key is out of line with 200 175 source of demand, forcing current fundamentals.

150 supplier nations to recycle Estimates of federal 125 dollars. But we would argue budget deficits are 100 that a growing percentage of declining materially, 75 50 those reinvested dollars will seemingly every week.

25 find their way into equities.

Private economic They are cheap by forecasters now believe comparison and the growth the budget deficit may FTSE US Index FTSE US Government Bond (10+ yrs) Index FTSE EPRA/NAREIT US Index prospects are compelling. come in at about 2.5% Data as at July 2005. Source: FTSE Group

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In the Markets BERMUDA RECOGNITIONS

BSX gains recognition From the start of September, the Bermuda Stock Exchange (BSX) will enjoy Designated Investment Exchange status by the United Kingdom’s Financial Services Authority (FSA).

ESIGNATION BY THE UK’s FSA for the BSX continues a momentum of recognitions following last month’s announcement that the BSX had been granted Approved Stock Exchange status under Australia’s Foreign Investment Fund (FIF) taxation rules. BSX first applied for Designated Investment Exchange status from the UK financial regulator, the FSA, and Recognised Stock Exchange status from the UK tax collector, the Inland Revenue some years ago. “From the FSA’s point of view the BSX has the proper regulatory infrastructure in place that is reinforced by jurisdiction’s legal framework,” says Greg Wojciechowski BSX’s president and chief executive officer (CEO).

The designations are the culmination of work by the BSX and Bermuda’s regulators to ensure that a regime of internationally accepted regulatory and operating standards are implemented and practiced in Bermuda. Wojciechowski acknowledges that designation by the FSA “represents a significant milestone in the global regulatory recognition of the BSX.” He adds that “in addition to very closely scrutinising every aspect of the Exchange’s regulatory and operating infrastructure, including financial resources, investor safeguards and monitoring and enforcement procedures, the FSA had to be satisfied that the jurisdiction of Bermuda upheld internationally accepted regulatory standards.”

BSX is a fully electronic market with daily trading and book-based centralised settlement. Established and

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operating since 1971, the BSX in 1992 took the approach of demutualisation and incorporated as a for profit entity.

Trading memberships on the exchange are freely available to international brokers who meet BSX requirements.

Some 3.3bn shares trade on the BSX International Crossing Market through the year with an associated value of $119bn. Total market capitalisation on the exchange by the end of last year stood at approximately $120bn, of which $1.85bn represented the domestic market, although last year domestic trading volumes were slightly down. Overall, the Royal Gazette/BSX Composite Index, the exchange’s official index ended the year at 3,208.05 points, up 8.2%.

The BSX announced a number of seminal listings in 2004 including HSBC Holdings plc, Aspen Insurance Holdings Ltd., and American Safety Insurance Holdings Ltd. The BSX has also introduced new regulations which will make listing on the Bermuda Stock Exchange easier and clearer. The incoming regulations updated exchange rules for its members and standardised the wording of listings.

“We have worked very hard to ensure that international standards of stock exchange operation and regulation have been adopted in Bermuda and feel that recognition by international securities regulators indicate that we have been successful in meeting this goal,” adds Wojciechowski. During the application process the FSA provided very useful input in respect of the development of our capital market and financial

services regulation in Bermuda. We are very confident that the regulatory regime, which is the foundation of Bermuda’s financial services industry, is modern, efficient and completely in accordance with internationally accepted regulatory practices. We are proud that the BSX and Bermuda continues to set the commercial and regulatory standard offshore.”

Recognition by the UK regulator was very important for Bermuda, as it provides a clear indication to UK investors that they can expect broadly equivalent measures of investor protection when using the BSX, “as they have come to expect from the UK or other designated investment exchanges,” he says. “We anticipate that this development will stimulate commercial interest in the BSX from the UK and the European Union.”

Meanwhile, the essential function of Australia’s designation to the BSX is to provide clear guidance to Australian taxpayers when unrealised gains on investments held in a foreign country

by Australian taxpayers may be exempt from the Foreign Investment Fund taxation measures. The most widely applied exemption from the FIF taxation rules occurs when the foreign company is principally engaged in an eligible (or active) activity, one that does not fall on the “black list” of activities which is detailed in Schedule 4 of the Australian Income Tax Assessment Act 1936. There are two methods to determine whether a foreign company is principally engaged in eligible activities, the first is if it is listed on an Approved Stock Exchange and the other is by reviewing the financial activities of the company as set out on the company’s balance sheet. “This does build the momentum and the exchange will continue to seek other recognitions from global regulatory bodies as part of the BSX’s growth trajectory,”concludes Wojciechowski.

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U n i q u e l y

Established in 1971 the Bermuda Stock Exchange (BSX) is today the world’s fastest growing offshore securities market.

p o s i t i o n e d

The BSX is internationally recognised as an attractive venue for the listing of: Hedge Funds Investment Fund Structures Equities Fixed Income Structures Derivative Warrants

Advantage Bermuda

www.bsx.com e-mail: info@bsx.com 22 Church Street, Hamilton HM 11, Bermuda Tel: 1-441-292-7212 • Fax: 1-441-296-1875

The BSX is a full member of the World Federation of Exchanges.

Bermuda is a British Overseas Dependent Territory and is part of the UK for the purpose of OECD membership.

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Photo: FTSE Group. August, 2005

REGIONAL REVIEW 9

Market Leader NEW NASDAQ INDICES

Jerry Moskowitz, managing director of FTSE Americas

NASDAQ partners with FTSE on new US indices FTSE Group and NASDAQ have partnered to create the recently launched FTSE NASDAQ Index Series; four US domestic indices providing a host of new tools to measure, invest and trade on the NASDAQ market. Karen Jones reports.

ASDAQ AND FTSE Group are “a good match,” says John L. Jacobs, executive vice president and chief marketing office of NASDAQ and chief executive officer (CEO) of NASDAQ Global Funds, commenting on the new FTSE NASDAQ Index Series, which includes four new US domestic indices. These comprise the FTSE NASDAQ 500, FTSE NASDAQ Large Cap, FTSE NASDAQ Mid Cap and FTSE NASDAQ Small Cap. This is first alliance of its kind for NASDAQ and Jacobs says he is excited about the possibilities.“FTSE is about expertise and so are we. One verb I use to describe NASDAQ is execution. We go out there and we see what we want to operate and move forward. We share that DNA.”

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The relationship between FTSE and NASDAQ has built steadily since the announcement in November 2003 by the electronic stock exchange that it would reclassify its nearly 3,400 listed companies according to the FTSE Global Classification System (GCS).

While “the NASDAQ 100 is very successful,”says Jacobs,“with these new series of indices there will be a whole variety of strategies you can use.

Obviously FTSE has the expertise in building this.” The developing relationship with FTSE is part of a larger trend among stock markets to diversify their product offerings. Jacobs underlines that he is also aware that for stock markets to remain viable today, new business strategies must always be pursued in line with the ever-evolving

FTSE NASDAQ INDEX SERIES CAPITAL INDEX PERFORMANCE

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investment industry. He cites selling market data and creating “financial products” such as indices as two more lines of business markets pursue today.

“In the past, stock markets had two lines of business, they traded stocks and listed companies and pretty much traded the companies they listed. That has all changed,”he explains.

“We try to create, through partnerships, licensing or on our own, financial instruments based on NASDAQ indices to extend our brand, add value to our companies so they see the value of being listed here. This also creates other opportunities for trading and investing to increase our transaction business and make our database richer,”continues Jacobs.

Jacobs also does not see the FTSE NASDAQ 500 in competition with the S&P 500. “We are looking for a diversified growth index and a broader growth index. The S&P is US only. NASDAQ does not do that. We are an international market.”

The new FTSE NASDAQ Index Series comprises the FTSE NASDAQ

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ack histories for the new FTSE NASDAQ Index Series 100 demonstrate the value of size-based investment strategies on 80 NASDAQ. Over the five years since December 1999, while the NASDAQ 100 and NASDAQ Composite have only recovered from a 60 loss at September 2002 of over 70% to a loss of approximately 40 50%. On the other hand, the FTSE NASDAQ Small Cap Index has 20 recovered all its 45% loss over the same period and is now above 0 its levels of December 1999. Consequently it has outperformed the NASDAQ Composite by 44.2% and the NASDAQ 100 by 51.4%. This is true also (although to a much lesser extent) of the FTSE NASDAQ Large Cap FTSE NASDAQ Mid Cap FTSE NASDAQ Small Cap performance of the FTSE NASDAQ Mid Cap Index, where the index FTSE NASDAQ 500 NASDAQ 100 NASDAQ Composite has outperformed the NASDAQ Composite and the NASDAQ 100 Data as of July 2005. Source: FTSE Group by 9.5% and 16.7% respectively.

In both instances, the relative outperformance is primarily due to the relatively low weighting of technology stocks in the indices, compared with the NASDAQ 100. Equally, the same is true of the NASDAQ Composite, which also outperformed the NASDAQ 100 over the period. Although each FTSE NASDAQ Index is open to Financials companies, this has had little effect on the performance or profiles of the indices. Tracking error and correlation analysis shows that the new FTSE NASDAQ 500 Index has much the same profile as that of the NASDAQ Composite Index, providing a low tracking error of 3.6%, and a high correlation of 0.997.

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500 which consists of the largest 500 companies in the NASDAQ Composite Index ranked by full market capitalisation; the FTSE NASDAQ Large Cap, which is made up of the largest 70% of companies in the NASDAQ Composite Index; the FTSE NASDAQ Mid Cap which consists of the next 20% of companies in the NASDAQ Composite Index; and finally the FTSE NASDAQ Small Cap, consisting of the smaller 10% of companies in the NASDAQ Composite Index. All companies included in the indices are ranked by their full market capitalisation.

Jerry Moskowitz, managing director of FTSE Americas, underlining the significance of the new indices, calls

the new FTSE NASDAQ Index Series partnership “huge”for FTSE.“We are a global company. We do business in the US but we don’t really have a US domestic index. Most of our business is based on non-US indices driven by pension plans outside the US. Now that we are calculating our first US domestic indices for the US domestic market, it puts a flag down saying we are not only a successful global player, but indicates we can be a successful domestic US player as well.”

Moskowitz explains the partnership blossomed after the classification system was initiated. The result of classification was that now NASDAQ companies had to “deal with FTSE directly”if there were any questions regarding which industry

they were placed in. He adds they have managed to take the problem of companies exerting direct pressure on NASDAQ to be placed, for example, in highly desirable industries such as Biotech onto their shoulders. “We are willing to intervene and be involved with their clients and listed companies and handle them well.”

Moskowitz says that once NASDAQ saw that FTSE Group had the expertise to provide a comprehensive and accurate classification for their companies the way was opened for a closer relationship between the two institutions. “The next step was for us to propose these new indices and allow us to calculate them and jointly brand them and build off this base of high quality client support.”

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FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2005

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Market Leader RETURN OF THE 30 YEAR BOND AUCTION

US returns to the 30 Year bond At the beginning of August, the US Treasury announced that it had decided to re-launch semi-annual 30 Year bond auctions in February 2006. While the market had expected some move this year, it remains something of a turnaround. The Treasury discontinued 30 Year nominal and inflation linked bonds back in October 2001 because of a reported fall in its borrowing needs.

N ITS QUARTERLY refunding report, the US Treasury announced it has revived the 30 Year long bond after a four-year break and added it will sell $44bn in other notes in the third quarter of this year—the smallest sale in more than two years. The move is timely as demand has grown for long-dated bonds, mainly from institutional investors in search of paper that more closely matches assets with their liabilities. The average maturity of US debt is now 53 months, compared with an average maturity of 70 months when long bond sales were halted in October 2001. The Treasury is financing government at long-term interest rates that are about the lowest since mid-2003.

Earlier this year, both the United Kingdom and France successfully sold down 50-year bonds – the French via syndication and the UK via an auction process. In recent years, the longestdated US Treasury bond has been a 20year inflation-protected note. Treasury assistant secretary Timothy Bitsberger says that specific auction sizes will not be announced until closer to each auction, adding that the government is not considering eliminating any debt maturities currently offered and does not plan to offer 50-year bonds. “We pretty much, after some internal analysis, restricted ourselves to 30 Year bonds—in part because a lot of what we do is pretty simple and 30 Year bonds have an existing brand-name for us, it is an established market. Fifty-year bonds are a new security. It might take decades for that market to develop,”he says.

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Bitsberger stresses that the long bond is not necessary to meet government financing needs and that its reintroduction was designed to diversify its borrowing options and widen the pool of investors for Treasury products. By pushing out the maturity of government debt, however, the long bond will help lower the Treasury’s frequency of refinancing. However, he adds,“We just want to highlight to the marketplace that there is some uncertainty going forward, so the markets should have a broader range of expectations as to what Treasury issuance sizes will be across the curve.”

The shoots of a return were visible as far back as the Spring. In late April, the Treasury had announced it was thinking of returning to the long bond market and formally requested public comment. In reply, the Bond Market Association (BMA) and the Senior Executives Group (SEG) of the Asset Managers Forum (AMF) began a survey of investors in May, collecting data on investor sentiment towards the issuance of 30 Year US Treasury bonds and also to quantify potential demand for the long term securities. Additionally, BMA’s Government & Federal Agency Securities Division formed a 30 Year Treasury Bond Task Force that studied the benefits of a resumption of the longer term bonds to taxpayers, investors and the US bond market as a whole. The Task Force comprised a diverse group of dealers, asset managers, pension consultants and hedge funds.An anonymous survey was

distributed to TBMA members and SEG institutional investor participants today with a deadline for responses of by the start of July.

According to Henry Hunt, director of fixed income for global government bonds at F&C Asset Management: “The market expects $20 to $30bn worth of long dated paper to be made available in 2006.” Hunt says the first auction is expected in February 2006, and will involve between $10bn to $12bn worth of bonds, with a second auction in August 2006 “for another $10-12bn worth”he adds.“In terms of pricing, I expect these new offers to trade at a 10 to 15 basis point (bp) yield discount to the 2031 bond which was the last 30 Years paper issued in 2001.

This discount means that the US Treasury is able to borrow money in a cost effective way, but conversely investors are not getting much extra return on long bonds given the current shape of the US Treasury yield curve.”

The US government is reissuing the 30 Year bond at a time when long-term yields are lower than a year earlier and the gap between 30 Year Treasuries and other maturities is shrinking. The difference in yields between 10 year and 30 Year bonds shrunk to 19bp during the first week of August, the lowest since 2000. The yield on the 30 Year bond was 4.54% on the day of the Treasury’s announcement. Continues Hunt: “One reason this bond will be popular with investors, despite poor returns, is the current pressure from the White House budget proposal to

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begin mark to market accounting on defined benefit pension liabilities in the US as it is now done in Europe.”

In mark to market accounting, defined benefit pension liabilities must be shown on a company's balance sheet. This accounting system, introduced 18 months ago, is encouraging European pension trustees to pile into long dated bonds to match assets to liabilities sometimes at the expense of investment performance.

The US Treasury Borrowing Advisory Committee is confident that it can tap into demand from long-term defined benefit plans and other long-term investment pools. Hunt explains: “It is more than coincidence that the 30 Year bond is being reissued as this pension accounting debate is ongoing. The amount outstanding of US long bonds

has declined markedly since 2001. We might even venture to say that the US Treasury and Congress are exhibiting some joined-up thinking on this issue.”

Despite the pension demand and looming account reform, Hunt thinks it is also an attractive time for the US to issue long dated paper because 10Year and 30 Year spreads are very narrow.“These narrow spreads mean that it is cheap for the US Treasury to launch a 30 Year bond because they will only have to pay around 10 bps more to borrow money for 30 years than they are now paying to borrow money for 10 years.”

The return of the long bond may be the clearest sign yet that the administration recognises large federal budget deficits are here to stay. Hunt expects the 30 Year bonds to be available

for at least five years.“The US is running a budget deficit of $300bn to 350bn per year and the 30 Year bond is likely to be a regular feature of deficit financing again. In recent years, the Treasury has also been launching 20 Year Treasury Inflation Protected Securities (TIPS), in other words – index-linked bonds. The US Treasury may eventually re-launch 30 Year TIPS, but there wasn’t anything mentioned about them today.”

The Treasury will auction $18bn in three-year notes, $13bn in five-year securities and $13bn in 10 year debt during August, the smallest since the first quarter of 2003. Citing increased revenue from an expanding economy, the Bush administration says it has cut the budget deficit from a record $412bn last year to around $333bn to fiscal year ending September 30.

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Face to Face Photo: PCAOB. August, 2005

FACE TO FACE WITH THE PCAOB

Restoring Investor Confidence William McDonough, chairman, PCAOB. “We adopted the supervision approach, that is to work with the accounting profession on the assumption that these were honourable people...,“ says McDonough

Enron and WorldCom called into question the accounting profession's ability to regulate itself.

Outraged investors concerned about conflicts of interests no longer trusted the American Institute of Certified Public Accountants (AICPA) to set auditing standards and supervise firms that conduct US public company audits. In response, Congress created an independent agency, the Public Company Accounting Oversight Board (PCAOB), to assume those responsibilities. Neil A. O’Hara talks to William McDonough, the current PCAOB chairman, at the agency's New York office.

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CAOB’s BIRTH WAS part of a wider effort to restore investors' confidence in the financial markets. The fledgling regulator suffered acute embarrassment when its first chairman, William Webster, had to resign over, of all things, a conflict of interests—an inauspicious start for an agency intended to eliminate those conflicts. The Securities and Exchange Commission (SEC) then asked McDonough, former president of the Federal Reserve Bank of New York, to pick up the gauntlet.

Walking in the door, McDonough discovered much to his liking. Charles Niemeier, the acting chairman and continuing board member, had already hired highly qualified people as heads of

P

supervision, inspections and regulation, and standard-setting. “The four board members had gotten the place off to a very good start,”McDonough says,“Not only did I think they had chosen well, but the policy decisions they had made I found I would have done exactly the same things.”

McDonough drew on his experience as a central banker for a regulatory model. He compares the periodic inspection of audit firms required by the Sarbanes-Oxley Act (SOX) to the examinations that lie at the heart of banking oversight. “We adopted the supervision approach, that is to work with the accounting profession on the assumption that these were honourable people who were trying to

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By co-opting the American Institute restore the faith of the American six years’ audit experience, usually at a people in their profession and their large auditing firm. The people that of Certified Public Accountants’ firms,”he says,“The other side of that is head our inspections of the larger firms (AICPA's) auditing standards as its when we find them doing something have on the average about 20 years’ own on an interim basis, PCAOB that they should not be doing we bring experience,”he says,“When they go out avoided having to re-write the entire them up very smartly—if necessary and meet with the people they are rule book overnight.

Instead, McDonough assembled a through an enforcement action—but inspecting, from the top of a major firm certainly by some very active coaching down, you want to field a team that small group of specialists, led by people take seriously. Ours are taken Douglas Carmichael, to review the rules during our inspection process.” and draft permanent standards in order Two years later he sees no reason to very seriously.” of priority. A Standing change a model that works.“I Advisory Group on Standard think the leaders of the Setting weighs the competing accounting profession have To date, PCAOB has brought only one interests of investors, auditors, really learned that the audit enforcement action, against a relatively lawyers and consumer groups has to be their single most small firm. Although the number will to fix those priorities. Next up: important product,” he says, probably increase over the next few years, one standard governing the “They have to take that McDonough expects actions to tail off as provision of tax services by responsibility very seriously. audit firms and another on the They have to train their the accounting industry adapts. “We have audit work required to people well so that they are hundreds of firms now that audit public confirm that an issuer has adhering to both the letter companies, but some audit only two or rectified a material weakness and the spirit of the three. Adding all the accoutrements that in internal controls under Sarbanes-Oxley Act.” He you need to do a public company audit for Section 404 of SOX. believes that PCAOB's three companies – is this a business The PCAOB proposes to existence has pushed audit bar audit firms from giving firms to raise their standards model that makes sense?” he asks. what McDonough calls “tax and boosted investors' McDonough thinks the answer is obvious; advice of a speculative nature confidence in financial he expects some reduction in the number where the issuer is gambling statements as a result. of firms that perform public company on the likelihood that the Not surprisingly, the audits as a result.

Internal Revenue Service or PCAOB has strong ties to the Inland Revenue will allow both the Financial them to get away with it.”The Accounting Standards To date, PCAOB has brought only one agency wants to prohibit auditors from Board (FASB) and the SEC. “Accounting standards only make enforcement action, against a relatively preparing individual tax returns for sense if they are auditable so there’s a small firm. Although the number will executives who have authority over close working relationship,” says probably increase over the next few financial reporting, too. Otherwise, McDonough, who meets regularly years, McDonough expects actions to McDonough takes an expansive view. with FASB chairman Robert Herz and tail off as the accounting industry “The auditor, just in the course of Don Nicolaisen the SEC’s chief adapts.“We have hundreds of firms now doing the audit, knows so much about accountant.“We try to make sure that that audit public companies, but some the issuer and its tax aspects. We think what we are doing is intellectually audit only two or three. Adding all the it's in the interest of the issuer that they accoutrements that you need to do a be allowed to use their auditors for tax consistent and coherent.”

McDonough’s regulatory philosophy public company audit for three purposes,” he says, “It’s also in the infuses PCAOB’s allocation of resources. companies—is this a business model interest of the accountants, because The key role of supervision in his eyes that makes sense?”he asks rhetorically. auditing firms are a business as well as shows up in the 180 staff dedicated to McDonough thinks the answer is a profession. It increases their ability to inspections and registration. He insists obvious; he expects some reduction in attract people and pay them properly.”

How long will it take to complete a on seasoned professionals. “We do not the number of firms that perform public review of auditing standards? “Eternity hire anybody who does not have at least company audits as a result.

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Face to Face FACE TO FACE WITH THE PCAOB

comes to mind,” says McDonough, who recognises that although auditing standards do not change as fast as businesses they still need to reflect developments in the economy.“Having been a naval officer with service on a destroyer I know how fast the rust can return,” he says, “That’s why we have set up a rather large advisory group on auditing standards to make sure that we have people from every aspect of the economy telling us,‘Hey, this one is now becoming important. You had better get it on your list’.”

The PCAOB’s oversight extends to foreign auditing firms whose clients have issued securities in the US. In effect, a nation state is trying to regulate capital markets that have become global, a problem McDonough knows well from his days at the New York Federal Reserve.“We are in the process of working out cooperative arrangements [with foreign regulators],” he explains,“It is very like the home host supervisor in banking. If the part of the Financial Services Authority (FSA) that deals with auditor oversight wishes to inspect an American audit firm, the working presumption is that they will ask us to do their inspection on their behalf.

Conversely, when we inspect United Kingdom firms (because they audit issuers with securities in the US), we will ask the FSA to do those inspections on our behalf.”

Cooperative agreements allow the agency to exercise its authority abroad without creating a new bureaucracy.

The PCAOB consulted European Union officials to ensure that its standards for international dealings meshed with similar provisions in the European Union’s (EU’s) Eighth Company Law Directive, too. “I worked that out with Fritz Bolkestein, who was then the EU Commissioner for the internal market. I see no reason why he and I should not share the Nobel peace prize,” McDonough quips.

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Joking apart, PCAOB has come a long way during his tenure. By July 2005, the agency had registered 1,534 auditing firms, 599 of which hail from 79 foreign countries. It has inspected the Big Four accounting firms twice and is about to start a third round. In 2004, it inspected the four next largest US firms as well as about 90 smaller firms. It has finalised three auditing standards, including AS2, which governs audit procedures for internal controls over financial reporting under SOX Section 404.

McDonough has publicly acknowledged that Section 404 imposed unintended burdens on some issuers. Last May, the PCAOB published additional guidance on the implementation of AS2 that encouraged auditors to tailor procedures to their clients’ needs.“Some of the audit firms clearly were doing a little too much checking of the boxes and therefore doing work that would not appear to have been necessary,”says McDonough, “In a litigious society there is no question that auditors might prefer if we put out a very clear checklist. We can't do that. The list that makes sense for General Electric doesn’t make any sense for Microsoft, never mind anybody else.

We do believe very strongly that auditors have to use judgement.”

Issuers cannot expect auditors to spell out how to account for specific items because if the issuer simply follows instructions the auditor is left auditing its own work. But issuers can still seek advice.“If the issuer says,‘Here is how I plan to do it. What do you think?’ the auditor not only can but should answer the question,”McDonough says.

SOX interposed the chair of the audit committee into the relationship between an auditor's engagement partner and the issuer's chief financial officer. The change created friction in some cases. “That need not bring about a situation in which the CFO and the engagement partner suddenly become enemies. It should be three

Photo: iStockphoto.com. June, 2005

How long will it take to complete a review of auditing standards?

“Eternity comes to mind,” says McDonough, who recognises that although auditing standards do not change as fast as businesses. people working together for the best interests of investors and the company,” McDonough says, “There was a bit of a breakdown of people exaggerating just how apart they had to be and both the SEC and PCAOB are very strongly encouraging a restoration of a sensible amicable relationship between the two sides.”

Over the next 12 months, most issuers will go through a Section 404 review of internal controls for the second time. McDonough believes that both issuers and auditors can improve the process. “It would be very disappointing if the second year isn't quite a lot better,” he says, “There have to have been some onetime costs. Nobody gets anything exactly right first time. Auditors should ask how they can do the second year better, more rationally and more cost efficiently.”

In the longer term, McDonough thinks the PCAOB should evolve to reflect changes in the economy but otherwise stick to its remit. “It is very important that the PCAOB not fall into the trap that public institutions can, which is to keep looking for new worlds to conquer,” he says. On McDonough’s watch, at least, the PCAOB seems unlikely to abandon its admirable bureaucratic restraint.

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Market Leader PRINCIPLES FOR RESPONSIBLE INVESTMENT

The United Nations (UN) is pushing for the establishment of a consistent set of principles for responsible investment (RI) through the coordinating auspices of the United Nations Environment Programme (UNEP) and the UN Global Compact. Can common ground be found between the investment returns desired by institutional investors and the sustainable development objectives of the UN? DVOCATES OF RESPONSIBLE investment have it that the convergence of social, environmental, and governance issues is material to company performance over the long term. The approach has found its strongest sponsor in UNEP and the Global Compact, which recently announced that it is working with just over 20 of the world’s major institutional investors to develop a set of globally recognised principles for responsible investment that aim to be published in the late autumn.

The project was originally convened by the UN Secretary-General Kofi Annan, under the umbrella of UNEP and the UN Global Compact initiative —begun by him in 2000.

The United Nations Global Compact initiative has grown rapidly since Annan's speech at the World Economic Forum in Davos back in January 1999 when the Secretary-General called on global business leaders to embrace nine universal principles in the areas of human rights, labour conditions and environmental practices.

Most recently, Annan invited “a cross section of the world’s leading institutional investors to join a process that will develop a set of principles that will have a global application,”explains Paul Clements-Hunt, head of unit at UNEP FI in Geneva. The Principles for

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Defining materially responsible investment Responsible Investment process kickedoff with a meeting of more than 50 investment experts held in early April in Paris. At the meeting, organized by the UNEP FI (and hosted by Caisse des dépôts) participants from a range of institutions, —including regulators, financial managers, academia, nongovernmental organisations— proposed a global alliance of investors to guide responsible investment best practice. At a later meeting in the middle of June participating investors also reportedly encouraged UNEP to co-ordinate its work with relevant international organisations and initiatives such as the IFC, the OECD, the International Corporate Governance Network and the Carbon Disclosure Project. Regional groups pinpointed for collaboration also included the Investor Network on Climate Risk in the USA and the Institutional Investors Group on Climate Change in the UK, although Clements-Hunt says that“the Chatham House Rule was agreed by all parties and no comment on the participants or their interim discussions can be made.”

The intention, explains ClementsHunt is to identify and act on the common ground between the goals of institutional investors and the sustainable development objectives of the United Nations.“The new principles will protect long-term shareholder value by integrating environmental, social and governance concerns into investor and capital market considerations,” he explains. The prominence of the UN will carry weight in giving legitimacy to the principles and helping to introduce them into

mainstream investment calculations. It also provides a global forum for an exchange of best practice. According to Hagart,“it is the participating investors that give mainstream legitimacy.”

Clements-Hunt acknowledges that it will not be a short process. “It is envisaged that it will involve quite an elaborate rollout procedure once the Principles are defined. I would expect it would involve a timeframe of two years or so to establish global awareness and capacity to absorb the principles into everyday investment procedures,” he explains. The rollout will include the establishment of an investor toolkit that will provide a framework for introducing responsible investment principles into portfolio management and practical guidance.

“There is an established and growing body of evidence that environmental, social and governance issues can affect investor value,” says Gordon Hagart, Project Manager in UNEP FI’s Investment Team. “The institutional asset owners involved in the PRI process acknowledge that only by making the management of such issues part of their core investment strategy can they discharge fully their responsibilities to their beneficiaries.

Moreover, they recognise the logic of addressing global problems such as climate change and human rights on a global platform and the benefits of sharing expertise and acting in concert with likeminded institutions.”

According to Clements-Hunt, the project lies at the nexus of a groundswell of market research, changing investor attitudes, and regulatory developments that are

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moving towards a more inclusive approach by institutional investors towards responsible investment and related issues.

Since the 1990s, responsible investing has threatened,“to become the latest thing,” admits Clements-Hunt, although he notes that a groundswell has been building for the last five years and “over the last 18 months in particular.” A number of developments provide the bedrock for this change. “The amount of publicity and press coverage following the corporate governance scandals around the millennium [Enron, WorldCom, Parmalat et al. were 2001, 2002] have encouraged corporate executives and shareholders to focus on what good and bad companies are about,” says Clements-Hunt. Added to this, issues

such as “climate change, the debate about carbon emissions and the coming together of the more classical corporate governance and corporate responsibility agendas,” he says, add to a growing sense that “something has to give.”

Key papers released this year include one on Mainstreaming Responsible Investment, released by AccountAbility and the World Economic Forum in January this year, which found that asset managers are primarily focused on compliance with mandates to maximise returns against particular benchmarks, generally over a short time frame.

The report, The Materiality of Social, Environmental and Corporate Governance Issues to Equity Pricing was launched at the UN Global Compact Leaders Summit on 24 June 2004 in New York.To

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g sin i a r ’re we

compile the study, UNEP FI worked with a group of 21 fund managers and brokerage houses to explore the impact of environmental, social and governance issues on share prices.

Specific issues covered include climate change, occupational and public health, corporate governance and trust, and human, labor, and political rights. “We believe the global investment community is ready for a comprehensive set of principles to assist with the complex process of responsible investment.” concludes Hagart and while he acknowledges that not every issue is necessarily financially material to every investor, he believes that strategies can be developed that meet RI criteria while also meeting usual fiduciary responsibilities.

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Market Leader RESPONSIBLE INVESTMENT

When bribery and corruption counts The FTSE4Good Index Series has been designed to measure the performance of companies that meet globally recognised corporate responsibility standards and facilitate investment in them. In a new development, the FTSE4Good Policy Committee has asked FTSE Group to enhance the FTSE4Good inclusion criteria to include specific criteria regarding countering bribery and corruption.

CONSULTATION EXERCISE HAS begun to gather market opinions and thoughts on issues that constitute good corporate practice in countering bribery and corruption.

The consultation will be completed by the end of the year. The criteria will ensure that companies included within the FTSE4Good indices that have been assessed as having a higher potential risk of exposure to bribery and corrupt practices are managing these risks appropriately.

A consultative paper has been prepared, outlining proposed criteria for countering bribery and corruption that are intended to set a standard for companies that is “challenging, but achievable,” according to Marianne Huvé-Allard, director, FTSE Group.

There is widespread and interchangeable use of the terms bribery and corruption, explains Huvé-Allard, and these can include both domestic and foreign bribery, embezzlement, trading in influence and illicit enrichments, for example. The consultation document will help in creating internationally accepted standards that companies can adhere to, she explains.

The paper has been drafted with the help of Transparency International (TI) and a range of stakeholders including companies, investors and relevant nongovernmental organisations. In the international arena, TI raises awareness

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about the damaging effects of corruption, advocates policy reform, works towards the implementation of multilateral conventions and subsequently monitors compliance by governments, corporations and banks. At the country level,“national chapters work to increase levels of accountability and transparency, monitoring the performance of key institutions and pressing for necessary reforms in a non-party political manner,” explains Jermyn Brooks, a member of TI’s international board of directors. TI does not expose individual cases of corruption.

Instead it prefers to make long-term gains against corruption through prevention and reforming systems. The proposed FTSE4Good criteria take the TI Business Principles for Countering Bribery as a starting point. TI brings a strong element of objectivity into process, suggest Brooks,“and will try to develop more meaningful analysis to support what FTSE is doing.”

TI produces a number of indices and reports related to bribery and corrupt business practices. This includes the monitoring of conventions concluded within the framework of global organisations such as the Organisation for Economic Co-operation and Development (OECD) and special emphasis is placed on the UN’s Global Compact initiative explains Brooks. TI produces its own bribery and corruption indices, the principal one being the

Corruption Perceptions Index (CPI)—a poll of polls, reflecting the perceptions of business people and country analysts, both resident and non-resident. TI's Bribe Payers Index (BPI) meanwhile looks at the supply side of corruption, ranking the leading exporting countries according to their propensity to bribe.

The CPI ranks countries by perceived levels of corruption among public officials because “Perceptions are truer than facts,”says Brooks.

The CPI draws on 18 surveys provided to TI conducted by 12 independent institutions. The statistical work on the index was coordinated by Professor Johann Graf Lambsdorff at Passau University in Germany, who is advised by a group of international specialists, says Brooks. Countries with a score of higher than nine, with very low levels of perceived corruption, are predominantly rich countries, such as Finland, New Zealand, Iceland, Singapore, Sweden and Switzerland. “Often the poorest countries, most of which are in the bottom half of the index, are in greatest need of support in fighting corruption,” adds Brooks. FTSE4Good working with TI takes a dual approach in its analysis of private sector bribery and corruption risks, he explains. “We look at which types of companies are most at risk and we do this in two ways. We start with those companies operating in countries with a high level of corruption and look at the percentage of their overall business which is conducted in those countries. Then we look at companies in sectors which are particularly susceptible to bribery and corruption.” Companies falling under both risks categories will then be asked to fill out a questionnaire to enable their response to these risks to be evaluated by the FTSE4Good team.

This will decide which higher risk companies remain in the index.

To access the consultation and give your feedback please visit www.ftse.com/ftse4good

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A world of risk.

A world of opportunities?

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Regional Review RUSSIA

Russian IPOs continue strong through 2005 In spite of some ambivalent signals emitting from the Kremlin, investors remain committed to Russia, evinced by the response to the debut of Novatek, Russia’s largest independent gas producers, on the London Stock Exchange in late July. There has been a spate of overseas listings by Russian companies recently.

A rush to list in 2005 and 2006 is on say market watchers, as completing an overseas listing in 2007 or 2008 may be difficult as presidential elections come closer. In the meantime, strong demand for Russian equities continues, amid a shortage of other initial public offerings and a continual search for higher yields.

THIRTEEN TIMES OVERSUBSCRIBED, Novatek’s $880m offering on the LSE (at a value of premium price $16.75 per single share) was the most heavily subscribed Russian initial public offering (IPO) this year and the second largest following the $1.3bn issue by Sistema back in February. In these days of over-rich oil prices, the level of investor demand for Novatek’s share issue should not be a surprise. Founded in 1994, Novatek is an open joint stock company. Its shares have been listed on the Russian Trading System (RTS) since December 2004.

The issue is the latest in a growing list of Russian firms anxious to raise finance overseas this year. Prior to Novatek Russian firms issues have issued a record $2.9bn worth of shares overseas, the bulk of this amount—over $2.5bn —has been listed in London. Leading issues have included Rambler Media’s $40m offering in June, AFK Sistema in February, worth roughly $1.55 billion,

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discount retail chain Pyatyorochka in May, which raised nearly $600m and steel and mining group EvrazHolding, which amounted to over $420m.

Compare this with local drinks firm Lebedyansky’s $150m offering in March which is Russia’s largest domestic flotation this year. That pattern may not continue for too much longer however.

Russia’s Federal Service for Financial Markets, or FSFM, expects a bill seeking to introduce stricter regulations of shares issued by foreign companies with significant assets in Russia to be submitted to the State Duma. If the bill becomes law, foreign companies with no less than 75% of their assets in Russia will have to get permission from Russian regulators to issue shares abroad, Current legislation theoretically obliges firms to list on Moscow’s Moscow Interbank Currency Exchange (MICEX) or RTS bourses before holding IPOs abroad.

A growing number of companies have used loopholes to bypass it in recent

months, including Russia’s biggest steelmaker Evrazholding.

Putin’s government has been critical of companies going abroad to raise capital. Following Pyatyorochka’s listing in May, FSFM released a statement saying that the Netherlandsregistered company’s initial public offering IPO skirted Russian law. As a foreign-registered company with all of its assets in Russia, Pyatyorochka evaded Russian laws that require FSFM approval to list shares abroad, the regulator said then. What will likely happen is that Russian companies will increasingly seek dual listings. In a country where capital flight reached $33bn last year, listing in Moscow alongside London is probably a more effective way to blunt the Russian government’s growing regulatory zeal to rein in Russian companies.

Novatek is involved in the exploration, production and processing of natural gas and liquid hydrocarbons in the Yamal-Nenets region—the world's largest natural gas producing area, which accounts for around 90% of Russia's natural gas production and 20% of the world gas production. The company has proven oil and gas reserves that are more than twice as large as those of US oil firm Unocal, which has been the subject of a $17.1bn takeover bid this year. The strong showing for Russian energy companies is not unexpected, given for example, that natural gas for January delivery in Britain, Europe's biggest gas consumer, sells for 77.57 pence per therm ($13.55 per million British thermal units). That level is more than double last January's average price of 28.8 pence per therm. Novatek, second in Russia to state-owned Gazprom, last year produced enough gas to supply Spain, Europe's fifth-largest economy.

Novatek’s international debut was essentially a sell-down of some 17.3%

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GROW WITH US IN CENTRAL AND EASTERN EUROPE. www.ri.co.at

Raiffeisen International Bank-Holding AG is a subsidiary of Raiffeisen Zentralbank Ă–sterreich AG. It manages the RZB Group's subsidiaries in Central and Eastern Europe.

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Regional Review RUSSIA 26

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of its outstanding shares. Among the Federal Anti-Monopoly Service, the comparable with those in China. Like China, Russia offers a strong leading sellers of shares in Novatek is official competition regulator.

Novatek’s selling price was a urbanised workforce that is generally SWGI Growth Fund (Cyprus) Ltd, Pension and which is controlled by billionaire surprise however—even allowing for highly educated.

Leonid Mikhelson. Mikhelson, who the fact that it is one of the few truly insurance reforms are underway and helped create Novatek after the fall of independent oil and gas producers in by 2007, all Russian companies will the Soviet Union, probably has a net Russia and is likely a reflection of the have to conform to IFRS accounting worth of more than $2 billion after the continued strength of investor interest procedures and local tax rates remain low—24% on profits and sale and could receive as 13% on income. much as $335m from his FTSE Russia All-Cap Index vs. FTSE Global The strength of interest part of the offering. His Equity Index Series in direct investment into remaining 29% of Novatek 130 the consumer sector is would be worth $1.7bn at 125 120 evinced by a recent deal current prices. Novatek's 115 financed by the EBRD and owners sold 52.45m GDRs 110 Raiffeisen Zentralbank for $16.75. “The demand 105 Österreich AG (RZB), for this transaction in 100 Vienna,Group lending terms of size and quality 95 €65m for a St Petersburg was among the best seen 90 shopping centre. It will be for any transaction in the developed by France's last 24 months,” said Vinci Construction Henrik Gobel, head of the FTSE Russia All-CaprIndex FTSE Global Equity Index Series Grands Projets SA with European equity syndicate Data as of July 2005. Source: FTSE Group the aim of attracting high at Morgan Stanley, after the IPO. An additional 1.7% of the in key sectors in Russia. Rich oil and quality international retailers to capital can be bought out by the issue gas resources are not the country’s Russia's second-largest city. The organisers, through a so-called over- only draw. Investor interest remains EBRD is the lender of record for whereas RZB is allotment option, giving Novatek strong also in the mining, retailing €48.75m, shareholders a happy $966.3m in total and consumer products sectors. participating with €16.25m under an revenue. Morgan Stanley and UBS Foreign investments in these sectors EBRD A/B loan structure. The Investment Bank were joint global are particularly attractive compared to remainder of €16.25m is provided by Raiffeisenbank Austria, coordinators and also took on the role investments in basic resources, as they ZAO of book runners, together with Credit do not require government approval Moscow, as parallel loan. The EBRD's Suisse First Boston. Russian banks or participation. Foreign direct 10-year loan will be disbursed on involved in the deal included Troika investment [FDI] is equally buoyant. completion of the turnkey project, Dialog Investment Bank (as co-lead In 2004 alone, corporations and PE expected in the autumn of 2006. The manager), while Alfa Bank and funds closed more than 300 M&A legal borrower is Ralmir Holding BV, Vneshekonombank were co- deals in Russia—a 70% increase on incorporated in the Netherlands and managers. The deal also marked the 2003. Last year, Russian gross representing a group of international strong show of global law firm Latham domestic product (GDP) rose 7%, investors who, acting in a private and Watkins which advised both thanks to record world oil prices and capacity, have committed to buying Novatek and Sistema on their IPOs. Russian credit risk is regarded as the completed project from Vinci.

Skadden Arps Slate Meagher & Flom investment grade. It is the world’s These include Jacques Fournier, acted for the co-lead arrangers. The third fastest growing emerging former chairman of Carrefour, the IPO sealed the firm’s forward strategy economy, after China and India and world’s second biggest international as its debut in London signalled the offers investors a range of competitive retailer, as well as René de Picciotto end of a touted deal to sell 25% of its advantages. Energy prices, for and Philippe Setton, who are both shares in a private sale to France’s example, are around a third of typical Geneva-based private bankers. All Total— a deal thought to have been prices in western European markets the EBRD and RZB Group funds will stymied by resistance from the Russian while local labour costs are be disbursed in Russia.

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Photo: Securities and Exchange Commission. August, 2005

Congressman Christopher Cox – new chairman of the SEC?

COX IS WEIGHED IN THE BALANCE FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2005

NORTH AMERICA: NEW SEC CHAIRMAN

The nomination of the congressman from California, Christopher Cox, to be the next chairman of the United States’ Securities and Exchange Commission (SEC) is being hailed by many as a pro-business choice by the Bush administration. But SEC chairs do not always tow the party line. Opinions vary greatly as to what his tenure might bring, but it is clear that Cox will be a force to be reckoned with. Karen Jones reports from New York.

T WAS INITIALLY thought that former chairman William Donaldson, co-founder of Donaldson, Lufkin & Jenrette LLP and chairman and chief executive officer (CEO) of the New York Stock Exchange between 1990 and 1995, was not going to tighten Wall Street’s regulatory reins. However, when he took charge of the SEC in February 2003, investors were still reeling from a series of corporate and financial scandals of Enron, WorldCom and more. The Commission responded with a tough regulatory and enforcement agenda – including hedge fund regulation and a comprehensive overhaul of the way mutual funds are run.

This aggressive agenda often pitted Donaldson against his fellow Republican SEC commissioners who favoured less aggressive tactics and caused howls of protest from corporate pressure groups. Nonetheless during his farewell remarks Donaldson congratulated his staff on their efforts to correct rampant market abuses. “I arrived while this effort was underway, and in my time as SEC chairman, the agency has continued to work tirelessly to rebuild the trust between investors and their fiduciaries and agents.” He added that he was sure the agency would continue these efforts “with dedication and zeal.”

Although investor advocacy groups express concern whether Cox is the best choice to continue these efforts, his professional qualifications are undisputed. A simultaneous graduate of Harvard Business School and Harvard Law School in 1977, Cox was a partner in international law firm Latham & Watkins and worked as a senior associate counsel to the Reagan White House. He has been a member of Congress since 1988 and has served as chairman of the House Policy Committee and chairman of the House Committee on Homeland Security.

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Regional Review

Photo: Gibson, Dunn & Crutcher LLP. August, 2005

NORTH AMERICA: NEW SEC CHAIRMAN 28

understanding the big themes, “he can work across the aisle with people from a different political background.” As to whether he thinks Cox is more “pro-business” then Donaldson, Olson says, “I do not think Donaldson was antibusiness. But to the surprise of many, including me, he had more faith in the command and control regulation then I would have anticipated given his background.”

It is hard to know what Cox will do during his tenure, says Olson, Olson, partner of Gibson, Dunn & Crutcher LLP but his history suggests a President Bush has called him “a philosophy favouring “market driven champion of the free enterprise solutions and disclosure approaches system” who will be an “outstanding” as opposed to additional regulation. leader of the SEC. From his position at You would also say he is a supporter of Homeland Security, Cox says he has strong law enforcement and always seen “the critical role that America’s voted for enhancing the SEC budget giving them additional financial markets play in our society” and adding that the 9/11 attacks were enforcement powers.” Though how aimed “very deliberately at the the Commission directs its efforts and financial heart of America’s economy.” what the commissioners will choose “There are not too many people in to prioritise changes with each new Congress who have these credentials,” chairman, Olson predicts Cox will be a says John Olson, partner of Gibson, “very tough enforcer and back the Dunn & Crutcher LLP. Although they enforcement division very strongly.”

Meanwhile, Barbara Roper, director reside on opposite sides of the political fence, Olson calls Cox “a very good of investor protection for the Consumer lawyer. He reads everything” and says Federation of America, a not-for-profit he has enjoyed working with him on consumer advocacy organisation, is not several legislative matters. “He does too sure. She says that the CFA does not just rely on what someone tells not endorse or oppose nominees but him in a briefing, he is detail oriented. they do “raise issues.”She observes that When he works on legislation, he is Cox has made it clear he believes in a one of the people that reads bills and limited role for government and has taken some “troubling” positions on cares about the nuances.”

Olson explains that because Cox has legislation. “He is a lead author of the held important positions in Congress 1995 Private Securities Litigation and is accustomed to having to Reform Act (PSLRA) which we complete critical projects while consider probably the most anti-

investor piece of legislation introduced in Congress over the last few decades.

This is a bill that a number of legal scholars have argued contributed to the problems we saw at Enron and WorldCom by appearing to limit the liability of auditors,”she explains.

The PSLRA was enacted to address abuses in securities fraud class action suits by raising the standard of proof for investors. According to securities lawyer William Lerach, chairman of Lerach, Coughlin, Stoia, Geller, Rudman & Robbins LLP, a specialty firm representing investors in corporate securities litigation, the PSLRA“greatly increased the pleading burden on a defrauded investor at the outset of the case.” He also believes the “massive fraud upwave [sic] that engulfed the US securities markets at the end of the century and caused trillions of losses to investors was in no small part a result of the 1995 act.”

That said, Lerach terms Cox, “the wrong person”to put in charge of the SEC, and explains,“I’m not saying he is a bad person and as far as I know he is a person of integrity. But that job deserves someone whose priority is investors, pension funds and the individuals who put their life savings at risk in the market, not corporations, investment banks and corporate executives that have been his constituency his whole life.”

Meanwhile, Ira Hammerman, general counsel of the Securities Industry Association (SIA) the leading trade association for the broker/dealer community representing 600 securities firms, calls Cox “an excellent choice”for SEC chair. He observes that Donaldson came into the SEC during a “perfect storm of issues” which included fallout from 9/11, economic woes and serious problems within the mutual fund industry.“He took the bull by the horns and really tackled that.”Fast forward to today and he says,“We do not think it is

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an environment where we need a bunch of new rules and an adversarial relationship with the SEC.” Hammerman would like to see Cox steer the SEC towards being a “more prudential”regulator and initiate a more cooperative effort between the SEC and the industry to “find out what is best for investors. That is everyone’s goal.”

Hammerman adds that he hopes the current massive amounts of paperwork mandated by government regulations can be reduced by implementing initiatives that will improve investor knowledge and give them the information they need in a timely and understandable format. “We want to contrast that with giving them information that is responsive to burdensome regulations that are too detailed and complicated. No one has time to read an 80 page prospectus on the XYZ growth fund they want to invest in. We hope to see a movement to clear user friendly disclosures to investors so they get the info they need and can understand.”

He suggests that since Cox lives in technology-laden southern California (and is familiar with the professional applications of the Internet) this might eventually yield a “simple two-page Internet disclosure” for investors that would cover the core basics of investment decisions such as fund objectives, past performances and risks.

Hammerman also says it is too early to classify Cox as investor or business friendly but considers him “very professional, bright and intelligent.” He adds that anyone who takes on a “significant leadership role” such as Chairman of the SEC with the heavy mandate of insuring investor protection “takes it very seriously. It would be inappropriate to label him one way or the other.”He adds that“time will tell in terms of any proposal initiatives or crisis that any leader will have to deal with.”

The US Chamber of Congress

(USCC) is the world’s largest business federation, representing more than 3m businesses and organisations. David Chavern, director of capital markets programmes for the USCC says they have some “issues” with where the SEC has gone over the past few years and also feels Cox is a good choice. He believes the pendulum has “swung too far in terms of over regulation and unfair enforcement practices” such as requiring independent chairs for mutual fund boards which he terms “regulation for regulation’s sake.”

Another contentious issue, says Chavern, is Section 404 of the Sarbanes-Oxley Act. This requires annual reports to include an internal control report by the management and an external accountant’s statement certifying the effectiveness of the company’s internal controls.“SarbanesOxley is a big piece of legislation. The only area of controversy is Section 404.

I have not heard an argument that that if Section 404 had been instituted earlier, there would not have been an Enron or WorldCom.” He does feel, however, that more information about internal control “is valuable.”

Meanwhile, Roper says that the USCC“can hardly contain its glee”about Cox. The association has made “no secret”of its desire to drive back many of the gains that have been made for investors in the past few years. She believes they do not just want to say enough is enough, “they want to scale back.” Either way, Cox is a “big profile guy”who is the “last person”you would go to if looking for someone to babysit the SEC, says Roper.“This is not the job he is taking before he retires.” As to where he will lead the Commission, she admits to being wrong in the past regarding SEC chairs, including Donaldson.“He was brought in to calm the waters after Harvey Pitt’s tumultuous term as Chair. Donaldson was very diplomatic, restored staff morale and also

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2005

had a very aggressive agenda that I wasn’t expecting. It wasn’t consistent with government philosophy.”

Although she expects Cox will be more aligned with the other Republican Commissioners, she says that if he would refrain from dismantling the protections put in place and “not succumb to pressures from groups like the USCC to dismantle the important protections and aggressively enforce the securities laws we have on the books, that might not make him an ideal SEC chairman but certainly one we can live with.”

Hammerman meanwhile feels that since the industry is already heavily regulated it is time to take a more measured approach.“This industry has invested heavily in lawyers, accountants and compliance professionals and the technology to supervise it all. Let’s recognise that as we move forward and maintain our global competitiveness as the US capital markets, we regulate in a more efficient, smarter way.”

Barbara Roper, director of investor protection for the Consumer Federation of America

“The USCC can hardly contain its glee about Cox’s appointment, she says.

Photo: CFA. August, 2005

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Caption to go here

GCC Report GCC REPORT

Local liquidity oils

Gulf exchanges

Five years ago, in most Gulf countries, if you were to take a taxi to your hotel from any airport in the Gulf, the pleasantries were unlikely to extend much beyond the weather and the local traffic. If you take a taxi today in Bahrain, Doha, Dubai, or Riyadh, you are unlikely to avoid your driver’s thoughts on the local stock market, the performance of his portfolio and the prospects of any forthcoming Initial Public Offerings (IPOs). Welcome to the Middle East, where stock markets have been transformed over the last five years by rising liquidity and a new breed of investors coming to the markets.

ESPITE SOME RECENT corrections the main indices of all of the Gulf Co-operation Council (GCC) markets have posted remarkable gains over the last 12 months driven by massive levels of liquidity in the region and in particular into those economies most highly dependent on the hydrocarbons sector.

“We have seen a lot of petrodollars coming into the Kuwaiti economy and the GCC as a region and this is fueling a boom in infrastructure and private sector consumption,”explains Wafa AlRasheed, manager of the technical bureau department at the Kuwait Stock Exchange, a market that has been a major beneficiary of the high oil prices. Despite efforts at diversification in the region Randa Azar-Khoury, chief economist at National Bank of Kuwait (NBK) expects oil to account for more than 60% of all economic activity in Kuwait in 2005 and 91% of income.

High oil prices fuelling liquidity in the region is nothing new, but in previous years the majority of this liquidity was invested overseas.“That is not the case this time,” thinks Riyad

Photo reproduced courtesy of the DIFC

D

High oil prices are fuelling liquidity in the region. This is nothing new. But in previous years the excess money was invested overseas.

This is no longer the case.

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Bank’s president and chief executive officer (CEO) Talal Al Qudaibi.

“International equity and bond markets outside the Gulf have not provided very attractive returns, interest rates are low globally and the markets here are very buoyant. The natural inclination is to invest locally and this has been fuelling the phenomenal growth in local equity and real estate markets.”

Some of the increase in liquidity has also been attributed to the repatriation of money following 9/11. “There is no doubt that we witnessed an inflow of money following the attacks on New York and combined with the oil revenues this has fueled a lot of local growth” thinks Douglas Dowie, chief executive officer (CEO) at the National Bank of Dubai (NBD). But many in the region question the amounts of money being repatriated.“Although we do not have registration on the movement of capital, we have certainly witnessed the capital of some individuals coming back into Saudi Arabia, but I do not believe it is on the scale of some of the numbers that have been mentioned,” thinks Hamad Al Sayari, governor of the Saudi Arabia Monetary Authority (SAMA).

“We know that the Saudi economy has always been a capital surplus economy”, he explains, “and there has always been a flow of capital abroad. But I think it more likely that increasingly this flow of capital has been reduced as more of the capital is retained.”

As well as increased local liquidity there are also a number of underlying trends that are beginning to emerge around the region. The key trend is a combination of privatisations and deregulation believes Omar Abdallah, head of Middle East and North African (MENA) capital markets at NBK. “Privatisation and deregulation is taking place in many countries and is opening up a number of sectors that were previously closed to the private sector.

In Qatar, for example, over the last two or three years the Qatari government has IPO’d [sic] or listed most of the companies that work in extraction and the export of natural gas. The same thing has happened in telecoms in Saudi Arabia which privatised its telecom monopoly a few years ago.

“Qatar National Bank (QNB) has been involved in nine of the 10 new issues on the Doha Securities Market (DSM) since it opened in 1997. There is no doubt that the listings of large organisations such as Qatar Industries in 2003 and Nakilat, the Qatar Gas Transport Company this year, have contributed greatly to the depth and breadth of the market,” explains chief executive officer, Saeed Al Misnad. He explains that it has been a key factor in the burgeoning number of local retail investors investing for the first time.

The extent of this local investor market was amply demonstrated by the initial public offering (IPO) in October 2004 of Ettihad Etisalat, the Saudi Mobile phone consortium. The IPO was oversubscribed by 51 times according to Eisa Al Eisa, chief executive officer of SAMBA Financial Group, one of the arranging banks. Some 20m shares were on offer at SR50 ($13.3) each, totaling SR1bn ($266.6m), but the number of applicants reached a staggering 4.28m, from a total Saudi population of 23.4m of which 65% are under 21. The shares have since risen 10-fold and are currently trading on the Saudi Stock Exchange (the Tadawul) between SR550 and SR600.

The rapid increase in share values across the region has led many to fear that an unsustainable bubble is developing. “Valuations have gotten ahead of themselves in Jordan, Saudi Arabia and the United Arab Emirates (UAE), as far as markets trading at 40 or 50 times today’s earnings”claims NBK’s Omar Abdallah.“It is not so much the absolute levels of price/earnings (P/E)

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2005

Photo: ANB. August, 2005

REGIONAL REVIEW 9

Nemeh Sabbagh, managing director, Arab National Bank [ANB]

ratios, as in many cases there is underlying operating earnings growth to support it, but the speed with which those markets went up without more than a 5% to 7% correction in the last three or four years.”Most markets have indeed come off their twelve month highs during July, but is this simply the regional markets drawing for breath over the summer or the beginnings of a more serious correction? “The problem is that individual investors who have never been in a bear market are just chasing greed and have never experienced fear. Once that turns round, once greed turns to fear, then it tends to happen very quickly at the market turning point. Markets could fall by up to 40%. Even a correction of this magnitude,” he adds, “would still leave many markets up on the year.”

Others expect a less severe correction. “In Saudi Arabia we have not really seen any of the oil money from the government filtering through yet, and once it does, the economic boom could be more sustainable than people think. The market is not cheap, but the expectation of continued strong corporate profitability is a reason for high P/E ratios. The market will probably be more volatile but we may be able to avoid a crash scenario,” thinks Nemeh Sabbagh, managing director and CEO of Arab National Bank (ANB). Andy Stevens, CEO at Commercial Bank of Qatar (CBQ) says, “It depends how you look at it.

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GCC REPORT

Combine recent past performances with projected future GDP and future earnings growth; and some of these P/E ratios look more justified.”

Fuelling some of this earnings growth has been the dismantling of cross border restrictions that previously prevented companies operating in one country from expanding into others in the region. “There has been talk about a common currency and a central bank for sometime, but it is only in the last three or four years that the [authorities] have become really serious about achieving these things. By 2010 they want a single currency, central bank and market place.

They have already introduced the common customs tariffs, though not everyone is necessarily complying.

Where they are getting it to work then it has created a very powerful market place,” claims Douglas Dowie. “We are already seeing that here in telecoms,” agrees Omar Abdallah. “One of the Kuwaiti operators here MTC is now running a third generation network (3G) in Bahrain. Etisalat in the United Arab Emirates (UAE) has started operating a second license in Saudi Arabia and you

have Q-tel in Qatar which was stagnating as mobile penetration reached saturation levels in its domestic market, but now operates in Oman, which is the region’s most underpenetrated market.”

Many in the wider region are surprised that the trend towards deregulation and privatisation has continued over the last 18 months.

“Traditionally whenever oil prices were high governments backed away from plans to deregulate or privatise because their budgets were in surplus and they could afford the status quo. But in some countries it has taken hold so much that we think that they are unlikely to be derailed by high oil prices and this is a really positive step for the region,” believes Randa Azar-Khoury. SAMA’s governor Hamad Al Sayari agrees that this is definitely the case in Saudi Arabia, “We were already witnessing the benefits here in the Kingdom before the current high oil prices and what is encouraging is that the economic reform measures have not been pushed off track by our improved economic and financial position. I think this sends out

a clear message to investors that Saudi Arabia is serious about reform.”

As well as seeking business opportunities in other countries, many companies are also looking to list their businesses overseas. Both Bahrain and Kuwait have non-domestic sectors on their exchanges and are actively seeking other overseas firms to list. “We have reduced the listing fees for non-Kuwaiti firms by 50% and have recently listed four major companies – two from Egypt and two from Lebanon. We are also in discussion with a number of others,” claims Wafa Al-Rasheed at the exchange.

The new Dubai International Financial Exchange (DIFX) which is scheduled to launch on September 26th is also looking

Stock Market

Annual Return of primary index July 1st 04-June 30th 05

Open to non-GCC Investors

Direct or indirect restrictions

Abu Dhabi Securities Market

151%

Yes

Bahrain Stock Exchange

42%

Yes

Dubai Financial Market

305%

Yes

Kuwait Stock Exchange

61%

Yes

Doha Securities Market

99%

Yes

Saudi Arabia Tadawul

117%

No

Many companies have restrictions on non-UAE share holders Max 49% of free float available to nonGCC members Many companies have restrictions on non-UAE share holders 50% tax on capital gains from shares for non-GCC investors, some restrictions on banking sector ownership.

Max. 25% of free float available to nonGCC members Investment through limited number of mutual funds marketed to overseas investors, restrictions on GCC Investors in banking sector

Source: Various GCC country stock exchanges. August, 2005

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Saeed Al Misnad, chief executive officer Qatar National Bank

In most countries restrictions often apply to non-nationals for IPOs (particularly government led)

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Photo: QNB. August, 2005

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GCC Report GCC REPORT

to attract firms. “We have been approached by a number of firms from across the region interested in listing as well as from further a-field. We see the DIFX not just as a regional market but one that encompasses Africa, Central Asia and the Indian subcontinent;” explains DIFX chairman Lynton Jones.

“The important thing for the DIFX is not necessarily where a company is located, but that companies seeking a listing comply with our listing procedures which have been structured in such a way as to ensure internationally recognised levels of best practice.”

One key deterrent for international investors interested in the region is the lack of hedging options in many of the exchanges.“In developed markets as an investor you always have a futures market to hedge your position without liquidating it. But we do not have the instrument here so you do need that flexibility,” explains Randa AzarKhoury. Lynton Jones agrees; “We see the development of a derivatives market in the first 12 months as key to the successful development of the DIFX. We have already held discussions with FTSE Group about the possible listing of derivatives of other market indices as well as a number of international firms who are interested in helping us to develop the market.”

According to Wafa Al Rasheed, the KSE already has a well established derivatives market:“We already provide listed options trading which is not yet available anywhere else in the GCC as well as futures and foreign trading as well. We expect derivatives to be a big area of growth for us.”

Phillip Thorpe, chairman and CEO at the Qatar Financial Centre Regulatory Authority (QFCRA) thinks that eventually all of the stock markets in the region will restructure their operations and listing requirements. “There are a number of relatively small regional markets which have been performing in

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the way you would expect them to with marginal liquidity at times and with differing often inadequate levels of transparency and corporate governance standards below international norms.

These markets will not survive in this state for ever. Investors are demanding more and the corporates are becoming increasingly mature. As foreign investors gain access to these markets they are also going to expect more. It is therefore not surprising that everybody is undertaking some reform whether it’s the Gulf States, Kuwait, Saudi or Oman.”

Increasingly foreign investors are interested in the Gulf and according to figures released by the BSX now account for 21% of the trading by value on the GCC, compared to 40% by other GCC members and 39% by Bahraini citizens.“Until now there has been very little international institutional investors interested in Kuwait or Qatar, even though the markets are open. So we think in the next two or three years we will see increased institutional interest in those markets, just like we saw in Egypt, Jordan and Morocco when those markets opened up in the mid1990s. The reason they are not here yet probably has to do with infrastructure issues such as the lack of proper custody, low brokerage service quality, and so on, but that will change in the next few years,” thinks Omar Abdallah. Many institutions already seem to be witnessing an upsurge in international interest.

R. Seetharaman, general manager at Doha Bank, estimates that global investors now account for 5% of all transactions on the Doha Securities Market (DSM). “It is currently a trickle of investors but I expect this process to gather momentum over time.” QNB’s CEO Saeed Al Misnad agrees; “Since the opening of the DSM in April, we have had a number of global institutions come to us and

Photo: DIFC. August, 2005

it is one of the reasons behind the launch of the first DSM equity-based mutual fund to be established in Qatar. This will allow them to diversify their portfolio and provide a smooth entry into the market.”

The development across the region of financial products such as mutual funds is perhaps the key to the future development of the equity markets in the Gulf. With retail investors currently accounting for up to 80% of markets such as the Dubai Financial Market (DFM), the development of local institutional investor markets though may be the key to future stability. Encouraging retail investors, such as the region’s taxi drivers to buy local investment products, will minimise their market exposure to single stocks and sectors and successful funds will provide an easy route of access for international investors. “It is about balance,” explains Yousef Al-Awadi, chief GM & CEO of Kuwait’s Gulf Bank. “We are keen to introduce our clients to investment products such as our Local Equity Guaranteed Fund. These offer bigger returns than vanilla products such as a savings account, but at the same time insulate them from some of the wider risks associated with the capital markets that they may not fully appreciate. Our reputation, and our ability to compete with international firms coming into this market, is dependent upon us finding a balance for clients with a low risk threshold but an expectation of high returns.”

With a plethora of financial products being launched across the Middle East, the only problem that may remain is persuading the region’s taxi drivers to give up their well honed

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Over the last three years, rising oil revenues have created private wealth in the Middle East that is estimated to be in the region of $1.3trn. Increasingly this wealth is being invested locally and to take advantage of this opportunity more and more international and regional financial firms are seeking a local base. To meet demand three financial centres, the Bahrain Financial Harbour (BFH), Dubai International Financial Centre (DIFC) and the Qatar Financial Centre (QFC) have been established, each with the purpose of attracting international and regional financial service firms in order to become the preeminent financial centres in the Middle East.

PEAK TO ANYONE at the DIFC’s futuristic head office building, The Gate, and eventually they will repeat three words which have become something of a mantra for the organisation: “Transparency, integrity, efficiency” proclaims Omar Bin Sulaiman, director general at the DIFC. “This is what we wish to establish here and throughout the Middle East. The financial industry is naturally very conservative. They expect and need transparency, integrity, best practice and good governance and unfortunately the Middle East has not traditionally been associated with these traits. It is only by addressing these issues that we can attract the international firms that we need to develop the financial services industry in Dubai, the UAE and the Middle East as a whole.”

The message is being adopted wholesale throughout the Gulf Cooperation Council countries.

“Standards are very much as you would expect in an emerging market region,” explains Phillip Thorpe, chairman and chief executive officer (CEO), of the Qatar Financial Centre

S

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Regulatory Authority (QFCRA). Qatar is encouraging higher standards on disclosure, transparency, adherence to international accounting standards.

Improving corporate governance in the region is just one of the goals expressed by the three competing financial centres: the Bahrain Financial Harbour, the DIFC and the Qatar Financial Centre as each seeks to establish itself as the leading financial centre in the Gulf. In some ways the BFH already has a head start in that it already possesses a well established financial community with over 362 licensed firms regulated by the Bahrain Monetary Authority (BMA) that also regulates the BFH. The issue for BFH then is to encourage those firms to relocate within its financial centre, which is scheduled for completion in 2006.

The DIFC has taken a more international approach. “This is probably the first project in the region which has started from an international perspective before focusing on a more regional and then local level,” believes Dr. Omar Bin Sulaiman.

“The international

Photo: DIFC. August, 2005

GCC REPORT

Transparency, integrity, efficiency Dr. Omar Bin Sulaiman, director general at the DIFC

companies are the big players and we are trying to introduce new layers of financial services to this region; including wholesale banking, reinsurance, Islamic financing, asset management and fund registration.”

He explains: “These organisations were not really present here because of the legal framework and environment. We have now created a legal environment that has attracted 63 organisations that have been awarded licenses since we started operations in September last year.You cannot just say I want a financial centre. It took countries such as the UK and US hundreds of years to develop their systems and we have learned from them and created a regulatory environment acceptable to the international community.”

The future success of the Qatar Financial Centre will hinge on whether it manages to,“create an environment that is familiar to institutions coming from more established markets – it gives them confidence. If you have a firm coming from New York, London or Frankfurt, will they recognise what you are doing? If they do and the business

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operating officer at HSBC Bank Middle East Ltd is applying to be a founder member firm and “welcomes the boost to liquidity that the exchange will bring.”

DIFX chairman since 2003, Lynton Jones suggests that HSBC will not be the only international firm to be involved. “We expect the majority of the world’s major investment banks who are members of the worlds other major exchanges to seriously consider membership of the DIFX.” With the high levels of liquidity in the region and the inevitable interest that attracts from international financial firms there is a good chance that all three centres will flourish.“We are committed to all three countries – Qatar, Bahrain and Dubai – and I think with any new development there is a stage of mutual discovery and due diligence which you go through. It is our intention to be present in as many markets as we can in this region where we see an opportunity and this includes all three financial centres,” says HSBC’s Smith.

Islamic banking is already well established in Bahrain and high demand in Qatar for project finance is likely to ensure a willingness by firms to establish a presence there, with perhaps the DIFC blazing a trail as a centre for regional capital markets.

“Will the BFH and the QFC be competitors? Yes, in some areas of course they will and it will be good for us all, as it will keep us on our toes!

There is enough business in this region for us all to prosper,”thinks Dr. Omar Bin Sulaiman before quickly adding “but of course while they may have offices in the other centres their head office will be here in Dubai.”

Matthew Smith, regional chief operating officer at HSBC Bank Middle East Ltd

Photo: HSBC. August, 2005

GCC REPORT

case is right then they will locate here,” says Thorpe.

The business case in Qatar is based on an economy that grew in excess of 10% last year with planned investment in a variety of projects in the region of $110bn over the next five to six years. Much of this investment is already funded by a government benefiting from record oil receipts and a rapidly expanding gas sector.

Local analysts estimate that between $60bn and $70bn will be financed by private sector funding, much of it through the capital markets. Until now Qatar’s development has been funded via markets anywhere but in the region. It is a question of the region needing a fully operating capital market and there isn’t one at the moment.That is what we want to bring to Qatar and the wider region.

Thorpe is well placed to comment on the development of the financial centres having previously been head of the DIFC Authority prior to a well publicised split last summer. “The recent tendency to see financial centres as property development can lead to a confusion of purpose. It is very hard to align the property developer’s aims and the expected participant’s aims. I think we are see ing that it can lead to a bit of an identity crisis. Are you trying to fill buildings? Or are you trying to attract the most useful elements for the development of your financial services environment. It may be possible to do both, but it is a difficult balancing act. The QFC with no property development remit has none of these issues. We are simply trying to bring in the right institutions to create a viable market.”

Not surprisingly perhaps, this is not a view shared by Dr. Omar Bin Sulaiman at the DIFC. “We have to

create property because we are an independent jurisdiction within Dubai,”he explains.“For us to achieve this, we have to create a physical environment where companies can come in the knowledge there is a sophisticated infrastructure to support them. We are not simply talking about offices, but a complete solution – a city within a city if you like. This means creating an entire environment, with the best facilities, the best legal framework and the best lifestyle to match.” Even Thorpe concedes that there is a property challenge of sorts for the QFC in booming Doha as, “sourcing sufficient office space is proving difficult for new businesses entering Qatar, though private sector developments should address that issue by the end of 2006.”

With regards to the development of a viable international capital market in the region, the DIFC seems to have stolen a march on its rivals with the creation of the Dubai International Financial Exchange (DIFX). Due to be launched on the 26th September this year,“the DIFX is the jewel in the DIFC crown” according to Dr. Omar Bin Sulaiman. “It will be the first time this region has an international stock exchange, with an international regulator, that can attract investors from all over the world”.

Matthew Smith, regional chief

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Photo: SAMA. August, 2005

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Until recently the banking sector in most of the GCC was heavily protected from international competition.

Any moves to liberalise the sector would have been perceived as a serious threat by local banks. But things are different today. The region’s banks are well equipped to meet any challenges head on and view the opening up of the sector as an opportunity not just to demonstrate their domestic expertise, but to expand into neighbouring Gulf Cooperation Council (GCC) countries.

ECORD RESULTS ENJOYED by many GCC banks during the first half of this year are not only the result of booming local economies, but also a result of strategic decisions taken over many years. Improved product offerings, far ranging investments in front end and back office systems, the widespread introduction of information technology (IT) and the development of new business lines such as investment banking, fund management, and insurance have all contributed to robust growth and brighter prospects for the region’s banks.

“Five or six years ago you could have looked at a particular area of a local bank and you would have found something archaic—in terms of governance, compliance, service or systems,” explains Matthew Smith, regional chief operating officer (COO) of HSBC Bank Middle East Ltd. But all that has changed he adds explaining that “increasingly they are moving further and further up the curve in terms of sophistication, capability and product range.” Talal Al-Qudaibi, president and chief executive officer (CEO) at

R

Hamad Al Sayari, governor of the Saudi Arabian Monetary Authority (SAMA) He believes banks in Saudi Arabia are in a strong position and can well withstand competion from foreign banks.

GCC BANKS RAISE THE BAR

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Riyad Bank agrees, noting the growing sophistication of the banking sector in Saudi Arabia. He explains that the bank has invested heavily in a broad brush of sectors, such as retail and commercial banking, Islamic banking, and investment management. “To support these initiatives we have also had to invest heavily in our risk management capabilities, our IT and our back office,” he adds. Similar investment has been occurring in other markets. Kuwait’s Gulf Bank provides a microcosm of what is happening throughout the region. Explains Yousef Al-Awadi, the bank’s chief general manager and chief executive officer (CEO), “We have replaced our IT systems; introduced state of the art e-banking channels— such as internet, mobile and 24/7 telebanking—radically redesigned and expanded our branch network; simplified and streamlined our operating processes and procedures; reskilled and enhanced the quality of our staff; and improved customer service.”

In turn, these investments are now bearing fruit, allowing local banks to

Photo: Riyad Bank. August, 2005

Talal Al-Qudaibi, president and chief executive officer (CEO) at Riyad Bank, Who notes the growing sophistication of the banking sector in Saudi Arabia.

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best leverage today’s high oil prices, deregulation and growth economies of the Gulf.

The results are clear to see. Banks across the region are posting record profits for the 2005 first half year.

Saudi-based Arab National Bank (ANB), for example, posted a net profits increase for the first half year of 55% to $238m, with profits up across all departments in the bank. “Retail, corporate banking and the treasury all have done well and it has been our continuing investment in these areas which has enabled the bank to achieve a compounded annual growth rate over the last five years in excess of 35%,” explains the bank’s managing director and CEO Nemeh Sabbagh.

Results outside Saudi Arabia have been equally impressive. National Bank of Kuwait (NBK), for instance reported a record first half net profit of $337m, an increase of 51%. Ibrahim Dabdoub, CEO of NBK further explains that performance is not the result of “oneoff items. We [have] achieved improved margins, higher fee income and

strategically focused growth across our business activities, from lending and trade finance to wealth management and advisory services.”

In Qatar the three biggest banks have seen even bigger gains. In the first half the Commercial Bank of Qatar (CBQ), Doha Bank and Qatar National Bank (QNB) posted profit increases of 81%, 84% and 71% respectively.

According to the general manager of Doha Bank, R. Seetharaman, “Performance, innovation, quality, security and service have been the hallmarks of Doha Bank.” Andrew Stevens, CEO at CBQ concedes that “Yes we are lucky to benefit from one of the most rapidly expanding economies in the world.” But he adds that to take advantage of local growth, “we have had to invest heavily in our business. We have embarked on a strategy that focuses on capturing growth opportunities. Retail has been a traditional strength of this bank, however in recent years we have invested significantly on the corporate banking and capital markets side which is now beginning to reap rewards.”QNB has also benefited from an expanding project range. “We have expanded and diversified our product range, explains chief executive Saeed Al Misnad. “As a result we have benefited from an increase in demand for existing and newly-offered financial services such as insurance, investments and wealth management.”

One area where many of the region’s banks have expanded their product offerings is in Islamic finance and banking.“Five years ago it was seen as a fringe market which catered to a small and perceived to be an unsophisticated segment,” says Matthew Smith. “Our experience at HSBC Amanah, our Islamic banking arm, has been that as it has developed the spreads and bank charges have come down to the same levels as

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GCC REPORT

conventional banking and finance.”

Saeed Al Misnad is keen to expand QNB’s presence in the Islamic market.

“There remains significant growth and potential in the Islamic banking market. We know this because more and more of our customers have asked for Shariah compliant banking services.”Not surprisingly Saudi Arabia remains the biggest market for Islamic banking. National Commercial Bank (NCB), the region’s biggest bank, is already totally Shariah compliant and although Islamic products are available from all it’s branches, Riyad Bank has dedicated 80 of its 200 branches to Islamic Banking Services. “We have a whole range of new Islamic offerings in consumer and corporate loans and we continue to develop more”says Nemeh Sabbagh of ANB’s strategy.

Deregulation as a new business driver With the deregulation of much of the banking sector across the region another area making a positive contribution to many of the region’s banks are profits from overseas either through acquisition or by obtaining a local banking license.

“NBK already has a presence in 10 countries both in and around the region.

We will imminently be opening branches in China and Saudi Arabia. Besides China our current focus is on the wider GCC region,” says Ibrahim Dabdoub, who explains that NBK has already applied for a license in the United Arab Emirates (UAE) and has acquired a majority stake in an Iraqi Bank.“We keep our eyes open for opportunities to enter other markets at the right time, the right place and with the right model,”he adds.

Meanwhile other banks are expanding for different reasons.“As a local bank we have reasons to believe that the space is limited for new capacity,” thinks Seetharaman, who acknowledges that the bank needs to establish a broader presence in the region,“and that is what

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we are doing. We have already approached local regulators and we have reason to believe we will be receiving a number of new licenses in the near future.”

In Dubai, Douglas Dowie, CEO at National Bank of Dubai. (NBD) is cognisant of this need for physical growth; particularly with the threat of foreign banks encroaching on its domestic domain as the market opens up. “This is a small market and if NBD is to compete against the larger Saudi and Kuwaiti banks then it needs to expand. Now there is no reason why we should not be able to compete headto-head with those banks, but we need to expand the bank’s size and reach in anticipation of the Central Bank allowing new banks to enter this market.

Overseas, we already have a very successful representative office in Tehran and are particularly bullish of the Qatar economy. We are already involved there through participation in project finance and have an interest in establishing a presence in that market.”

Outside of the immediate region a number of GCC banks have expressed an interest in start up operations in some of the more under-developed banking markets. Syria, for example, is an interesting market, “as is Iran and Libya. All three offer immense opportunity but, although they are beginning to open up, more needs to be done by the relevant [and local] regulatory authorities to allow us easier

Ibrahim Dabdoub, CEO of NBK NBK has already applied for a license with UAE.

Photo: NBK. August, 2005

GCC Report

access,”thinks QNB’s Saeed Al-Misnad.

Despite the penchant for GCC banks to show an interest in neighbouring markets (Bahrain’s Gulf International Bank and National Bank of Bahrain, UAE’s Emirates Bank, NBK and Oman’s Bank Muscat all have licenses) Saudi banks seem less inclined to expand in the region.“We are blessed with a big country here and a big market and there is a long way for it to go,” believes Nemeh Sabbagh. “The effort that ANB would spend on expanding its business in the Kingdom is much more profitable and beneficial to the bank than looking overseas. We know the risks here and we know what will make us money and what will not. If I managed a bank in a different country, one of the smaller states, then maybe I would look at it differently.” Talal Al Qudaibi agrees; “We are already in the biggest

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market, so for the time being we have no interest in other countries in the region. We already have operations in the three main regions where the Kingdom and our clients have trade flows which are the UK for Europe, Houston for North America and Singapore for Asia, where Saudi Arabia now exports 50% of its oil and petrochemicals.”

In many cases the region’s banking markets have not just been opened up to local banks, but also to the global banking community. “There has been a case for insulating developing national and regional banks from the full force of global competition while they have been in a relatively fragile state. But this is increasingly no longer the case,” believes Matthew Smith.“You have a growing number of very confident, very capable and very well capitalised regional players who are holding their own in which ever markets they are choosing to operate.” This is a view shared by Hamad Al Sayari, governor of the Saudi Arabian Monetary Authority (SAMA) which has recently issued banking licenses to BNP Paribas, Deutsche Bank, and JP Morgan.“The Saudi banks are in a very strong position,” he believes. “If they fail to face this challenge then they have a problem, but I am confident they are prepared.

Competition of this sort can only add to efficiency and competition in the Saudi market.”

Perhaps surprisingly, this is a view shared by many of the banks facing this challenge. “Competition is healthy for the Saudi banks because it will spur us on and encourage us to do even better which can only be good for everybody” believes Talal Al-Qudaibi. He believes that,“Riyad bank is well placed, with a footprint in Saudi Arabia created by a large network of branches, and strong client relationships.”

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National Bank of Dubai building, Dubai Creek

Photo: iStockphoto.com. June, 2005

“There remains significant growth and potential in the Islamic banking market. We know this because more and more of our customers have asked for Shariah compliant banking services.” Not surprisingly Saudi Arabia remains the biggest market for Islamic banking. National Commercial Bank (NCB), the regions biggest bank, is already totally Shariah compliant and Riyad Bank has converted 80 of its 200 branches to Islamic Banking.

For others, a more complex dynamic is at work. ANB’s Nemeh Sabbagh, for instance, thinks that there is distinct difference between competition in commercial banking and investment banking. “In commercial banking ANB and the other Saudi banks are well positioned. We have the products, the capability and are very close to a dispersed customer base. It will be very difficult for new banks to compete very effectively.” However, he adds, “when it comes to investment banking, [it] is a different proposition. Historically this has not been a forte of banks in this part of the world. I think that that is where the international banks coming in are going to focus: wealth management, private banking and corporate advisory, the Mergers and Acquisitions side of the business.”

In many of the region’s markets international banks have had a presence for many years. CBQ’s Stevens believes that “as more international inward investment reaches our shores the need for accurate local advice of business customs and protocols combined with the right introductions will give local banks an edge. But this is not enough on its own. They will also need to acquire financial, intellectual and human capital that an increasingly multinational clientele demands”.

With the Bahrain Financial Harbour, (BFH), the Dubai International Financial Centre (DIFC) and the Qatar Financial Centre (QFC) all trying to attract more international financial firms to the region, more competition in the region’s banking sector is all but guaranteed.The GCC banking sector, with its record profits growth, strong balance sheets and loyal customer base looks better prepared than ever before to meet his challenge and well equipped to stand toe-to-toe with the new arrivals.

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COVER STORY

KERKORIAN

calls an inside straight on

GM

F YOU WANT to see the human face on Adam Smith’s invisible hand, then it would look just like Kirk Kerkorian’s craggy features. For no other perceptible motives than his own financial aggrandisement he has built airlines, helped a turn a tiny desert outpost into a burgeoning metropolis, rescued one failing car-making giant, and may be turning around another. A former GM investor who dropped his stake some years ago suggested a parallel with Warren Buffet, another man of affairs whose hyperactivity continues long past socially expected retirement age. Buffet disclaimed retirement plans at a lunch and explained “I am just having so much fun running these businesses, I just don’t want to do anything else.”

Kerkorian has almost a decade and half on Buffet, but seems as determined as him to carry on.

However, while Buffet clearly relishes the public attention, not to mention adoration of his thousands of happy

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shareholders, Kerkorian is by comparison reclusive. According to his office, he refuses all media interviews although he seems to have broken his one rule for the local newspaper in Las Vegas, the city he has done so much to reshape. Brought up in an Armenian-speaking family in California, Kerkorian’s public concession to sentiment is the family’s Lincy Foundation, which has spent over $200m into helping the development of his impoverished ancestral homeland. But no one is suggesting that his General Motors investment’s primary purpose is to get Armenia back on the road. The name of the foundation, like that of his holding company, Tracinda, is portmanteau homage to his daughters Tracy and Linda, but these are rare extrusions of his private life into the public arena. Indeed, even his Armenian philanthropy gets little or no publicity outside its Caucasian beneficiary.

Kerkorian is a figure from a former buccaneering age. He is not a chief executive officer (CEO) who plodded his way

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Photo: Empics/Associated Press, August 2005

GM EDITORIAL 9

They say you can’t take it with you. At the grand old age of 88, Kirk Kerkorian is either planning on immortality; has bought celestial futures or, as some cynical observers suspect, is throwing away his wealth on a lost cause in the shape of General Motors. He already owned 20m shares and pretty much doubled his stake this June. Reportedly, he has now put around 20% of his reputed $5.8bn personal fortune into shares in the mega autoconglomerate. Ian Williams finds out why.

through the ranks of a corporate hierarchy until he was in a position to loot the shareholders’ money. He made his cash in entrepreneurial and on occasion dangerous activities, and for the last decade has engaged in seemingly impulsive, but apparently profitable investments.

The consensus is that whatever his plans for posterity, his 7% stake in GM has a sharp point directed straight towards GMAC, the company’s highly profitable loan and finance section, which makes money unburdened by huge historical health care and pension costs. GM’s market valuation is considerably below its asset value, so only its size protects it from an outright takeover.

In the meantime, Kerkorian made over $100m in a month on his $581m purchase in June as the GM price shot up from the $31 per share that he paid to approaching $37.

However, when you put that much money in, it becomes a self-fulfilling exercise. The prices went up because he paid

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as much as he did and investors expected more of the same. Indeed his purchase led directly to GM’s biggest rise in 40 years, over $5.

On one level GM management should be gratified that anyone wants to buy their unsecured equity shares since the rating agencies class the company’s bonds as close to Junk.

Just before he bought his stake, the company announced a record first quarter loss of over $1bn. However, there are clear signs of nervousness in the GM boardroom.

Kerkorian’s team made a courtesy visit, after doubling his stake, but they have not so far communicated any plans explicitly. Officially, the line from his holding company, Tracinda, is that he thinks the shares have bottomed out and can now only gain in price.That is a judgment call which not many would risk over a billion dollars on, even if we thought we only had a few years to spend it.

Most observers assume that he will use his stake to prod GM management into disgorging assets towards shareholders in general, and himself in particular. Robert Monks, the veteran corporate governance activist, suggests that “In a sense, investors [such as] Carl Icahn and Kerkorian are the people who provide a theoretical backing for the idea that an independent shareholding is an effective discipline on corporate managements. In a sense, these are the models for economics professors who are usually like a stopped clock, right twice a day.

Kerkorian is one of the places where the clock stops and they are correct. The fact that someone like him is prepared to confront General Motors has a vast impact.”

He adds “Think of Kerkorian getting into Shell for example. Any sane person would realize that it will take five years to turn round Shell, but a Kerkorian may be able to do it in a year.”Clearly the other investors who drove up GM’s price after Kerkorian moved in share Monk’s optimism.

No one has suggested altruism, or any abstract concern for the future of the beleaguered US automobile industry as a primary motive for Kerkorian, but General Motors poses a major challenge for any reformer. Even if all the best corporate governance features are in place, the unwieldy company is widely regarded as too big to fail— but too big to turn around either. The iconic company that half a century ago considered that what was good for GM was good for America now says Monks “has had a devilishly hard time making cars that anyone wants to buy.

They don’t. They rely on fleet sales to rental car companies that they own! Their auto business is a loss leader for their finance section to generate loans. At the end of the day, no matter how big you are, you cannot keep it up.”

Kerkorian’s track record does suggest someone who could indeed milk the GM mammoth. Kerkorian’s life has been characterised by adventurous deal-making, sometimes churning in and out of businesses, each time making more money. There is no playing to the moralist gallery. Getting richer is its own justification. He does not do speeches, and keeps his social life to the people he wants to see rather than those someone in his position “ought”to be schmoozing with.

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Beginning almost as a teenage drop-out in California, Kerkorian had gone into boxing, but preserved his brains intact. Instead of continuing welterweight boxing, he took off on the path to heavyweight finance. He talked himself into flying lessons, and made his first stake for investment out of ferrying Mosquito fighter bombers from Canada for the Royal Air Force towards the end of the Second World War. This was not combat, but it was very hazardous, since the transatlantic flight was at the very limits of the planes’ range.

The pilots were paid $1,000 a delivery, which for those who survived it was a very adequate return. Perhaps it is significant that Kerkorian has never tried to portray this as heroic altruism, helping the Allied war effort. It was the money in his sights, not the Nazis. He took his savings from his thirty three trips for RAF Transport Command and invested in a plane in Las Vegas. Perhaps almost as risky as flying planes across the Atlantic in war time, he moved into Vegas in the era when the then small city was being built by hard-hitting entrepreneurs from North Eastern cities whose names usually ended in vowels and whose careers often ended in mayhem and arrests. But, like the restaurant business, location is everything and Las Vegas was growing rapidly.

Kerkorian played the tables as well as his hunches, but learned that it was easier to lose at the tables than in business.

He built up his single Cessna into Trans International Airlines, which he sold for $104m back in the sixties, when that was serious money, and indeed when airlines made money. His Armenian connection helped his investor relations, since Armenian-Americans had bought their local hero’s airline stock.

But he kept his feet on the ground and in the early 1960s began to invest in property in burgeoning Las Vegas— specifically, the land on which Caesar’s Palace was built.

The resources he raised allowed him to build the biggest resort hotel in the world: the International.

But bush pilots have to get used to rough landing, and SEC refusal to allow a public offering meant he had to sell a large stake at a big loss to pay off debt. He had bought the Flamingo hotel to train the staff for the International and the Flamingo had been built and run by the mafia, so law enforcement showed an unhealthy interest. He already had another place to take off. He had been accumulating stock in the faltering Metro Goldwyn Meyer (MGM) film studio which offered opportunities in a precursor of his later involvement in GM and Chrysler.

He took control of MGM and took it into the hotel business, most specifically to build the MGM Grand, an even bigger casino/resort hotel in Vegas. He sold the movie side, MGM to Ted Turner in 1986, bought it back again months later and held on for a few years and resold. In 1996 he took it back again when last year it paid out a huge $8 per share dividend, which netted him over $1bn—after Washington axed taxes on dividends. This year it is going to Sony, giving him more of a war chest to go after GM.

Once again there is a recurring theme. He seems to keep coming back. It is not sentimental attachment, as he showed when sold off MGM’s back lot and the props that had excited a generation—Dorothy’s Ruby slippers from the Wizard of Oz being one of the more memorable examples. But he knows where the gold is buried in these companies and so far has exhumed it when others have failed or refused, and comes back for more whenever the current owners show signs of missing it.

He merged MGM Grand with Mirage in 2000 to become MGM Mirage and last year took over Mandalay resorts in a deal that the analysts called “audacious.”Since Kerkorian is majority owner, one would have thought he had enough on his plate shuttling between his Beverley Hills office and Las Vegas. But while he has wisely stayed out of the moribund airline business in recent decades, he keeps coming back to pick at the relics of the American auto industry.

In 1990, he began to build up a stake in Chrysler. With former Chrysler chairman Lee Iacocca as a partner, he tried but failed in a hostile takeover in 1995, but he did get a representative on the board, and turned the company round to the direction he wanted which would benefit shareholders like him. In 1998, Chrysler officially merged with Daimler. Kerkorian has been in litigation since claiming, not without justice, that in effect Daimler took over the company. However the Judge dismissed his claim that as a shareholder he had been cheated of the premium that Daimler would have had to pay for an overt takeover. DaimlerChrysler AG pointed out that the value of Kerkorian's Chrysler shares shot up from just under $3.7bn to $4.8bn after the merger. Kerkorian is appealing In contrast another group of Daimler Chrysler have riposted with a suit against him for insider trading, alleging that he unloaded stock in anticipation of impending poor results. It is a cut-throat business making money from decaying car-makers. His foray into Chrysler gives some form of flight plan for what he hopes to do with General Motors, and more to the point, the flexibility of his options. He will make money from the increase in stock price in any case. He will batter the board into submission to benefit shareholders in general and himself in particular. At the very least management will use Kerkorian’s lack of concern for the healthcare, union benefits and welfare of the company’s workers and pension to help batter the unions – even as he batters the management.

Reinforcing the image of Kerkorian as Adam Smith’s hand incarnate, Robert Monks praises him as “the ultimate expression of the market is when you have someone who is wealthy enough to take a dominant position in a publicly-owned company. There are not many people who can do that, and Kerkorian is one of the more conspicuous in that he does it rarely—but dramatically when he does.”

As the old Chinese curse has it, GM management is in for interesting times.

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AUTO SECTOR REPORT

Panicked in

HERE WAS A time not too long ago when General Motors, the world’s leading automotive force, was as integral to the American way of life as baseball, Elvis and T-bone steaks. ‘See the USA in your Chevrolet’ was not just a slogan, it was reality for millions of Interstate dwellers, who faithfully plunked down a couple thousand bucks each year for the privilege of driving a brand new Impala, Camaro or Malibu off the lot.

During the 1960s and into the 1970s, nearly one in two drivers owned a GM vehicle. At one point, the Big Three automakers—GM, Ford and Chrysler—accounted for a whopping 87% of the market. To help meet the incessant demand, auto workers were paid top wages including daily overtime; in the Walter Reuther-led United Automobile Workers, employees had the backing of a powerful union that helped furnish the kind of robust benefits that would become the model for the entire business world. It was America at its very best.

But foreign competition and shifting consumer tastes soon began to whittle away at America’s lock on the automotive world. During the 1980s, GM’s market share fell

T There was a time not too long ago when General Motors, the world’s leading automotive force, was as integral to the American way of life as baseball, Elvis and T-bone steaks. ‘See the USA in your Chevrolet’ was not just a slogan, it was reality for millions of Interstate dwellers, who faithfully plunked down a couple thousand bucks each year for the privilege of driving a brand new Impala, Camaro or Malibu off the lot.

Bill Ford, chairman and CEO, discusses Ford Motor Company’s 2005 first quarter financials. Ford and executive vice president and chief financial officer, Don Leclair, announced net income of 60 cents per share or $1.2bn for Q1 2005.

Photo: Ford Motor Company, April 4, 2005.

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at the rate of one percentage point each year. Today, only a everyday low price strategy has only set the domestic quarter of the marketplace belongs to GM, while Asian industry's starting price point a notch lower, and in the long automakers now account for 31% of the market. In July, run, will further erode brand-equity and residual values."

If this story has a familiar ring, it is because the auto GM reported a second quarter (Q2) loss of $318m, or 56 cents a share, compared with earnings of $1.4bn, or $2.42 a industry has been down this road before. The year was 1979 share, a year ago. Analysts had expected a profit of 3 cents when gutsy ex-Ford president Lee Iacocca assumed control per share for the quarter. The loss followed a troubling first of the ailing Chrysler Corporation, a company that many quarter that saw the company losing $1.1bn overall, had given up for dead. After securing a $1.2bn loan including a $1.3bn loss in its global automotive operations. agreement from the US government, Iacocca began a Things have not been any rosier over in Dearborn, where major cost-cutting initiative in an effort to reverse years of Ford reported Q2 net profits 19% lower than the same budgetary excess and production inefficiency, then period last year, with North American losses totaling launched a folksy television ad campaign in which he $900m. In a particularly ominous turn of events, Ford said personally implored Americans to come out and test-drive that its auto division would remain in the red for the full his new products. By the early 1980s, Chrysler was able to financial year, after indicating a possible $2bn profit earlier begin repaying its loans, and with the arrival of the in the year. Overall earnings for the full year were re- legendary minivan in 1984, Iacocca completed one of the adjusted to between $1 and $1.25 per share, sharply lower most stunning comebacks in business history.

Among other things, Iacocca understood that the than the $1.75-$1.95 per-share forecast issued in the prior industry’s reliance on quarter. Rather than shoot oversized gas hogs was its and miss yet again, Ford, Continental Drift - FTSE Automobiles and Parts Indices 130 Achilles heel—a point like GM, refused to which became painfully speculate on earnings for 120 obvious during 1979, when the coming quarter. Shares 110 a major energy crisis of Ford which have been 100 gripped the nation, traditionally cheap, have causing long rationing become even more so, and 90 lines and tripling prices at

by July were trading close 80 the pump. That year, to a two-year low.

70 Japanese auto exporters Following July’s such as Toyota and Honda announcement, Ford’s began making a serious chief financial officer Don FTSE US Automobiles and Parts Index FTSE Asia Pacific Automobiles and Parts Index FTSE Europe Automobiles and Parts Index dent in the domestic Leclair blamed, among market with a steady other factors, a Data as at July 2005 Source: FTSE Group stream of affordable, wellpronounced pullback in the sale of trucks, an area in which Ford has traditionally engineered vehicles capable of doing a 45-mile trip on a been a market leader. “The competition has been single gallon of gas. As the new decade began, Japan tremendously aggressive,” said Leclair.“We earned around knocked the US out of the top spot as the Big Three $720m in net income, and you could think that was pretty produced its weakest crop in nearly 20 years. To Iacocca, the good—but then you look a bit closer and see the loss we message was clear: Either get with the programme, or get had on the automotive side, particularly in North America. smoked by the competition. Led by the fuel-friendly Kmodel, Chrysler proved that marketing fuel economy could That's what the real issue is."

In an effort to reduce bulging inventories and stimulate indeed be a profitable long-term concept, and by the midconsumer demand, in June GM announced an aggressive 1980s, the US had finally regained its competitive edge. marketing programme, offering customers the same “The greatest discovery of my generation,” observed discount afforded GM employees for new vehicles. It was an Iacocca, who retired in 1992, “is that human beings can immediate success, with sales of GM vehicles climbing alter their lives by altering their attitudes of mind.”

Had the price of gas gone up and stayed up, as it had in more than 40% and prompting the company to extend the campaign into August. GM’s shares off nearly 35% earlier other parts of the world, things may have turned out much this year, rose sharply through the period. In July both Ford different for the American automotive industry. But and DaimlerChrysler followed with their own price cutting throughout the ‘80s domestic fuel costs remained relatively promotions with equally impressive results. But what is stable at just over $1 a gallon, and by the 1990s, gas good for the consumer will not necessarily solve the guzzling was back in style. Consumption was led by the fundamental problems that continue to dog the domestic mega-popular sport utility vehicle, which consumed automakers, say analysts, who worry about the long-term upwards of a gallon of gas every 12 miles. By 2001, the impact of a Big Three price war. “While we certainly average fuel economy for all light vehicles had dropped to understand GM's need to maintain volume,” says Merrill just 20.4 miles per gallon (mpg)—its lowest level since the Lynch analyst John Casesa, “we are concerned that this crisis of 1979-1980. Nevertheless, in 2003 the Bush

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administration signed into law a controversial tax provision allowing small businesses to deduct up to $100,000 for the purchase of a new sports utility vehicle (SUV).

All of this was good news for GM, which led the industry in full-size pickup and SUV production. Through the first quarter of 2004, the company pulled in a cool $1.3bn as its stock closed in on the $50 mark. But when gas prices suddenly shot up during the spring and summer of 2004, demand for SUVs began to tail off as consumers turned to more efficient "crossover" vehicles (sport utility vehicles built on a car, rather than truck, body). Almost overnight, GM’s light-truck dominance became a major liability, and within a year the company’s market capitalisation would be neatly cut in two. "GM's financial performance has been heavily dependent on the profit contribution of its SUVs," said Standard & Poor’s (S&P’s) credit analyst Scott Sprinzen. "Recently however sales of its midsize and large SUVs have plummeted, and industry-wide demand has evidently stalled."

Incredibly, many of the same issues that triggered the crisis of 1979 to 1982—including rising fuel prices and intense Japanese competition—have once again placed US automakers in a desperate financial situation. Indeed, the TV reappearance of an aging Iacocca—hired by Chrysler to pitch its "Employee Pricing Plus" programme—has only added to the sense of déjà vu.

Naturally, one has to wonder how an industry as entrenched as the auto business could allow history to repeat itself in such a fashion. "You can dig into the particulars around products and manufacturing processes for an explanation,” observes Wharton management professor John Paul MacDuffie, “but I guess the broad impression is that US companies don't tend to be good learning organisations."

Despite steadily increasing fuel prices, not all consumers are expected to abandon the light-truck market.

Unfortunately for domestic manufacturers, analysts believe that the Japanese will reap the lion’s share of the business—the first time that such “transplant” companies have encroached on territory that has long been the domain of the US. According to Harald Hendrikse, equity research analyst for Credit Suisse First Boston, the ability of Asian manufacturers to produce enticing new models, as opposed to the same old packages offered by US automakers, has resulted in the shifting dynamics.

“Lack of product-vision from many US and European OEMs as the market segments fragmented into smaller niche segments, often generating huge growth for new competitors at the expense of incumbents stuck in declining ‘old’ segments,”says Hendrikse.

One potentially significant new player is China, which has already made its presence felt in the production of engines, transmissions and other auto parts. While it may be several more years before China becomes a serious auto-exporting force, Subaru of America founder Malcolm Bricklin has already tossed his hat into the Beijing ring with Visionary Vehicles LLC, an international automobile

import/distribution company. In 2007, Bricklin will roll out the first in a series of export models produced by partnership firm Chery Automobile Company of Wuhu, China. The company’s goal: to undercut comparable-value domestic models by 30%.

Observers worry that a prolonged pullback within the US auto sector has the potential to wreak serious economic havoc worldwide. Among the most vulnerable foreign interests are Mexico and Canada, which currently account for roughly 20% of all North American auto production. In Mexico, where scores of factories employ thousands of autoworkers, a significant cut in production could pose a major threat to the local economy. "The recent woes in the US from creditChairman downgrades Fordautomotive Annual Generalindustry, Meeting, May 12, 2005. and CEO,to production schedule high inventories, have raised Bill Ford, opens thecuts 2005and Motor Company annual shareholder concerns how vulnerable Delaware.

Mexico'sPictured economy is," meeting atabout Hotel just DuPont in Wilmington, left to said Morgan Stanley in vice a recent report.

The financial situationofficer; is just right: Don Leclair, group president and chief as precarious to president the north, where the officer; auto Bill industry Jim Padilla, and chief operating Ford, represents thanPeter 6%Sherry, of thegeneral Canadian gross domestic chairmanmore and CEO; counsel, corporate and product, compared roughly in the US and senior vice commercial matters; to David Leitch,1% general counsel Under the right circumstances, however, a restructuring president. in Detroit could actually benefit these regions, notes Hendrikse.“A lot depends on the kind of solutions Detroit comes up with. For instance, DaimlerChrysler’s suggestion that it wants to start producing and exporting Chrysler cars from China is entirely logical, given that Honda is already making investments to do exactly the same. However, if new capacity comes on stream and outdated, expensive US capacity cannot be closed down due to union restrictions, problems may arise.”

In early May, veteran value investor and billionaire Kirk Kerkorian announced that he would raise his stake in General Motors to 9% sending GM shares to their largest one-day percentage increase in decades. But just days later, both GM and Ford were dealt yet another blow when Standard & Poor’s reduced the companies’ credit rating to junk status, resulting in lower borrowing limits and higher fees for the already beleaguered manufacturers.

Indeed, most experts believe that US automakers will need to address a number of major concerns before any real momentum can be achieved. Overcapacity, as well as the automakers’ inability to terminate old, outdated and inefficient capacity due to UAW contracts in the US and government job protection in Europe are just a few of the leading culprits, according to Hendrikse.“This means that as new capacity is added in new US greenfield sites, in Mexico, or in Eastern Europe, the existing OEMs do not have the power to respond to reduce costs to similar levels, or even improve efficiency to similar levels. As automation in the sector has progressed, the many job-protection measures in the industry are clearly not helpful.”

Skyrocketing pension and health-care costs, which continue to plague all of corporate America, pose perhaps the greatest threat to the auto industry going forward. In 2004, the Big Three paid $8.5bn in combined health care costs; GM, which ranks as the single largest health care provider in the world, shelled out over $5.2bn for 1.1m US

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employees, retirees and dependents last year. At the same time, the company’s pension obligations reached $89bn, due in large part to a massive retiree base. "GM is at a critical crossroads, needing to do everything it can to reduce costs," says Jack W. Plunkett, chief executive officer of Plunkett Research Ltd., a market research firm in Houston.

Lower interest rates, combined with the lingering effects of weak asset-market returns during 2001-02, have opened the huge pensionand healthcare-funding gaps that currently exist at the Big Three, says Hendrikse. “This has added substantially to annual costs of production and the per-unit cost of production,” he said. However, Peter Morici, an economist at the Smith School of Business at the University of Maryland, believes that the problem has been exacerbated due to pricing inefficiencies within the auto sector. "The math of General Motors just does not make sense," says Morici. "Basically, they sell cars for less than it costs to make them. They like to blame the legacy of health care and pension costs, but remember, the Japanese who make cars in this country have to pay health care and pension costs, too.”

Some have suggested that Detroit’s mass-production system—the very cornerstone of the US auto empire— should be replaced by a European-styled system of masscustomisation.“Customisation and platform-sharing is not just an answer, it is an entry requirement,”says Hendrikse.

“Given global competition and already fragmented segment and model offerings, in our view there are no more Lee Iacocca or minivans. The only way out is to reduce costs to competitive levels—manual labour rates must be cut by 30% to 40%, and pension and healthcare benefits must be lowered as well. Otherwise, competition will only continue to ramp up, and the result will be no jobs and no benefits.”

Given the severity of the situation, it is likely that GM and its domestic competitors will be forced to undergo a protracted period of downsizing, resulting in the closure of numerous production facilities and the termination of tens of thousands of employees. Like Ford, which recently announced a significant reduction in salaried positions at its North American operations, GM has slashed 25,000 jobs as it prepares for a face-off with union officials over healthcare cost containment. Other possible solutions include the elimination of a GM brand name—either Buick or Pontiac, perhaps both. While a restructuring of this magnitude would be unprecedented in recent times, says Deutsche Bank analysts Rod Lache and Michael Heifler, “the end result is that GM could emerge as a smaller—but healthier—automaker."

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2005

The evolution of Ford motor cars. Photos from top to bottom: 1. Reconstruction of the Model T, assembled in 20 minutes – Dearborn MI, June 13 2003. 2. 1955 Ford Thunderbird commemorative stamp, from a US postal service collection saluting sporty cars of the 1950s. 3.

Focus RS at the 2005 Rally Argentina. 4. Jaguar XKR, from the Bond film ‘Die Another Day’.

Photos: Ford Motor Company.

Bill Ford, chairman and CEO, Ford Motor Company 2005

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TRANSITION MANAGEMENT

Merrill Lynch has thrown a spanner into the works of the global transition management business. Many would argue that more than a decade after its establishment, transition management is still a business in search of a consistent identity and for years a battle has taken place as to whether the broker/dealer approach to transition management is better or worse than the alternative investment management approach. By trying to combine both models in a single offering Merrill Lynch threatens not just to raise the bar but to redefine a business that is currently in flux.

Francesca Carnevale reports.

Charles Shaffer, managing director and global head of transition management, Merrill Lynch Global Markets Investment GMI Banking Group

MERRILL LYNCH

SETS A NEW BAR HEN CHARLES SHAFFER left his job as global head of Deutsche Bank’s transition management team in New York to join Merrill Lynch earlier this year the transition management market was agog. At Deutsche Shaffer’s team had set new benchmarks in the transition management business. The bank had developed an enviable volume of global transition business that had carefully been built on quantitative modelling, a robust portfolio trading capability, ultra-competitive pricing, a highly diversified team and a sales strategy that boasted the backing of a strong and flexible balance sheet. Over the last couple of years some of the core team dispersed (though Deutsche still maintains a strong business line in TM) to set up new and successful operations elsewhere aided by their experience in building up a TM franchise across Europe: Jody Windmiller’s move to UBS, and more latterly Paul Marchington’s to Lehman Brothers are but only two examples.

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Interest in Shaffer’s departure was of a different magnitude however – for two reasons. Wonderment first settled on his destination. Merrill Lynch already had a fully operational and staffed transition management team, albeit based in the bank’s asset management arm Merrill Lynch Investment Managers (MLIM). The transition management team (TRIM) is one of the longest established and highly respected teams in the market, headquartered in London and headed by Michael Marks, with its roots firmly in the investment management area. In fact, TRIM lays claim to being one of the earliest providers of transition management services, which gives it a particular cachet as well as colouring its approach to the business. At least four of the executives who established the TRIM team in the early 1990s had their roots in Mercury Asset Management, for example. Shaffer’s expertise, on the other hand, is firmly based in the broker/dealer model of transition management that had characterised the TM offering at Deutsche Bank. Before that he had been at Morgan Stanley.

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Photo: Merrill Lynch. August 2005

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Interestingly, Shaffer’s appointment, in fact, was not with business? If it succeeds then Merrill Lynch could in fact set MLIM, but rather with Merrill Lynch’s Global Markets and a new bar, a new standard that other houses would be hard Investment Banking Group (GMI), which provides pressed to meet.

Talking separately to both Marks and Shaffer, there is a institutional sales and trading, investment banking advisory and capital raising service – a different part of the bank strong thread of solidarity and commitment to working out altogether. Inside GMI, Shaffer has taken on the role of the mechanics and the ultimate offering. According to managing director and global head of transition management. Shaffer,“It is very clear that senior management have realised Three questions immediately went begging in the TM the benefits to the client that a collaborative and integrated marketplace. Transition managers were intensely curious as offering can bring.”And if the “partnership”as he describes it to how the traditionalist, high touch, asset management succeeds, he thinks it will be an important step in the based approach of Marks’ TRIM could sit happily and evolution of the market itself; bringing to clients a truly 360 degree service. contiguously with the more It cannot be, stresses rumbustious broker/dealer Shaffer, that in future, clients approach to transition Marks at MLIM concurs. “Hand on heart should be in the position of management that Shaffer in developing the business model we had, having to choose between“the represents. The broker/dealer we cannot say, this is the only way it can broker/dealer model and the TM approach is predicated be done. We see strengths in other asset management model.” on the ability to analyse and models that up to now we might not Marks at MLIM concurs. then efficiently distribute a “Hand on heart in developing portfolio through an innecessarily have been able to supply. To the business model we had, house trading capability, with provide a better service at lower cost we we cannot say, this is the only the client trusting that the are looking at ways of extending, for way it can be done. We see broker/dealer would not use example, the use of technology and order strengths in other models that the trades to benefit its own routing (in other words, algorithms and up to now we might not book. A key selling point of necessarily have been able to the asset management quantitative models).” supply. To provide a better approach, by contrast, is an service at lower cost we are independent (or broker neutral) approach, guaranteeing complete independence looking at ways of extending, for example, the use of and objectivity. For Shaffer, the question is straightforward. technology and order routing (in other words, algorithms and “The offering is that of a full service investment manager quantitative models).”But, Marks cautions,“Issues have to be that is fully integrated with the direct market access that is resolved. But the desire to get there is 100%.”

Shaffer thinks that four questions are at the crux of the provided by a global broker dealer.”

Shaffer acknowledges however that it writes more easily Merrill Lynch approach.“As a client, you should be asking: than it is applied.“True, there have been certain attempts to ‘Will you as a transition manager link your compensation achieve it and no one has gotten it quite right. But look at to my performance?’ It invariably puts pressure on us to the result of that failure. Clients have to choose one provide accurate estimates. Second, the client should be asking ‘can you commit your capital to guarantee a fixed structure over another, to their detriment.”

Then again, asked the market, why has Merrill Lynch shortfall?’ Estimates of implementation shortfall are not swallowed whole the chestnut that its global transition enough, the client should be asking for a guarantee. Third, management business requires two heads rather than one? ‘can you work as an investment manager or advisor?’ and The market expected and still expects the wholesale finally,‘If I am being asked to use this broker/dealer, would slamming of doors and egos across MLIM and GMI. my own managers use them?’” If the answers to these According to one transition manager,“if Merrill Lynch joins questions are in the affirmative, “then you have a great the two models, it will eventually gravitate to the transition manager,” says Shaffer. That combination, he broker/dealer model. There will be a strong business case to stresses, lies at the heart of Merrill Lynch’s integrated trade away.” It may yet happen, but not yet. Too much is, offering. And it is here that the threat to the rest of the perhaps, at stake. And the heart of the matter beats market from the Merrill Lynch offering is most apparent. strongly in the third question. What if the cross-fertilisation Shaffer had already introduced some of this radical of the best of the TRIM model, evinced by Marks and his thinking into market when he was at Deutsche Bank (see team and the best of the broker/dealer model, distilled in FTSE GM Issue Five, January/February 2005) when he Shaffer and his team, actually works and their combined introduced an implementation shortfall linked strengths are brought to bear on a market already in flux? compensation package, or money back guarantee, to What happens then in a marketplace that is still coming to clients. “Once that particular genie was let out, it is very terms with growing competition, an increasingly cost hard, even impossible, for it to go back into the bottle,” conscious client base and growing strains over the states Shaffer, who maintains that the same approach will definition and form of the ‘ideal’ transition management be adopted at Merrill Lynch.

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TRANSITION MANAGEMENT

The engine for Merrill Lynch to think the previously unthinkable is driven by a number of factors. First the source of business is becoming more diverse. Once the preserve of large pension funds handling a multitude of investment portfolios, the transition management business is now seeing smaller, more discrete funds wanting to utilise their services – including high net worth family investment funds and smaller pension funds—as well as mutual funds and insurance companies. In May last year TRIM introduced a Smaller Transition Services product in response to these changes, explains Marks.“We started off working with the larger funds and now also do more work with smaller funds. It is all to do with providing a comprehensive service.” And many market watchers believe that Shaffer’s existing relationships among the global pension fund community and in the financial services sector will bring in a diversified client base to Merrill Lynch that will include a multitude of large and small pension funds and financial services clients as well.

“We are not targeting specific clients,” explains Marks, but when you do the inevitable exercise of starting with a blank sheet of paper and ask the question,‘where are we missing out on business?’ then obviously we try to fill the gaps.”

While Merrill Lynch is diversifying its client base in the search for more revenue, it acknowledges that that client base is becoming more sophisticated and demanding; with cost a particular driver. The onus then on transition managers to

provide a 360 degree service that can handle this spread of business is intensifying,“in one place,”says Shaffer.

It is too early to say whether Merrill Lynch will succeed in its bold experiment. One of three things might happen. One, it will succeed and begin to redefine the business, as did TRIM when it helped establish transition management more than a decade ago. If it does succeed, it will hasten the consolidation of business around both the larger players offering an integrated service and the sophisticated quantbased offerings of more discrete players. And those larger players will be forced to consider the Merrill Lynch model as a baseline business template. Two, it will only half work and the two businesses will co-exist uneasily together, working on large complex projects in tandem and then each going its own way on the smaller projects, competing with each other on a P&L basis. In which case, the market will continue to blur at the edges as the various houses vie to differentiate themselves from other transition managers. Or, worst case, it will be totally unworkable and either one or other side will eventually be absorbed. It seems that Merrill Lynch has taken the view that in an increasingly diversified marketplace providing all things for all men might just be the answer. Whether that analysis is the right one, is yet to be seen. For the next year or two at least, the market will have breathing space while the issue is ultimately resolved.

Either way, every transition manager will be watching developments at Merrill Lynch very closely indeed.

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EUROTUNNEL

A tunnel between England and France had progressed nearly two-thirds of a mile under the sea before it was abandoned in 1882 when Queen Victoria labeled it “very objectionable.” Some 123 years later, many of the shareholders of Eurotunnel plc/SA, the company which operates the modern version of the channel tunnel, would likely agree with her. Dogged by cost overruns in the tunnel’s construction and unrealistic traffic targets, Eurotunnel has found itself buried under £6.5bn of debt. Shares in the group, which as recently as 1999 traded at more than £100 currently trade at about 17 pence. Paul Whitfield reports on the company’s efforts to stay afloat.

Photo: Empics/Associated Press, August 2005.

GM EDITORIAL 9

THE SEARCH FOR A NEW

TRACK

UROTUNNEL FACES AN uncertain financial future, with many industry watchers predicting eventual bankruptcy. Jacques Gounon, Eurotunnel’s president and chief executive has warned that it may fold as early as October (does he mean 2005?). The fate of the group rests on the outcome of negotiations, currently underway, between Eurotunnel’s management and its lenders. On July 15 Eurotunnel said it had delivered its initial proposal for a new debt restructuring to an ad hoc committee that represents the majority of its lenders.

Details of the proposal have been kept secret but it is probable that it included a request to write off the majority of the company’s debt and leave shareholder capital largely untouched. Gounon was re-elected to be President of Eurotunnel on June 17 after promising shareholders that he would ask lenders to write off all but €3.3bn (£2.2bn) of the company’s debt. The Eurotunnel board believes that this is the maximum amount of debt the company can sustain.

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The lenders, dominated by American and British hedge funds as well as a smattering of specialist debt boutiques, have said they will not accept a write off. They favour a debt for equity swap that would massively dilute or wipe out shareholder ownership.

The two positions seem hopelessly divided. But this is not the first time Eurotunnel shareholders have seen such brinkmanship.

If, and that is a big if, Eurotunnel and its lenders reach an agreement to save the operator it will be the fifth time that bankruptcy has been stayed by a last minute restructuring.

If no agreement can be reached, then the lenders will likely take up an option to substitute their loans for control of the group – closing the chapter on one of Europe’s most troubled and fascinating business ventures. The history of how Eurotunnel came to this point is a modern business fable – a warning of the dangers of coupling innovative and expensive infrastructure projects with optimism and billions of pounds of private financing.

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The story begins in 1981, when UK Prime Minister annum on the Eurostar, a passenger-train run by a separate Margaret Thatcher and President Francois Mitterrand of company which pays to use the channel tunnel. Passenger France, invited tenders for the construction of a rail or road traffic peaked at almost half of that in 2004 when some link between the two countries. Eurotunnel was awarded 7.2m people traveled on the train.

The estimations for freight traffic were even more the contract. Its passenger and freight rail tunnel—based on a plan first suggested in 1975—beat competitor optimistic. The original plan accounted for 7m tones of proposals including a plan to suspend a large tube from a freight each year. Actual tonnage for 2004 was 1.8m tones. bridge, a road tunnel and a combination of a suspension “There was no basis on which to forecast usage of the tunnel so it was a very difficult thing to get correct.” says bridge for cars and a tunnel for trains.

From the start Eurotunnel’s costing of its project was Mady Chabrier, head of public relations for Eurotunnel.

Faced with the prospect of bankruptcy Eurotunnel hopelessly, though perhaps forgivably, optimistic. Part of the problem was that the engineering and construction of a accepted a repackaging of its debt that handed creditors marine tunnel the length of the Chunnel (as the link is often 45% of its equity in exchange for the cancellation of billions called) had never been attempted before. The project was, as of pounds of loans. The deal also put in place a series of a result, a leap into the unknown, making efficient costing initiatives to delay repayment of debt. Notably it gave almost impossible. For this reason and as a symptom of the Eurotunnel the option to issue stabilisation notes which competitive tender for the project, the company’s estimates of allowed it to defer interest payments. The hope was that both the money and the time it would take to complete the the new deal, which is still in force today, would give the project were massively optimistic. The original budget, agreed group time to build its business so it could meet payments on its loans. But the new with the tunnel’s builders business plan, which was TransManche Link, was A tunnel or a rollercoaster? finalised in 1998, was once £4.9bn. In the end, the final Eurotunnel vs. FTSE Developed Europe Index again deeply flawed by cost of the tunnel was some 150 optimistic business targets. two and a half times that.

125 Under pressure from its Money for the project 100 creditors, which were was raised in an initial 75 understandably keen to public offering and in the secure as large a debt market – ironically, 50 repayment of debt as the two governments that 25 possible, the company for commissioned the project 0 a second time massively would own no stake in it. overestimated its In 1987 Eurotunnel floated passenger and freight on both the London and Eurotunnel/Eurotunnel SA FTSE Developed Europe Index numbers.

The new Paris stock exchanges Data as at July 2005. Source: FTSE Group. business plan budgeted for where, despite early concerns over budget overruns and the already looming about 14m Eurostar passengers – still almost twice the 2004 possibility of bankruptcy, it raised about £770m in equity. figure. It also included a forecast annual freight tonnage of At the same time it secured some £4bn in loans from 174 about 4.3m, almost two and a half times higher than the 2004 figure. banks and development agencies mainly in Europe.

The fatal optimism of the second rescue plan was Within a year the project was in serious financial trouble.

By 1990, when French and British engineers broke through compounded by a failure to foresee the evolution of to connect the first of the three tunnels, the company faced competitor businesses. Ferry operators, who were expected collapse. It returned to the equity market where it raised to fold as car and lorry traffic switched to the train, cut prices another £556m. In 1994, the year the tunnel opened, it was stayed in business and forced Eurotunnel to lower its own once again forced to go to the equity market to shore up its prices. At the same time low cost airlines emerged as a finances, selling a further £858m of shares. And all the time serious competitor. British passengers who were expected the company was dipping back into the debt market. The to drive to holiday homes in the south of France began to fly cost of the tunnel was calculated in 1995 to be about £12bn. to hub airports like Nice instead, while cheap plane tickets Of that about £9bn was financed by debt, landing between Paris and London compounded Eurotunnel’s Eurotunnel with interest payments of about £2m a day, an misery.To add to the operators woes, at the end of June 1999 amount it could not hope to meet. In September 1995 the travelers within the European Union were stripped of their company suspended interest payments on part of its debt – right to buy duty-free goods, removing their incentive to cross the channel for a day’s shopping trip.The upshot has essentially declaring itself bankrupt.

By this stage it was evident that a hopelessly optimistic been revenues well below expectations, and a subsequent construction budget was not Eurotunnel’s only mistake, it inability to raise enough cash to meet debt repayments.

And, seven years after the first restructuring, the group now had also drastically overestimated its traffic estimates.

The company had budgeted for 16.3m passengers per finds itself back in much the same position.

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Well not exactly the same. The first important difference is that the lenders have changed. Eurotunnel’s initial 174 lenders largely consisted of European commercial banks and development agencies. Most, but not all of them, have since sold their debt. “The sale and resale of that debt, particularly in the past year, has increased the number of lenders to about 200 mainly US and UK hedge funds and specialist debt boutiques,” says Xavier Clement head of Eurotunnel investor relations.

Despite increasing the total amount of lenders the debt trading has served to concentrate debt ownership amongst companies that share reasonably homogenous goals. Both the hedge funds and debt boutiques are primarily short term investors, far more interested in flipping investments for quick gain than being a long term investor, let alone an equity owner. That could aid Eurotunnel’s management in its bid to come to a new debt repayment plan, particularly if the plan offers the hope of increasing the value of Eurotunnel’s debt.

The group’s debt trades at about 50 pence in the pound.

Few of its current lenders have paid more than that, according to a Eurotunnel source.

The flip side of that argument is that many of the new debt holders have bought their stakes knowing that Eurotunnel’s bankruptcy is both likely and near. This may mean they are more likely to accept an end game that sees them take control of the company with a view to selling it on once the debt has been wiped out. Negotiations are underway with two lenders councils. The first is led by US insurance group MBIA, which through proxy voting rights represents the holders of about 20% of Eurotunnel debt, and also consists of Oaktree and Franklin Mutual, two US hedge funds and the European Investment Bank, a noncommercial bank.

The second, which represents holders of riskier debt, is

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2005

led by representatives of financier George Soros, who recently bought a significant stake in Eurotunnel debt. “The first phase of those negotiations is focused on arriving at a business plan that both the company and its lenders agree is feasible,”says Chabrier. Only after this plan can be agreed will Eurotunnel begin to discuss a new debt repayment schedule she adds. That new plan will necessarily involve a reduction of operating revenue targets.

It must, Gounon has said, also involve a restructuring of the contract that the company operates under. That means negotiation will also take place with the governments of the UK and France which established the commission that dictates Eurotunnel’s business.

In particular Eurotunnel wants to dump onerous provisions in the contract such as the requirement to run a train every hour of every day – a rule that means many run empty or nearly empty.

It will also lobby to have capacity allocations removed. At the moment the company must allocate 50% of its capacity to Eurostar and freight trains, yet average traffic from the two users rarely demands anything approaching that capacity. The company also admits that it does not use its own 50% of the tunnels potential capacity, meaning the tunnel typically operates at less than 50% of its potential.

The operator also wants to remove a requirement for it to fund dedicated emergency services and security personnel; a cost that it rightly points out is not born by other rail operators. “We operate under all the usual financial regulations but under some peculiar state constraints,”says Clement.

Eurotunnel’s hope is that the renegotiation of the contract and an agreement on a new business plan will clear the way for it to emerge as a new type of business altogether. The group has long envied the idea of becoming a full service rail-freight group, which it believes would enable it to

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increase traffic through the tunnel and thus revenues – something it does not believe either Eurostar or the rail freight companies are capable of or committed to doing.

The need to increase the traffic in the tunnel is made all the more urgent by the pending expiry, in November 2006, of a minimum user charge which has guaranteed revenues will not fall beneath a certain level. Payments made as a result of the charge accounted for 43% of the company’s 2004 operating revenues of £538 million, Eurotunnel was awarded a license to operate as a railfreight company in February 2004 and had planned to buy rolling stock later that year before the plans were vetoed by lenders who balked at the idea of the group taking on even more debt.

But Eurotunnel has not given up hope, it continues to investigate the possibility of finding a partner, either one that would buy into the business or agree a contractual partnership, that could provide the wagons. “We know there are interested parties,”says Chabrier.

The group also remains open to the opportunity, should it arise, to sell the business or at least a large equity stake in it.

This is not as fanciful as it might sound. The company is not an unattractive business, so long as you can ignore that pesky debt. It has a strong cash flow on a high margin and made £174.6m in operating profit in 2004.

The price tag on the company is not high, Eurotunnel’s market capitalization is £450m, but any buyer would also have to have a plan to repay the £6.5bn in debt. The likelihood of any such deal prior to a restructuring of debt is remote at best. And, unfortunately for both the company and its shareholders too, few experts seem to have much faith that a restructuring is in the offing. “'We remain highly concerned about whether an agreement between creditors and management on the debt restructuring will be possible. In addition, any dilution of equity—that is a debt-for-equity swap—will require shareholder approval, which is highly uncertain,' Jan Willem Plantagie a Standard & Poors credit analyst said in a report in mid-July.

In early-July, Fitch Ratings downgraded bonds secured on Eurotunnel debt, giving the company's frosty relationship with its banks as one of the reasons for the move.The intractable problem of a company that might not meet its debt and lenders that refuse to write them off is further complicated by Eurotunnel’s hideously complex debt structure. The issuance of new tranches of debt to fund the spiraling cost of construction and then again as part of the 1998 rescue package has created multiple layers of debt and multiple and divergent interests amongst lenders.

Eurotunnel has admitted that conflicting interests among its lenders could hamper negotiations. For the time being the negotiations have not even progressed far enough to expose these fault lines. Reports in the British and French press in July said that the ad hoc lenders council led by MBIA had rejected an initial proposal, which included Gounon’s proposed write-off of debt. Any plan devoid of that council’s support is undermined.

Photo: Empics/Associated Press, August 2005.

GM EDITORIAL 9

Jacques Gounon, Eurotunnel’s president and chief executive officer

And all the time the clock is ticking. Without some restructuring Eurotunnel will collapse within the next 18 months. Even if Gounon does not make good on his threat to declare the group bankrupt in October the company is unlikely to survive more than a few months more. In April of 2006 it must report its results for 2005. Without a restructuring of its loans it is likely that the company’s auditors will refuse to say the company is a going concern, triggering its collapse.

Yet, even if things go that far, there is one final hope for shareholders, and it is one that French shareholders in particular seem eager to grasp. The UK and French governments can veto the transfer of the company to the lenders – though in doing so they would have to come up with a viable rescue package.

The idea might seem incredible to most UK investors and no doubt to the UK government, but the French government has a history of corporate bail-outs. Most recently in the 2004 it stumped up €2bn to rescue engineering group Alstom. In Eurotunnel’s case hope of such a cavalry charge is almost certainly false. A cooperative rescue package between the UK and France is highly unlikely, not least because of the political division between the Blair and Chirac governments. Meanwhile, the deeply indebted French state is in the process of selling off assets to pay down its own debt and would be loath to reverse this process.

No matter what the fate of Eurotunnel there is some succour for those who use the Chunnel. The treaty that established the link commits both governments to keeping the train service operating no matter what. That is unlikely to make Eurotunnel shareholders feel better though.

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HEDGE FUNDS: EDDIE LAMPERT

Photo: iStockphoto.com. August 2005.

GM EDITORIAL 9

shoe fits?

If the

If Edward S. Lampert pulls off the revival of Sears, with or without the Kmart name, it could be one of the great business stories of the ages, starring a wunderkind investor who has compared himself and has been compared repeatedly to Warren Buffet, the long-time head of Berkshire Hathaway, and storied names in American retailing. Bill Stoneman reports.

DWARD S. LAMPERT knows value when he sees it.

It seems. Lampert picked up about 23m shares of AutoZone Inc., an automobile parts retailer in the United States between 1997 and 1999 after the stock languished for years at about $25. The stock has since climbed to more than $90, yielding a gain of about $1bn for Lampert and his ESL Investments Inc. Can he do it again with the Sears Holdings Inc.?

So successful has Lampert been since starting a hedge fund in 1988 at just 25 years old, that he landed on a Forbes magazine list of the 400 wealthiest Americans (at No. 288 back in 2002) with an estimated net worth of $800m. In the magazine’s most recent list, published in September 2004, Lampert’s net worth was pegged at $1.7bn and his ranking climbed to No. 142 — thanks mainly to investments in companies such as AutoZone and PS Group Inc., an aircraft leasing company, that are utterly devoid of the buzz that growth investors favour.

Moreover, it appears that his success with AutoZone and

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other stodgy businesses was just a warm up. Lampert got control in 2002 of Kmart Corp., once the second biggest retailer in the US, but then operating under supervision of bankruptcy court, for less than $1bn. He pushed it out of bankruptcy and subsequently watched the value of his stake grow to about $4.9bn by November 2004, when he orchestrated its acquisition of former No. 1 American retailer Sears, Roebuck & Co., in which he also owned a sizeable stake. And then the value of his stock kept on growing. His holdings in the two companies were worth $6.3bn when the deal was announced. By mid-July, after the two companies were combined under the name Sears Holdings Inc., his stake gained another $4bn in value, totaling $10.3bn, based on a share price of $160.

But now comes the hard part for Eddie Lampert, as his acquaintances know him, who has modeled himself after the now legendary value investor Warren Buffet. The challenge for Lampert, who today is as much a business manager as an investor, is to turn Kmart and Sears into serious money

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Sears Holdings’ Headquarters, Hoffman Estates, Illinois Photo: Sears Holdings

He says cost cutting will makers. Or, if not that, to then [Lampert] … joined Goldman, Sachs & boost margins and in turn perhaps extract value by Co., where he worked for Robert E. Rubin, earnings, even as sales selling their assets. continue to fall. That’s how With $55bn in annual sales then head of arbitrage for the firm, but AutoZone, with a significant and 3,800 full line and later its chief executive and then treasury push from Lampert, specialty retail stores in the secretary under President Bill Clinton. prospered, he says.

US and Canada, Sears Investor Richard Rainwater, known best for Either way, if not for Holdings ranks as the third managing the billions for the Texas oil Lampert’s track record, both largest American retailer, after as a stock picker and an agent Wal-Mart and Home Depot, a Bass family, helped Lampert set up his for change at far smaller seller of tools and building own business. Investors have included AutoZone, investors products. Key proprietary Michael Dell, the computer maker; probably would not be brands include Kenmore, Hollywood mogul David Geffen; and paying much attention to the Craftsman and a broad range members of the Tisch family – whose late new Sears Holdings. of clothing lines including Joe patriarch, Lawrence Tisch, was regarded as Whether the run-up in stock Boxer and Apostrophe. But price at Kmart and then Sears doubts about the holding one of the great value investors of his day.

Holdings should be company’s prospects are explained by investors widespread. Though once consumer icons, both Kmart and Sears appear to be well past jumping on Lampert’s bandwagon or real earnings power their best days. Their identities in the minds of many may not be clear for some time. With Lampert as its American shoppers are blurry at best. Observers increasingly chairman, Kmart returned to profitability about a year after speculate that Lampert will either sell assets, such as real it left bankruptcy. And earnings grew over the next three estate, or invest cash now being thrown off by the business quarters, before the Sears acquisition was completed in elsewhere. That is roughly what Buffet did with a former March. But sales fell quarter after quarter. Sears Holdings, in textile company named Berkshire Hathaway. Selling assets or its first quarterly earnings statement, reported a modest investing free cash flow, however, on sufficient scale to justify profit for the period ended April 30, before a charge related the current market capitalisation without draining the retail to accounting changes. But sales continued to drop.

The turnaround at Kmart, during and after bankruptcy, business of its remaining vitality would be difficult, many say.

“The Sears/Kmart combination is a story of two declining resulted largely from cutting operating costs, cutting capital retailers getting together to make a bigger declining retailer,” expenditures and selling stores. It closed about 600 stores, says Kimberly Picciola, an analyst with Morningstar Inc., out of the 2,100 it started with, while under supervision of the US Bankruptcy Court. And then it subsequently sold 18 who values Sears Holdings shares at $100.

Not everyone sees it that way, of course. Gary Balter, a stores to Home Depot for $271m and 50 stores to Sears for retail analyst with Credit Suisse First Boston, says the stock, $576m. Many signs point to more of the same at Sears, which has done little but climb higher since Kmart where Lampert continues on as chairman.

“We are encouraging our associates to do more with less emerged from bankruptcy in May 2003, can still go higher.

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and to treat the company’s money as they would their own,” industry observers guessing about his plans. Having wrote Lampert, who would not comment for this article, in a watched Lampert sell Kmart stores for $800m before the letter to shareholders accompanying the first quarterly Sears acquisition happened, observers wonder if Lampert earnings report under the Sears Holdings name. He added thinks the real value in his retail holdings is in their real that many stores were being remodeled, that some Kmart estate. Maybe he will exit the retailing business entirely, locations were being converted to Sears’ stores and that some say. But with 3,800 stores in the United States and some of Sears’ products would be sold at Kmart. But the Canada, Lampert can not possibly sell too many too emphasis clearly was on boosting margins by tightening quickly without torpedoing the real estate value, says operations, not on attracting new customers.“Too often our Howard Davidowitz, chairman of Davidowitz & Associates predecessor companies pursued higher sales and accepted Inc., a retail consultant and investment banking business in lower profits to meet objectives that, we believe, did not New York. That means Lampert needs to generate at least some value from the retail business until the timing is right increase the value of the companies,”Lampert wrote.

It is hard to argue with the bottom-line results – driven for each round of real estate sales, Davidowitz says. But it is mainly by cost cutting – thus far. But many retailing unclear the extent to which Lampert intends to create value industry observers say it is going to be tough in the long by cutting costs versus boosting sales and then whether he has a meaningful plan for run, unless Lampert improving sales. defines Sears’ and Kmart’s Has Sears Holding Inc. figured out the challenges of retailing?

Lampert said when he – if he continues to operate 700 announced Kmart’s under both names – 600 acquisition of Sears that identity in the marketplace 500 the transaction would far more clearly than either 400 produce $500m of company has for the last 300 “annualised cost and 10 or 20 years. “If you are 200 revenue synergies” within trying to save your way to 100 three years, $200m of profitability, you inevitably which would come will fail,” says Harry 0 from “cross-selling Bernard, a partner in opportunities between Colton Bernard, a San Sears Holdings Wal-Mart Stores Kmart and Sears’ Francisco-based industry Home Depot FTSE US General Retailers proprietary brands and by consultant. The long-term converting a substantial winners fulfill a specific Data as at July 2005 Source: FTSE Group / FactSet Limited number of off-mall Kmart role in consumers’ minds, he adds, citing Wal-Mart and its image as the king of stores to the Sears nameplate,”and $300m of which would discounters and Target’s reputation for discounting with a come from cost savings.

Expanding the Sears business away from malls would bit of designer style.

“It will be difficult unless there is a very clear-cut strategy continue a plan developed by Sears’ executives, who that will offer everyone a reason to shop there as opposed recognized before Lampert took control that many of the to anywhere else,” Bernard says. Neither Sears nor Kmart biggest successes in American retailing lately have been at offer as clear a reason for people to patronise them, non-mall stores. That the Sears name resonates with Bernard and others say. And while Credit Suisse First consumers more strongly than the Kmart name gives the Boston’s Balter says there is room for plenty more cost plan additional rationale. But just moving Sears away from cutting, not everyone is so sure about that.“It seems to me malls hardly is a complete strategy, observers say. “If you that they have gotten most of the fat out of these are not offering merchandise that brings consumers into companies,” says George Whalin, president of Retail the stores, it really does not matter where you’re located,” says Morningstar’s Picciola.

Management Consultants, San Marcos, California.

Lampert has given no indication that he will retire the Lampert has signaled his intention to stay out of the public eye. He put shareholders on notice in a June 7 letter Kmart name entirely, though many retail industry that they will not hear from him too often.“We believe that observers think that is likely. In the meantime, he has substantial amounts of time spent on investor relations suggested that he will offer some of each chain’s strongest activities such as road shows and investor conferences brands in the other’s stores, but has not said how distract and detract from accomplishing our fundamental extensively he will do that. Sears’ Kenmore appliances and objective of creating value for all our owners,” he wrote. Craftsman tools are well regarded. Kmart has garnered Instead, he says, he will communicate primarily through somewhat of a following for Martha Stewart branded Securities & Exchange Commission filings and press house wares. Selling Kenmore refrigerators at Kmart or Martha Stewart bedding at Sears could, however, just releases. There has been few of either.

As a result, beyond a few clues about his overarching muddle the identities of both stores more than they already thinking on management, Lampert has generally left are. In addition, manufacturers of goods sold at Sears may l-0

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not welcome placement in lower-brow Kmart. Perhaps reflecting exactly that thinking, though it did not explain its decision, Nike, the athletic footwear company, said in May that it would stop selling its wares at Sears.

Rather than show his retailing hand, Lampert has said more about general management in his SEC filings and occasional public comments. With more than 40% ownership in the company, Lampert and other board members will prosper if their stock goes higher, he said in his June letter to shareholders. Non-management directors, however, will not receive stock options or other stock compensation, he said. Executive compensation is tied to operating performance, not to the price of the company’s stock.

If Lampert pulls off the revival of Sears – with or without the Kmart name – it could be one of the great business stories of the ages, starring a wunderkind investor who has compared himself and has been compared repeatedly to Warren Buffet (the long-time head of Berkshire Hathaway) and storied names in American retailing. Lampert, now 43 and based in Greenwich, Connecticut, crossed paths with a number of leading players on the business and finance stage at an early age. As an undergraduate student at Yale University, he was a research assistant to economics Nobel Prize winner James Tobin. He then joined Goldman, Sachs & Co., where he worked for Robert E. Rubin, then head of arbitrage for the firm, but later its chief executive and then treasury secretary under President Bill Clinton. Investor Richard Rainwater, known best for managing the billions for the Texas oil Bass family, helped Lampert set up his own business. Investors have included Michael Dell, the computer maker; Hollywood mogul David Geffen; and members of the Tisch family – whose late patriarch, Lawrence Tisch, was regarded as one of the great value investors of his day.

Though Lampert is not well known as business titans go, he clearly has begun to cash in on his success. With the runup in Kmart stock driving an estimated 69% gain in 2004, Lampert picked up a cool $1bn paycheck, according to Alpha magazine, the most ever for a hedge fund manager, the magazine said, since it began tracking such business.

Lampert’s investing prowess, however, is only part of what would make a Sears turnaround story interesting.

Sears, Roebuck & Co., which traces its history back to 1886, was easily the US’s largest merchant for most of the 20th century, selling everything from clothing to washing machines, mostly away from the biggest cities. With its growth stalled by the 1970s, it tried to diversify into financial services. It briefly owned Allstate Insurance, the Dean Witter investment firm and Coldwell Banker, a real estate brokerage company.“Sears has tried to be everything to everybody,” said Bernard Collton’s Bernard. Kmart, successor to the SS Kresge Co., a chain of five and dime stores that dates to 1899, opened its first discount department store in 1961, the same year that Wal-Mart got started. And it was the leading discounter for its first 30 years. Wal-Mart passed both Sears and Kmart in sales in the early 1990s and has since left them both in the dust. Its

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Sears storefront at night

Photo: Sears Holding Inc. August 2005.

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$285bn in sales last year compared with $36.1bn for Sears and $19.7bn for Kmart.

Lampert acquired a 14.6% stake in Sears between 2000 and 2002. His investment in Kmart, perhaps even more than Sears, illustrates his penchant for buying assets when they are cheap. He began buying Kmart bonds after the company filed for bankruptcy in January 2002, when the outlook was bleakest. He pushed aside lawyers and consultants, who he once said were pocketing more than $10m a month during the bankruptcy period, to push forward a recapitalisation plan of his own. With his debt holdings converted into equity and additional shares purchased as a part of its reorganisation, Lampert held 53% of Kmart’s stock when it left bankruptcy. The stock, which started at $10, ended 2004 at $99.95 and then approached and briefly topped $160 in July.

People who know Lampert say he brings a keen intellect, great focus and a willingness to immerse himself in details to the table.“He has the unique talent for figuring out the challenges in retailing and a unique ability to look at retailers as other people don’t,”says Charles Elson, a fellow AutoZone board member and University of Delaware business professor.“He is very, very bright.”

But even for someone with an impressive record of seeing value that others missed, making a competitor out of Sears and Kmart is not going to be easy. If there’s a significant niche to fill in retail landscape, consultant Bernard says he does not know what it is. Says Morningstar’s Picciola: “It is tough to see how they are going to go up against Wal-Mart and Target.”

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BANK PROFILE: WASHINGTON MUTUAL

Outperforming to an indifferent audience

WaMu chairman Kerry Killinger

Bank of America founder A. P. Giannini did not live to see his pioneering vision of a national bank, stretching across the United States and serving ordinary working people and small businesses, materialize. On the other hand Kerry Killinger, chairman and chief executive officer (CEO) of Washington Mutual Bank (WaMu), America’s largest savings bank, with 2,000 fullservice branches and assets of $323.5bn has—but these days investors appear hardly to care.

Art Detman looks at the reasons why.

Photo: Washington Mutual. August 2005

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A Generator of Capital - Washington Mutual vs. FTSE US Banks and Financial Index 250

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one on Wall Street hates the stock. But few love it, and there are two reasons why.

“The first reason is that the primary product that the company sells is mortgages, and it is pretty widely believed that as interest rates move higher, the refinance portion of their business will largely die,”says Richard Bove, of Punk, Ziegel & Company. “The second reason is that the company intends to build 250 branches this year, and the market believes that this is excessive.

“So there is a great deal of fear that Washington Mutual is positioned wrong and is being too aggressive in expanding its retail operation.” Most other analysts agree.

Killinger believes the naysayers have not yet taken into account the management changes that he has made to strengthen the company, nor do they recognise the profit potential promised by hundreds of new branch offices.

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N JUNE WAMU chairman Kerry Killinger unveiled a deal to acquire Providian Financial, a Visa and MasterCard credit card issuer with nearly 10m customers and $18.4bn in receivables, and in July he announced that second quarter earnings had soared 73%, to $844m or 95 cents a share. In both instances the market shrugged. WaMu’s shares continue to trade in the low 40s, about where they were five years earlier; moreover, they command a lower price/earnings multiple than the stock of most competitors.

Sceptical investors point to the many challenges facing Washington Mutual. Interest rates are rising, squeezing the bank’s net interest margin. Housing prices in all its key markets may be in a bubble that, if burst, could lead to a nasty uptick in foreclosures and loan losses. Last year the company slipped to third place in mortgage servicing (it had been first) and to third in mortgage originations (it had been second). Turnover in the board room and among top executives continues (“revolving door” is the term used in one newspaper headline). The only bright spot seems to be a flurry of options trading now and then that suggests that Washington Mutual may be the takeover target of any of several far larger commercial banks in the US and abroad.

Despite all that, Killinger – who took the reins in 1990 – is optimistic, even enthusiastic, about WaMu’s prospects. After all, his company is one of the great banking success stories in US history and among its most unlikely. Founded in 1889 in Seattle, where its headquarters remain to this day, Washington Mutual’s branches – Killinger calls them “retail banking stores” – are now located in 14 states, including New York, Illinois, Florida, Texas and California. These offices accept deposits and offer checking accounts, make mortgage loans and extend home equity lines of credit, provide secured and unsecured loans to individuals and businesses, and sell mutual fund shares, insurance policies, and other financial products. WaMu is the nation’s third-largest issuer of debit cards, and will rank eighth in credit card receivables when the Providian acquisition closes, probably early in the fourth quarter. Another part of the company provides mortgage loans on apartment buildings and is the largest such lender in the US. And its Long Beach Mortgage subsidiary makes home loans to buyers with sub-prime credit scores. “Our primary mission,” says Killinger, “is to create the leading retailer of financial services for the consumer and small business market in the United States.”

One can easily imagine Giannini saying essentially the same thing as he was building Bank of America.

Washington Mutual was owned by its depositors until 1983, when it sold shares through an initial public offering (IPO). As Killinger eagerly points out, since going public WaMu has achieved a 21% annual compounded return for its shareholders, compared with 13% for the Standard & Poor’s 500 index.

This figure includes reinvestment of WaMu’s generous cash dividend, now around 4.6%, which analysts say have helped support the stock’s price in recent years. In fact, WaMu has increased its cash dividend every quarter over the past 10 years. Easy to understand then why perhaps no

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FTSE US Financials Index

Data as at July 2005 Source: FTSE Group

A bit of history is helpful here. By late 1996 WaMu had grown into a $22.4bn assets thrift largely on the strength of its operations in its home state of Washington. Seeking to expand, it sounded out the Texas-based owners of American Savings, a California savings-and-loan (S&L, or thrift) with assets of $21.9bn. Nearly all California thrifts were struggling with a variety of problems in 1996, while WaMu’s ratio of problem assets to loans had hit a low of 0.1%.

Killinger struck a deal to acquire American Savings, and soon WaMu was a $44.6bn company. A few months later, in early 1997, H. F. Ahmanson – owner of Home Savings of America, for decades the nation’s largest S&L – made a hostile takeover bid for Great Western Financial, a $40bn-plus thrift.

Killinger, who knew Great Western’s beleaguered CEO, suggested that Washington Mutual act as a white knight. The offer was accepted, and after a very public fight, WaMu won, becoming a $93bn S&L. “After we got the Great Western transaction completed, and things were going very well for us, I got a call from the people at H. F. Ahmanson,” Killinger recalls. “They said, ‘Now that you have won the deal, we’re finding it difficult to compete.’ And they asked if we would consider buying their company as well. We negotiated a transaction with H. F. Ahmanson and closed it during 1998.”

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Ahmanson’s assets were $50.4bn, so within two years Killinger had grown WaMu from a $22bn company to more than a $165.5 billion company. Other acquisitions followed, including that of the holding company for New York’s fabled Dime Savings Bank in 2002. By mid-2005, WaMu’s assets were more than 16 times greater than they were just a decade earlier.

From the standpoint of retail customers, the acquisitions were almost seamless. But in the bowels of the company, where the value of MSRs – mortgage servicing rights – is determined, trouble was brewing. Because these values are sensitive to changing interest rates, mortgage banking companies employ intricate hedging maneuvers to smooth out what otherwise would be great volatility that would whipsaw reported earnings. But WaMu did not have the necessary in-house expertise to properly effect such hedges for its rapidly growing loan portfolio.

Meanwhile, the refinancing boom triggered by low interest rates had temporarily played itself out. As a result, WaMu’s profits were slammed by both volatility in MSRs and a sudden decline in refinancings, and earnings per share plummeted by 32% in 2004. Return on shareholders’equity fell to 11.7% from 19.2%. Killinger moved to cure the MSR problem by bringing in seasoned hedging experts from major commercial banks.

As for the second problem, he dismissed nearly 9,000 of the 26,000 mortgage-related employees throughout the bank.

Meanwhile, Killinger also recognised that the bank needed an infusion of more capable senior executives. Until the mid 1990s, WaMu was being managed mainly by executives who had joined the company many years earlier, when it was a small depositor-owned bank. So Killinger began bringing in new blood, including – early this year – Steve Rotella, who had headed JP Morgan Chase’s mortgage banking operation and is now WaMu’s president and chief operating officer (coo). Today, of the company’s thirteen executive officers, twelve have joined the company since 1996.“Steve’s primary focus is making sure that we are executing our key strategies in the best possible way,” Killinger says.“He’s done a terrific job of helping to improve the operational effectiveness of everything we do.”

Just how hard that job is was underscored in results for the second quarter of this year, when WaMu’s efficiency ratio rose slightly to 57.24%. (This figure is determined by dividing operating expenses – not including interest expense or loan losses – by revenues. In banking terms, the lower the efficiency ratio is the greater the efficiency.)

“We would like to move the average over the coming five years down to 50% and trend toward 45% near the end of that period,” Killinger says. He also is aiming for a return on common equity in the high teens and per share earnings growth of 10% or more, all while maintaining a strong balance sheet and a tangible common equity to assets ratio of 5% or more.

One key to this ambitious five-year plan is gathering lots of cheap deposits in a low-cost manner. That is why Killinger is so eager to open new branches. “I think we have opened more new banking stores in the past three years than any

other bank in the country,” he says. “We opened about 250 banking stores last year, and this year we could open up to that number. Washington Mutual was really the first one in the market to emphasise the growth of retail banking stores.”

Another key is adding a business that generates higher profit margins than home loans. That’s where San Francisco-based Providian comes in. WaMu’s cost of funds is much lower than Providian’s, and Providian’s credit-card interest rates are much higher than WaMu’s rates on mortgages and home equity lines of credit. As for the branch office expansion, Killinger notes that many other banks have also announced plans to open new offices, but he is doubtful. “Because of the cost of opening those branches, it may not work out very well for them. Many of those branches announced in the last year or two may not be the best investment for shareholders.”

Killinger says WaMu has three advantages over its commercial bank competitors. First, it spends typically $800,000 to $1m to open a branch, about half or even a third as much as the cost of a commercial bank branch. Second, it builds deposits more quickly by offering free checking accounts (overdraft fees are steep, so the careless subsidise the careful). And third, it cross-sells other products – certificates of deposit, loans, mutual funds, insurance and the like – relatively quickly.“The average customer who has been with us for one year has about 5.8 relationships with us,”Killinger says.“We understand that is industry-leading.”

All its new branches use an innovative design called Occasio, introduced in 2000, that some have compared to a cross between a Starbucks coffee house and a Gap clothing store. Employees wear khaki and serve customers from freestanding teller towers. People who expect their bank to look like a fortress may find the concept unsettling, but Killinger believes the design (which actually received a US patent in 2004) provides an important competitive advantage by making WaMu’s branches more inviting to prospective customers. “When we move into a major metropolitan market, we like to have a network of about 200 stores,” Killinger says.“We currently have that many in the New York market and our long-term aim is to have about 400. It is a very similar story in Texas, Florida and Chicago. In each of those markets we are pretty close to about 200 stores, and ultimately I would like to see us have about twice as many.”

A look at some profitability figures reveals why Killinger is so eager to open new branches. The average monthly pretax profit for branches open more than five years is $160,000. If WaMu opens just 200 new branches this year, that carries the promise of $384m in additional operating earnings in 2010.

A de novo branch opened in a market where WaMu already has other branches loses about $30,000 the first month but becomes profitable in about 13 months. In a new market, a de novo branch loses about $40,000 the first month and becomes profitable after 21 months.

Saturating a market makes sense for several reasons, among them customer convenience. “If you are not going to pay high interest rates on deposits,” says one analyst, “you need to have the most ATMs and the most branches

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Photos: Washington Mutual. August 2005.

If Killinger had to relax a rule, it’s so your customers can access their probably well worth it in this case. money easily. People will sacrifice WaMu needs a credit-card operation interest rates for that sort of and starting one from scratch just convenience. So the more branches isn’t feasible. Although the multiyou build, the more pricing power step formula for buying Providian – you have in that market and the initially valued at $6.45bn – could more deposits you gather.” result in paying a stiff premium, the Killinger insists that Washington acquisition may still be a bargain.

Mutual can easily afford its aggressive What about selling WaMu if the expansion plan and long-term right offer is made? Killinger is cold to dividend policy of paying out 45% of the idea. He believes that Washington net earnings.“Our company is a very Mutual can deliver better long-term strong generator of capital,”he notes. returns to its shareholders by As for the impact of rising short-term remaining independent. interest rates, Killinger is not overly Still, there’s always the chance that concerned.“The greatest impact that a bigger bank might come knocking rising rates have is that our assets reon the door. There are at least 26 price slightly slower than our banks worldwide with more assets liabilities,”he says.“There is a certain than WaMu, including nine with amount of compression in our net assets of more than a trillion dollars interest rate margin when that each. “I think that Washington happens. Today, we are below our Mutual, which is valued at a lower normal margin of 2.90% to 2.95%, price/earnings multiple than some but that will return to normal when other banks, will continue to be a the increases in interest rates cease.” potential takeover target,” says Killinger appears more concerned Kenneth Bruce, a Merrill Lynch about the almost feverish run up in Latin for "favorable opportunity," the Occasio™ analyst. “Because of its attractive housing prices in many of WaMu’s term describes Washington Mutual's awardfootprint on the West Coast and in markets.“I hesitate to use the word winning, patented retail banking concept. The some other fast-growing markets, it ‘bubble,’” he says.“But certainly we concept combines banking and friendly customer would be attractive to a foreign or pay very close attention to the rapid service in a welcoming retail environment. domestic bank that does not have escalation in home prices in certain Washington Mutual led the revival of retail overlapping operations.” This is not markets. We adjust our loan banking when it introduced its Occasio™ retail what Killinger and his energised programmes accordingly, and banking concept in Las Vegas in 2000. The management team wants to hear. monitor our average loan-to-value concept was created in response to nearly two After all, they have built a ratio and other indicators. years of extensive customer research in which remarkably successful bank, “This is a high-risk period for customers said they liked to do business in a diversified by lines of business and residential home lending,” he comfortable setting with friendly, competent by geography that fulfills Giannini’s concedes, “but I think it is one that people. Combining the research with cues from populist dream of a century ago. we are well-positioned for. I think top-notch retailers, Washington Mutual set out Now, they are working hard to open we have taken the appropriate steps design it retail banking stores accordingly. new branches and integrate the in our underwriting and also in our Providian acquisition, all the while striving to improve loan-loss reserving.”

WaMu last bought a major bank in 2002, and Killinger efficiency and dodge the twin bullets of rising interest rates does not rule out acquiring another provided it meets his and possibly crashing housing prices.

But the fact remains that, even with all the new offices criteria. “One, it has to fit very tightly with our strategic plan. Two, we have to be able to integrate it into our and the Providian acquisition, WaMu is not only smaller existing operations and get the appropriate cost savings than many of its competitors but valued more cheaply by very quickly. Three, it must not present any significant the market. Suppose a bigger bank offers a premium to credit risk or stretch our capital positions. Four – and this is market of 25% or even 40%, which is the premium Bank of the toughest test – it has to meet our internal rate of return America (BofA) paid for its FleetBoston Financial takeover. threshold, and right now that means a return in the high That premium was derided at the time, but is widely praised now (please refer to FTSE Global Markets, Issue six, teens on an after-tax basis.”

Providian – not a retail bank – appears to be an exception March/April 2005, page 70). Could WaMu’s board decline to this last requirement. WaMu will not reveal its projected such an incentive to sell? If not, then Washington Mutual – internal rate of return for Providian, but expects it to begin like Giannini’s BofA, which itself was acquired a few years adding to earnings next year on both a GAAP and cash basis. back — will also find itself in the hands of another.

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US SECURITIES LENDING

Third party lending agents are shaking up the cosy world of securities lending in the United States. Auctions of exclusive rights to lendable assets allow lenders to test the market value of their portfolios and let smaller players bid against the dominant prime brokers on an equal footing.

In just five years, eSecLending has muscled in, forcing traditional lenders to change their ways.

Meanwhile, regulators are demanding better risk controls and more transparency. Neil A. O'Hara reports from Boston.

RADITIONAL STOCK LENDING programmes depend on relationships between the prime broker borrowers and custodian lending agents, such as Northern Trust or State Street, or beneficial owners that lend directly, such as AIG or Vanguard. Prime brokers prefer to borrow securities that command premium rates from their clients, such as US small caps, international equities and high-yield corporate bonds. To get access to the most profitable securities, borrowers have to accept run-of-the-

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mill general collateral (GC) as well. That favours the established prime brokers because smaller players may be unwilling or unable to take on large GC balances.

“Many broker-dealers who can bid aggressively and pay premium returns in specific sectors often cannot even participate in those sectors in a traditional programme,” says Chris Jaynes, managing director of eSecLending, "They get a capital hit for GC positions." He explains that brokers who accept GC balances have preferred access to specials at favourable rates, which they can lend on to either a client or another broker at a higher rate.“The profit has gone to the broker, it has not gone to the lender,” he says, “In our process, a broker that does not have the GC balances but can pay a premium fare would pay it directly to our lender client.”Auctions level the playing field among brokers willing to pay for exclusive portfolio access.

Principal lending creates a direct relationship between lender and borrower – whether negotiated directly or through an auction – and is far less common than agency lending, where a custodian handles the lending program for a fee. Custodian banks offer an extra layer of credit

Photo: iStockphoto.com, August 2005.

shook

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protection not available to principal lenders. They back lending services with a guarantee against borrower default.

Although a borrowing broker will guarantee a principal lender’s balance against default by its clients, the guarantee relies on the broker's credit.“In the event of broker default, that guarantee doesn't do you much good,” Jaynes points out. eSecLending has addressed potential client credit concerns through an insurance policy that matches the indemnification custodian lending agents provide.

Traditional lenders are not standing still.

Several major players, including Northern Trust and State Street, formed Equilend, a central hub for securities lending services that eliminates the need for multiple links among its members. Jeffrey Benner, head of North American securities lending trading at Northern Trust, says around 90% of its US equity lending is now handled electronically through Equilend or Northern Trust’s Auto Borrow facility, which links prime broker borrowers to participants’ systems so securities are delivered almost instantaneously.

Equilend launched its own portfolio auction platform in June 2005 when Robeco sold rights to a portfolio of Taiwanese securities.

Some Equilend members arrange portfolio auctions in their own right, including Northern Trust and Goldman Sachs. “As that model has gained some momentum, other providers have come up with competing products,” says Tred Mcintire, global head of Goldman Sachs' agency lending operation,“It is gaining some traction. Who knows whether it will continue?” He points out that auctions are based solely on price and do not give credit for operations or client service capabilities.

And clients may prefer not to enter into principal arrangements. The guaranteed fee may not compensate for the income an agency lender can generate from trading individual securities in the portfolio that go special.

State Street, a market leader in custodian lending, has bootstrapped its operational prowess to become one of the largest third party lenders.“Securities lending is a business where one bad corporate action can ruin your day,” says Edward O’Brien, executive vice president and head of State Street’s Securities Finance division. Common settlement glitches can be expensive, too, especially in foreign markets where penalties are high. “You make $5m and give $4m back in fails and fines and operational costs and where have you got yourself?” he asks. Non-custodial clients cite operations as well as program returns among their reasons for choosing State Street.

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Jeffrey Benner, head of North American securities lending trading at Northern Trust

Photo: Northern Trust, August 2005.

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Auctions of exclusive rights work best for portfolios that have the highest intrinsic values, according to Kathy Rulong, executive director of Mellon Global Securities Lending. “A guarantee of earnings typically attracts a focused buyer interested in only select types of assets,” she says, “That’s why you see them heavily in certain domestic portfolios, international portfolios, and highyield fixed income portfolios but you just don't see them across the board.”

The Risk Management Association (RMA) survey of securities lending activity for the first quarter of 2005 indicates how much is at stake. Weighted average spreads on US equities were 37 basis points (bp), compared to European equities at 60bp (including Scandinavian equities at 125bp). US corporate bonds earned 36bp versus 22bp for US Treasuries.

Participants in an eSecLending auction have a single opportunity to bid in which they specify a guaranteed fee and may commit to a minimum collateral balance, too. The lender sees all bids and picks the one best suited to its needs. That may not be the highest fee. Borrowers compete

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spreads, according to O’Brien.

Spreads have two components: the lending spread “below the line”, the difference between the overnight repo rate (effectively the risk-free reinvestment rate) and the stock loan rebate rate, and “above the line” spreads from reinvestment returns that beat the repo rate.

“When you are at 1%, you can only go down another 100 basis points,” he says, “With rates at 3.25% there is a little more breathing room. I'm seeing that in the pricing of securities on loan.”

Higher interest rates can boost reinvestment returns as well, but cash managers have Tred Mcintire, global head of to balance the temptation to Goldman Sachs' agency lending operation reach for yield by extending duration against the risk of based on guaranteed balances as well as fees, but brokers locking in low returns as rates ratchet up. Clear signals from that cannot afford to carry GC balances can bid up the fee the Federal Reserve Board have prompted reinvestment to win.“If a borrower is willing to pay a premium over any managers to keep duration short, a strategy other fixed other broker, from our viewpoint they deserve to get those income players have emulated. “The Fed’s telegraphic assets,” says Jaynes,“It makes no difference to us whether approach in managing the overnight fed funds rate has been they have large or small balances with us. Our client very kind to securities lenders,”says Rulong,“But you’ve got a lot of participants crowded into a very small market.”She deserves to get the best return.”

Although almost invisible to the public at large, securities notes that corporations have rebuilt their liquidity. Supply lending generates substantial revenues for the major Wall has dwindled while demand has increased – so credit spreads have tightened.

Street firms. The business Although Mellon’s lending keeps growing, too, driven in Some Equilend members arrange spreads have improved, part by money pouring into portfolio auctions in their own right, reinvestment returns have hedge funds. “Our volumes including Northern Trust and Goldman scarcely budged. are up overall across the Sachs. “As that model has gained some The best returns for lenders markets,” says Benner, “Our come from equity securities percentage on loan is up — momentum, other providers have come up that go special (i.e. attract a we’re utilising more of our with competing products,” says Tred premium spread), usually portfolios.” RMA surveys Mcintire, global head of Goldman Sachs' related to mergers and show respondents’ total US agency lending operation. acquisitions, convertible bond dollar lendable assets issuance, initial public increased 34% to $5.90trn in offerings or dividend tax the first quarter of 2005 from $4.40trn a year earlier. Aggregate loan volume rose even arbitrage. Merger and initial public offering (IPO) volumes faster, by 44% to $915bn, as assets on loan grew from 14% have picked up in the past year but remain far below peak levels. While convertible arbitrage took up the slack for a to 16% of the available supply.

Volume growth has pushed up prices for some asset time, issuance dropped sharply in 2004. Convertible arbitrage classes. Spreads on US Treasuries rose 4bp to 22bp, while hedge funds have reported dismal recent performance; last corporate bond spreads jumped from 27bp to 36bp, June, one prominent fund, Marin Capital, announced it according to RMA surveys. Equity spreads were a mixed would cease operations and return $1.7bn to investors.

Yet hedge funds are nothing if not nimble. As assets bag: flat in North America but lower in Europe and the Pacific Rim as a whole despite higher rates in specific under management continue to grow despite meagre returns from merger and convertible arbitrage, they have markets (Germany and Hong Kong).

Rising interest rates leave more room for wider lending turned to other strategies.“Hedge funds have been driving Photo: Goldman Sachs, August 2005.

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22nd ANNUAL CONFERENCE ON SECURITIES LENDING October 18-21, 2005 Boca Raton Resort & Club Boca Raton, FL The ORIGINAL industry-wide conference sponsored and developed by securities lending and borrowing professionals for securities lending and borrowing professionals

Presentations From Lenders, Agents, Borrowers, Consultants, & Business Leaders Discussing: N N N N

Legal/Regulatory Update Industry Leaders Panel Discussion Collateral Management Issues Hedge Fund Outlook & Impact on Lending Conference Keynote Speakers: Robert D. Hormats, Vice Chairman, Goldman Sachs International Dr. William Freund, Chief Economist Emeritus, New York Stock Exchange THE ORIGINAL SECURITIES LENDING CONFERENCE -- DON’T MISS IT!!!

Planning to Attend: For registration materials or questions, call RMA, Kim Gordon, 215-446-4021 *E-Mail: kgordon@rmahq.org or visit our web site at http://www.rmahq.org/RMA/SecuritiesLending/RMAConferenceInformation.htm Conference Co-Chairs Louis Molinari President Metropolitan West Securities Short Hills, NJ

Anthony Schiavo Managing Director Morgan Stanley New York

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US SECURITIES LENDING Photo: Mellon Global Securities Lending, August 2005.

a lot of demand for GC lending by virtue of market neutral or long/short programs,” says Mcintire, “They may choose to short one stock in a sector and go long another stock in the same sector, thereby creating demand to borrow stocks you might not otherwise see.”

The already low margins on GC lending may take a hit when the Basel II regulatory capital guidelines take full effect at the end of 2007. Agency lenders have to set aside capital to support their guarantee against borrower default, according to Angi Meyers, senior vice president and head of North American product for securities lending at Northern Trust. US regulators will not issue final rules until mid-2006, but interim guidance suggests that the effect on capital will vary by institution because Basel II permits a risk-based assessment. “There is motivation for moving from less sophisticated to more sophisticated calculations of regulatory capital,” she says,“The impetus is a potential reduction in your capital need.”

Custodian banks have the most to lose from higher capital requirements because their securities lending operations are so large relative to their capital bases. Not surprisingly, State Street made Basel II a priority, building on risk management software it developed in the mid-90s.

“We started working on this about four years ago. With some minor tweaks yet to come we're effectively almost Basel II compliant today and have been for about a year,” says O'Brien, who does not expect any change in the composition of State Street's securities lending business when the final rules take effect.

Northern Trust pursued a similar path, according to Meyers, enhancing a value at risk model used for internal risk measurement to reflect the anticipated Basel II rules.

For US banks that adopt an “advanced approach” under Basel II, capital requirements may even decrease.“The US regulators we've been in touch with have agreed that securities lending is a relatively low risk activity, and that the capital requirements under the current 1988 Basel I accord probably exceed the real risk,”she says.

The Securities and Exchange Commission (SEC) has launched a separate initiative to improve risk management in US securities lending. Prime brokers used to calculate capital requirements based on their exposure to lending

Kathy Rulong, executive director of Mellon Global Securities Lending

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Angi Meyers, senior vice president and head of North American product for securities lending at Northern Trust

Photo: Northern Trust, August 2005.

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agents. Now the SEC wants agents to disclose from whom they borrowed the securities so that prime brokers can track their exposure to the underlying lenders. “One borrower could be borrowing from a given legal entity through Northern. It could also be borrowing through State Street or other agents,” Meyers says, “When the second phase of this initiative goes live next year we will have to provide daily loan level information to the borrowers.” That will require automated data flows to handle the volume as well as secure handling to keep the information confidential.

Securities lenders have turned another SEC project, Regulation SHO, to their advantage. Intended to clamp down on naked short sellers by tightening procedures for fails and buy-ins, the new rule seems to be working. If the percentage of failed trades in a security exceeds certain thresholds, it must appear on a list each US exchange publishes daily. When first introduced last January, NASDAQ's list included almost 400 names, but the number shrank to about 200 by the end of June. Regulators may not have realised they were creating a marketing tool for lending agents, however. “In some cases, you will see an obscure name on the threshold list. You know somebody is trying to find those securities and is probably willing to pay a pretty good fee,” Mcintire explains. That may tempt third party lending agents to turn threshold lists into auction catalogues.

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SQUEEZE Brokers are feeling the pinch as commission rates continue to drop. Although higher trading volume offsets the lost revenue it comes at a price: more trades to process. That squeeze fuels a relentless quest to streamline sell side back offices through greater automation. But brokers have to persuade buy side clients, who do not face the same economic pressure, to change their ways. That may require a push from regulators. Neil A. O'Hara reports from Boston.

HE SECURITIES INDUSTRY has talked the talk for years, yet straight-through processing (STP) remains as elusive a goal as ever. The obstacles are many. In 2003, a report from the Group of 30 (G30) made 20 recommendations to strengthen international settlement practices, many of which demand more automation. That same year, the European Union's Giovannini group put forth proposals to facilitate a pan-European securities market. The aims may be laudable, but however authoritative these organisations are they have no legal power.“To drive some of these big changes in the industry you need a regulatory mandate,” says Lee Cutrone, managing director responsible for industry relations at Omgeo, “The best practices approach is not going to be enough to drive change on a uniform and consistent basis.”

Others see regulators as part of the problem. John Panchery, vice president and managing director, operations and technology, at the Securities Industry Association, has watched information technology (IT) budgets drain away from STP projects as firms wrestle with enhanced compliance obligations under the Sarbanes-Oxley Act, the Patriot Act's anti-money laundering rules and new regulations from the Securities and Exchange Commission. “STP has been sidetracked for a couple of years now,”he says,“The majority of resources are being taken up on compliance issues that must be done. There is not a lot of time and effort for discretionary spending on long-term planning.”

Some projects still make the cut. Industry initiatives in which all parties have an equal stake tend to move forward, according to Panchery, who cites continuous net settlement as an example.“That was a major improvement to the ‘Street side’ process. It worked well because it was driven by the industry utility,” he says. Projects that benefit one industry segment over others are more likely to stumble. He sees

Photo: Omgeo, August 2005.

T Lee Cutrone, managing director responsible for industry relations at Omgeo

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institutional trade processing as a major challenge because four players participate: the broker-dealer, the buy-side institution, the custodian and the depository. "It is very difficult to make a voluntary system work when you have parties that are regulated by different entities and they do not all get the same benefit," he says.

Automated solutions may conflict with market practice, too. In the US buy side institutions typically use average prices. Late day fills affect the final price, so money managers seldom allocate trades until after the close of business. The industry has set up a central matching utility that to handle allocations throughout the day but the buy side is unenthusiastic. "Behaviour change is a major impediment to efficient STP," says Panchery, "We could build the greatest system in the world but if you are not going to give us the information until after 4 o'clock what good is it?"

Omgeo's Cutrone agrees. "If everything waits until the end of business that puts a lot of pressure on the post-trade processing to get an affirmed trade by midnight that night," he says. The US same day affirmation rate has risen from 14% to 28% over the last five years, but among Omgeo's clients that use central matching the rate has reached 8590%. Cutrone believes the buy side switch to central matching will be gradual unless regulators demand higher same day affirmation rates. Like most businesses, brokers have a lopsided client base. "80% of their business comes from 20% of their clients and it's the other 80% of clients that cause most of the processing inefficiency," he says.

Brokers are in no position to force money managers to change their allocation methods anyway. Suppose an institution expects a broker to execute an order at the volume weighted average price. "Do you tell someone you are not going to accept that?" asks David Myers, a partner at financial services technology consultants Capco, "They will go somewhere else with the business."Buy side resistance runs deeper than a commitment to existing allocation methods, however. The underlying rationale is economic, according to Beth Liberty, a senior product strategist at SunGard Data Systems. "The buy side typically does not have accountability or responsibility for a lot of the costs associated with clearance," she says, "They do not see the return on investment."

That may be starting to change. SunGard finds hedge funds showing interest in tracking trades from execution through to settlement in order to minimise fails and monitor margin requirements. "Certain buy-sides that are figuring out that if they know what is happening with their account the economies will go back their way," says John Schipano, vice president, business development for SunGard’s Phase3 unit.

Hedge funds' IT budgets are still modest, at least in Europe. Capco estimates that funds managing $1bn typically spend no more than $2m per year (see Figure 1). "They leave it up to investment banks with a prime brokerage offering," Myers says, "They do not do a lot themselves."

Different buy and sell side attitudes echo the ancient tension between front and back offices at brokerage houses, where traders expect operations staff to clean up as necessary.

Myers sees increasing recognition among his clients that everybody is on the same team. "Chucking something over the wall is not enough because if it falls over it could lead to a fairly substantive penalty to the front office," he says. That is especially true for complex derivatives, a business where each transaction is customised and operations staff are often lawyers who negotiate contracts rather than paper shufflers.

Myers notes that several houses have had to curb front office derivatives trading because their back offices could not handle the volume.

A survey conducted by the International Swaps and Derivatives Association (ISDA) shows that outstanding interest rate and currency swaps rose from a notional $63.0trn in the second half of 2000 to $183trn four years later.

The industry is searching for ways to speed up processing to reduce the systemic risk from undocumented trades.“You can automate work flow. You can standardise the way transactions and data are described and you can standardise the mechanics of communication,” says Sam Johnson, chief executive officer (CEO) of TransactTools, “What you cannot do is standardise the way these products are identified, or what all the components of the products are.”

The growth in derivatives has created new challenges despite the progress made toward automating settlement of traditional assets like stocks and bonds. ISDA's 2005 Operations Benchmarking Survey found that across all derivatives categories respondents are automating more

Figure 1 – IT budgets

Figure 2 – Extent of automated settlement matching, 2004-05, percent of volume

Estimated Number of hedge funds in Europe by asset size as of Jan 2004 (905 total) 5% 6% 13%

Over $1bn $500m-$1bn $250m-$500m $100m-$250m $25m-$100m Less than $25m

Tier 1 Tier 2

Estimated IT budget by Tier

35 Estimated Number 100 289

AUM $500m and over $100m-$500m

Estimated Annual IT budget*

30

$585k-$2m and over

25

$117k-$585k

29 24

23

23

20

18

17

15

19%

10 27%

34

33

Tier 3

516

$100m and under

$117k and under

9

5 0

30%

8

12

11

10

8

9

5

3

0 FRA

IR swaps (vanilla)

IR swaps Interest rate (non-vanilla) options

Currency options

2004

Credit

Equity (vanilla)

Equity Commodity (non-vanilla)

2005

Sources: EuroHedge, EdHec, Capco analysis.

Notes: Estimated IT budget based on average management fee of 1.3% of AUM, and 9%

Source: ISDA 2005 Operations Benchmark Survey

of which is allocated to IT.

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functions. Even cash processes that have so far defied the trend, such as settlement matching, are starting to migrate to clearing houses (see Figure 2).

Not surprisingly, automation is more prevalent for plain vanilla derivatives than for newer or complex products.

Rising volume has long driven automated processing in traditional asset classes.

SunGard's Schipano recalls a mortgage backed securities (MBS) operation he ran in the 1980s when settlement was physical. "We had about 150 people between our cage, P&S and allocations to do $40bn a month," he says, "Now it is done totally book entry through the Federal Reserve.You can do $40bn a month with five people – and the cost is a lot less.

You would not be able to process what you do now without automation."

Liberty believes legacy software hampers many firms.

Systems evolved independently within divisions, so firms often have separate processes for equities, fixed income and non-dollar business. SunGard has developed multicurrency, multi-asset platform that allows firms to consolidate these systems. "Customers do not want to wait until batches finish before they see their exceptions particularly if they are in another time zone," she says, "They want to be able to push exceptions out to interested parties globally as those exceptions occur regardless of time zones or batch processing cycles."

Consolidated processing not only streamlines the back office but also creates opportunities to improve front office revenue, according to Johnson, who worked on the equity side at Goldman Sachs earlier in his career. He recalls that equity traders did not share information with debt or currency traders — and could not even if they wanted to.

"A customer who was not significant for us in the equities world – so they did not get that first call — might have been the firm's biggest customer overall," he says, "That is a real problem in a Balkanised world." Today, he sees firms that led the way in automating the back office trying to use the information "as a competitive business advantage rather than just an operational improvement."

The squeeze on profit margins is forcing brokers to consider differential commission rates for institutional customers based on processing costs, Cutrone says. "In effect you penalise the less efficient money managers for their lack of STP because it is costing you more to process trades," he explains. Nobody has done it yet because they are all afraid to go first. "Privately they are saying it is inevitable," he says, "They are either going to turn down that business or they are going to find a way to make it economically viable."

Although increasing automation of regular trades is a

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2005

major achievement, it is only a start.

Corporate actions represent the biggest challenge because they take so many different forms and information is not standardised, according to Panchery. The SIA is working with Depository Trust and John Panchery, Clearing Corporation (DTCC) to vice president and establish a communications hub managing director, for corporate actions. "They'll be operations and like a pass through mail box," technology, at the he says, "Rather than every firm Securities Industry having to connect to each other Association they will just go through this infrastructure." The SIA and DTCC set up a similar hub in 2004, the Automated Recall Management System, to handle stock loan recalls.

The industry is still wrestling with data management and standards for corporate actions, according to Myers, who notes that cash market problems proliferate in the derivatives market. For example, if a company splits its stock, the contract may specify a change in the strike price alone, or in both strike price and contract size. "It varies and some places do it differently," he says, "Corporate actions are one of the tougher nuts still to crack."

Even the simplest things can be complicated. Proponents of automated processing have argued for years that paper certificates are an anachronism, a view the G30 and Giovannini reports endorse. In the US, state laws that obliged companies to issue paper certificates upon request proved an obstacle, but on August 1st Delaware dropped the requirement from its corporate law. As home state to more public companies than any other, Delaware's action "was a major win for the STP project" Panchery says.

The SIA plans to notify Delaware corporations they can go paperless and has asked the major stock exchanges to amend their listing agreements to mandate eligibility for DTCC's Direct Registration System (DRS), a form of electronic share registration in the name of the beneficial owner (as opposed to traditional book entry in Street name). "They have all been receptive," says Panchery, "But they all want to do it at the same time so no one market is out there on their own." He hopes to get a date agreed by the end of 2005.

The simple obstacles multiply in Europe, where markets have different operating hours, settlement deadlines, netting procedures and taxation. The legal ownership of collateral varies by country, too, according to Myers. He sees progress, like the merger of LCH and Clearnet as well as efforts to align central securities depositories in Belgium, the Netherlands and France, but "it just does not happen fast enough". The pan-European market Giovannini envisages must overcome loyalty to established practices in each national market, too. "What will be the motivation to get individual markets to abandon those and adopt a panEuropean protocol?" Cutrone asks. It may take a push from the regulators to implement comprehensive STP in Europe Photo: Securities Industry Association, August 2005.

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CORPORATE ACTIONS TANDARDS OR THE lack of them is one of the major problems in the financial services industry. Not only does the use of different standards, be they proprietary or open in nature, make it difficult for trading partners to seamlessly interact with each other, it also creates integration issues within a firm itself. Corporate actions have long been regarded the last bastion of manual processing in the securities processing industry. Unlike other areas of the transaction cycle such as trade execution and settlement, corporate actions still entail a high degree of manual intervention, with fax, telex and unformatted emails commonly being used to transmit notices issued by publicly traded companies. However, in the last few years, automation has slowly crept in the corporate actions processing life cycle.

And the credit for this goes to the International Standards Organisation (ISO) 15022 messaging standard.

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Industry experts explain that earlier corporate actions notification messages were sent in different proprietary formats, which made it nearly impossible to automate corporate actions. But now, with the increasing acceptance of the ISO 15022 messaging format as the de-facto standard for corporate actions, automation of this space is no longer considered a pipe dream. Darryl Twiggs, product manager at corporate actions technology vendor, Smartstream Technologies remarks,“The usage of 15022 in corporate actions messages is one the few areas in banks globally, where there is complete harmonisation. I have participated in several corporate actions automation projects and the benefit of 15022 has been universally felt.”

Statistics from the Society for Worldwide Interbank Financial Telecommunication (SWIFT), which developed the 15022 standard in association with the ISO, corroborate

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Photo: iStockphoto.com, August 2005.

Industry bodies, financial institutions and vendors are working on various initiatives to develop and implement standards across different areas of the financial services industry.

Understandably, these efforts do not always achieve their stated goals, but one area where standardisation efforts have been extremely successful, is corporate actions. Rekha Menon reports.

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Photo: Telekurs Financial, August 2005.

vendor, FT Interactive Data, the trend towards increasing which launched its feed in usage of 15022 for corporate August last year, blames the actions data. According to market conditions and the very SWIFT, corporate action nature of the corporate actions messaging volumes on the space, “We have to understand SWIFT network have tripled that improved corporate since 2001, with 35.5 million actions processing does not corporate action messages actually contribute to the top being sent in 2004, a 17.5% line of a firm. It is only a way of increase over the previous year. avoiding losses. Hence firms Large custodian banks were are slow to decide on corporate among the early adopters of ISO actions automation projects.

15022 for corporate action There are a number of other messages with the adoption regulatory issues in the market slowly trickling down to the sell that require more urgent focus. side and then the buy side.

Corporate actions offer long “Global custodians and subterm benefits, which isn’t custodians deal with the necessarily a top priority right maximum amount of corporate now.” Smart however asserts actions data. So they adopted that 15022 is the way ahead, the 15022 message format first Dominique Tanner, head of business development of since they saw the biggest market data vendor, Telekurs Financial “Any large data vendor that does not go this route could well be potential of cost savings and risk management. The buy and sell side firms are further down out of the space.”

Brewin Dolphin, the largest independent private client the corporate action life cycle and they deal with a much smaller universe of corporate actions data. So their portfolio manager and stockbroker in the UK, has adoption was much later. The involvement of the market subscribed to Telekurs Financial’s 15022 data feed and the data vendor industry on the other hand is very new,” vendor is currently negotiating with another seven for the explains Dominique Tanner, head of business development same, says Tanner of Telekurs Financial. “We were faced of market data vendor, Telekurs Financial, which with two key challenges before we decided to go ahead successfully completed the project to distribute corporate with the 15022 project. The business challenge of evaluating if there was indeed adequate market demand actions data in the 15022 format in June of this year.

Indeed, the universality of the 15022 standard became that justified the substantial investment involved, and the irrevocably established when it was adopted by stock technical challenge of analysing the complex development exchanges and market data vendors that till very recently requirements to create the new data feed and connect to disbursed corporate actions data in their own proprietary SWIFTNet.” Ultimately, the positives far outweighed the data formats. Along with Telekurs Financial, FT Interactive negatives, says Tanner. For instance, by connecting to Data is the other data vendor that currently provides a SWIFTNet, Telekurs Financial has been able to target new 15022 corporate actions data feed. And among stock geographies like South East Asia, Australia and South exchanges, the London, Singapore, Tokyo and America more effectively.

Tanner however notes that the interest in 15022 has been Johannesburg stock exchanges have taken the lead.

The London Stock Exchange (LSE) has been providing a predominantly Euro-centric. Not surprising, considering 15022 corporate actions data feed since July last year. Until that Europe comprises almost 75% of the total volume of then the exchange had disseminated data through a web- corporate action messages on the SWIFT network. based diary and a proprietary feed. Mark Hussler, head of Explaining this trend, Tanner says, “Essentially, ISO 15022 reference data at the LSE says that the key driver for the has been used as a means to facilitate cross-border trading exchange adopting 15022 was customer demand. “A few – which is very high in Europe as compared to the US. For years ago, custodians and sell side firms approached the some countries such as Switzerland and Luxembourg, the LSE to discuss the potential benefits of the standard and cross-border component is as high as 80%, while in the US, asked for a 15022 corporate actions data feed,”he says. The only around 15% of the securities business is cross-border stock exchange was also approached by SWIFT and was at in nature. The US domestic business is already highly that time in discussions with market data vendors to adopt automated as it is for countries such as Japan. Hence there is less incentive to go for 15022 in these countries.” the 15022 standard.

In the US, the US Depository Trust and Clearing Despite the push by SWIFT, and the demand from customers, the actual take up of the 15022 data feed, both Corporation (DTCC) plays the lead role in the country’s from data vendors and stock exchanges has been rather domestic corporate actions arena, with its proprietary data slow. Colin Smart, European product manager at data format being used for exchanging corporate actions

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Photo: Xcitek, August 2005.

CORPORATE ACTIONS

information. While industry experts and the DTCC Twiggs of Smartstream counters, “It is true that 15022 themselves claim that their proprietary data format is much notifications are less rich than proprietary feeds, but 15022 more rich that the 15022 format, there are signs that this provides other benefits in providing account information industry stalwart too is beginning to soften its stance and workflow for instructions and confirmations that is not against 15022. In 2003, moving beyond its role at the US provided in the proprietary feeds.”

There is however, another criticism targeted at ISO depository, but drawing on its more than 30 years of practical experience as the largest processor of corporate 15022, about the level of interpretational risk involved. actions in the world, the DTCC launched a global Several industry experts state that because of its open, commercial solution called Global Corporate Actions flexible structure, 15022 can be interpreted in different (GCA) Validation Hub service targeted at all users of ways by different firms. Hence currently there are several corporate actions information. Handling securities traded versions of the standard in play in the market, which takes in the US, Europe and Asia, the GCA Validation Service away the core benefit of having a standard in the first takes in corporate actions data from a variety of sources place. Ian Barnard, head of corporate actions and income throughout the world, scrubs it using both automated at BNP Paribas Securities Services, which is currently in business rules and manual intervention and presents a the process of deploying a corporate actions automation uniform cleansed feed of corporate actions announcement solution from Information Mosaic for its third party fund information. Initially, the DTCC used its proprietary data administration business, comments, “We are expecting standard for this service, but in response to customer substantial divergence in the way SWIFT standards are being implemented by different demand, has now started offering custodians. This is the biggest risk the data feed in the ISO 15022 of implementing the corporate format as well. James Femia, actions automation solution.”

DTCC managing director and Tanner however notes that “There is such a lot of flexibility in head of the Global Corporate the interest in 15022 has the way ISO 15022 is interpreted Action business, says, “DTCC is been predominantly Euroby custodians that we are facing committed to promoting the challenges when comparing adoption and usage of standards centric. Not surprising, corporate actions data from within the industry. We adopted considering that Europe multiple sources,” adds Gerard ISO 15022 in response to growing comprises almost 75 percent Bermingham, vice president, interest among broker/dealers, of the total volume of professional services at banks, investment managers and corporate action messages Information Mosaic. hedge funds worldwide in our on the SWIFT network.

However, SWIFT strongly denies GCA Validation Service.” the presence of such lacunae in the The first customer to sign on to ISO 15022 standard. “ISO 15022 receive corporate action should be used in conjunction with announcement information from the Securities Market Practice for DTCC in the ISO 15022 format is Corporate Actions, which defines Abbey Grupo Santander. However, how the messages are used very another customer of the GCA specifically. Problems arise when Validation Service, UBS Investment firms do not follow these Bank, has opted for the DTCC guidelines,” asserts Catherine format stating that it is much richer Marks, SWIFTSolutions manager, in content as compared to ISO asset servicing at SWIFT. 15022. Hussler of the LSE echoes The debate continues, as does this opinion. Since ISO 15022 does the unabated increase in the usage not have the richness of the stock of ISO 15022 for corporate actions exchange’s proprietary format, he data. And as even the critics agree, says that the LSE provides extra minor issues aside, ISO 15022 has data analysis over their website successfully transformed the along with the 15022 data feed. corporate actions arena, which is “ISO 15022 serves its purpose very no mean feat. Brendan Farrell of well. But more improvement is Xcitek succinctly states, “Despite possible. The standard needs to its limitations, there is nothing evolve to be able to carry more else in the same league at ISO data. These are still early days and 15022. It is the largest industry we believe that it will take a few initiative for automation of more years for the standard to corporate actions so far.” become more stable,”says Hussler.

Brendan Farrell of Xcitek

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EQUITY TRADING

Who’s Afraid of the Big Bad… Algorithm?

Changes now rocking the domestic equitytrading world are reshaping the structure of the industry.

Liquidity is shifting away from traditional venues into newer platforms bringing (in turn) algorithms, crossing networks and direct market access (DMA) systems to a new level of importance. Regulation is clearly maintaining a stronghold on traders’ strategies and relationships, as the pressure to reduce soft dollars is changing the way brokers service their customers. The dynamics of the relationship between brokers and their clients then continues to shift as technological advances consistently require changes to the expectations and roles of market participants. Adam Sussman and Wendy Garcia of the TABB Group explain.

HE BUY-SIDE TRADER’S role—which has always been to execute the firm’s strategy as efficiently as possible while simultaneously incurring the lowest possible cost to the firm and with the least drag on the investment—is permanently altered. Their choices have become far more complex, as the size and investment style of the firm now have greater influence on determining the choices and strategies the trader has at his or her fingertips. Indeed, large firms have more commission dollars to spread around for research purposes, while quantitative shops are more focused on lowering commissions. In addition, the long-term institutional market changes have made trading a more efficient process. Commissions have been steadily declining while assets under management have been increasing. While all of these are positive changes, it leaves one to question why buy-side traders are still challenged.

One explanation for the buy-side challenges may be found in the shift in blame for difficulties in trading in today’s market. In 2005, institutional equity traders are no longer blaming their problems on external forces, such as exchanges and brokers. The current perception is that fragmentation is an inevitable part of the landscape, and that true liquidity is hiding in the backrooms of the marketplace. In TABB Group’s report Institutional Equity Trading in 2005: A Buy-Side Perspective, it is clear that the percentage of traders challenged by fragmentation nearly doubled in the past year to 83%.

Even so, grumblings about market structure plummeted to a mere 9% (see Figure 1).

The current intense focus on the markets’merger activity and regulatory oversight has crystallised institutional traders’ realisation that the major cause of fragmentation is

Photo: iStockphoto.com, August 2005.

T

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EQUITY TRADING

Figure 1 – Difficulties of Trading Today’s Market: A Two-Year Comparison Market Structure

Market Structure

71%

Liquidity/ Fragmentation

9%

Liquidity/ Fragmentation

46%

83%

Broker Communication

8%

Lack of Transparency

9%

Too Many Choices

8%

Algo Overload

8%

Trade Chopping

6%

Cost

8%

Robust Connectivity

4%

Regulatory Environment

Decimalisation

2%

Trade Size

4% 25%

2004

Response 100%

2005

Source: TABB Group “Institutional Equity Trading in 2005: A Buy-Side Perspective”

Figure 2 – Change in Order Flow Pattern by Year Order Flow Allocation 04-07 (projected) 48% 31%

Brokers via Phone

CAGR (04-07)

-25%

20% 31% 38% 37%

Brokers via Fix

ECN/DMA/Crossing Networks

Algorithms

2007 (proj)

6%

16% 20% 25%

16%

7% 11% 17% 2005

34%

2004

Source: TABB Group “Institutional Equity Trading in 2005: A Buy-Side Perspective”

Figure 3 – Projected Order Allocation Changes 20052007 (AUM Weighted)

Broker via Fix Broker via Phone

Response 100%

-12% -4%

ECN

2%

Prorietary Algorithm

2%

DMA/Aggregation

3%

Crossing Network

3%

Broker Algorithm

6%

Source: TABB Group “Institutional Equity Trading in 2005: A Buy-Side Perspective”

82

not market structure itself, but the trading strategies and technologies employed to hide liquidity within the market structure. Fragmentation and the inability of traders to sufficiently find size are likely due to higher usage and greater awareness of alternative trading technologies, such as Direct Market Access (DMA) and algorithms, rather than the changing configuration of execution venues.

Investment managers are significantly reallocating the way they route orders to the market in response to three interdependent and unique forces. The first is investment performance, as lower commissions enhance returns, while an attitude of regulatory one-upmanship is the second. As large firms position themselves as beyond reproach, regulators raise the bar for everyone else. Furthermore, there is regulatory pressure to not only seek lower commissions, but also to measure and improve other best-execution parameters such as market impact and execution price.

The third element is the struggle to provide access to liquidity centres. Brokers and technology providers now offer better and more integrated technologies to both access and utilise low- and no-touch trading technologies, making trading easier and more efficient. This year, there have been tremendous swings in the way buy-side traders route their order flow. Overall, buy-side firms routed 17% less order flow over the phone than they did just one year ago. If this trend were to be projected out to 2007, buy-side traders will only route 20% of their flow by phone.

In addition, while we are seeing a big increase in FIXbased order flow from 2004 to 2005 (from 7% to 38% of flow) money managers say that FIX traffic also will begin to fall over the next two years, predicting that only 37% of flow will be routed by FIX to sales desks by 2007. However, on a relative basis algorithms are making the greatest advances, as the compound annual growth rate for algorithm use from 2004 through 2007 is projected at 34% (see Figure 2). While the move away from the phone to other channels is dramatic, there is still much hidden in the averages.

If we look more closely at larger firms, we see they are not only moving away from the phone as a channel. They are beginning to divert a larger percentage of their order flow away from the sales trader entirely, and toward no- or low-touch channels. Analysing the same order flow data weighted by assets under management (meaning larger firms are given much more relative weight) demonstrates the major trend for larger firms is not away from the phone, but away from FIX. Larger firms over the next two years will direct 12% of their order flow away from FIX and 4% of their flow away from the phone, placing 7% more in algorithms, 5% more in DMA and Electronic Communications Networks (ECNs), and 3% more in crossing networks (see Figure 3).

Faced with the unprecedented challenge to profit in a more severely competitive market, traders must rely on advanced trading tools to drive their trading decisions. Program trading, algorithms, crossing networks, DMA and liquidity aggregation technologies, and transaction cost analysis have all received rapid adoption among buy-side traders in a

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relatively short period of time. More than these other tools, algorithms have become an integral part of the traders’arsenal out of competitive necessity, precisely because they are efficient and inexpensive and, when provided through a broker, stabilise a deteriorating relationship as they typically count toward soft-dollars quotas and limit commission drag on investment performance.

Although algorithms have not been welcomed to every trader’s desk, even those who feel that algorithms exacerbate fragmentation are compelled to use them. Large blocks of liquidity are so well hidden or move so rapidly that they cannot be found using traditional trading techniques, leaving traders to use algorithms simply in order to remain competitive. Unfortunately, many solutions for solving traders’ trading challenges are unrealistic (nickel Minimum Price Variations), out of the trader’s hands (development of a central limit order book, or the outcome of the SEC NMS regulations), or dependent upon critical mass, such as greater liquidity in crossing networks (see Figure 4).

Although many traders believe that algorithms have much to offer the marketplace—including helping to alleviate fragmentation—a backlash against algorithms has begun. Nearly 8% of respondents blame algorithms for the lack of size in the market. However, this should not be a concern to the brokers, even considering some have spent millions of dollars developing and selling complex algorithmic interfaces. It is simply the realisation of a selffulfilling prophecy wherein algorithms reduce trade size, accelerate the market, and hide liquidity to the point where only models can effectively find liquidity.

As more broker volume hits the algorithmic trading desks, the human sales trader’s role will continue to change.

As FIX changed sales traders from order-takers to idea providers, so too will algorithms turn them into algorithmic trading consultants and service providers. While continuing to provide trading ideas, the sales-trader’s role will expand to helping buy-side traders determine which models to use and how to set the toggles, as well as providing customisation advice and feedback to quantitative engineers, effectively adding “business analyst” to the sales trader’s job description. Brokers, however, are still most valued for providing liquidity, but as the buy-side does a better job of finding it on its own, brokers also need to focus on other areas that can create value in order to maintain valuable relationships. In the transition from phone to FIX, there are only winners. Buy-side traders can shift their attention to less menial tasks, while asset management firms can reduce the overall cost of trading. The broker’s sales desk still receives the same amount of order flow, and there is very little disruption.

However, during the shift from the sales desk (FIX) to low- and no-touch channels (ECN, DMA, algorithm, and crossing), not everyone is so lucky. The winners from this second liquidity shift are developers of algorithmic solutions (whether broker-based or independent), crossing networks, and to a lesser extent, DMA platform providers.

Algorithm use (broker-sponsored and proprietary) is

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2005

Figure 4 – Solutions for Solving Trading Challenges 20%

Nickel MPV

18%

Crossing Networks Better Connectivity

11%

CLOB

11%

It's Our Job

11%

More E-trading

11% 9%

Reg NMS 7%

Stop Focusing on VWAP No Soft Dollars

2% Response 87%

Source: TABB Group “Institutional Equity Trading in 2005: A Buy-Side Perspective”

Figure 5 – Projected Change in Order Flow Routing, 2005-2007 -11%

Phone -1%

FIX

Prop Algo

1%

ECN

1%

DMA Crossing Broker Algo

2% 3% 6%

Response 100%

Source: TABB Group “Institutional Equity Trading in 2005: A Buy-Side Perspective”

Figure 6 – Projected Change in Orders Routed to Traditional Sales Desk, 2004-2007

-16%

Large -13%

-3%

Medium

-14%

-2%

Small

-11% 05-07

04-05

Response 100%

Source: TABB Group “Institutional Equity Trading in 2005: A Buy-Side Perspective”

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EQUITY TRADING

projected to grow by 7% over the next two years, while crossing networks and DMA/ECN volume will increase at a 3% clip (see Figure 5).

Gains in market share for the alternative trading venues come at the expense of brokers’ traditional sales desk.

Orders routed to sales traders by phone or FIX continue to decrease in 2005, and the large firms that led the shift from phone to FIX over the last five years are now trailblazing the path away from FIX to alternative execution facilities.

In looking at the order flows from 2004 to 2005, we see the most significant shift was in large-sized firms as they migrated approximately 16% of their flow away from sales traders to more low- and no-touch channels, while medium and smaller firms shifted only 3% and 2%, respectively. By contrast, during the next two years, while larger firms continue to project a significant siphoning of flow off the desk, medium and smaller firms also plan to participate.

They project their routed order flow to sales desks will decrease by 14% and 11%, respectively (see Figure 6).

The long-term effects of the liquidity shift are just beginning to be felt, as brokers, exchanges, ATSs, and financial technology providers develop business strategies and products for the more independent and electronically oriented buy-side trader. Consolidation continues. ITG and Macgregor have merged to provide investment management firms with a complete trading solution, and further consolidation is expected. The question lies in whether or not algorithms, crossing, dark books, and sophisticated execution management platforms can and will help solve the problems we now face with fragmentation, or if these new tools just act to fragment and segment liquidity as before.

While advanced trading technology will become more popular, transparency and small trade size will become a

larger problem. Even the integration of recently announced mergers of the New York Stock Exchange/Archipelago Holdings and NASDAQ/Instinet is not likely to bring about a totally consolidated and de-fragmented market.

As institutional investor order size increases, the impact of information leakage becomes greater. It is natural for firms with large-size orders to strive to hide their liquidity.

To do this, traders are using DMA, reserve books, sophisticated order types, algorithms, and crossing networks, rather than risk leakage by tipping their hand by showing any size. Even with consolidated markets, the slicing of orders, automated executions, and sophisticated desktop technologies will make it more difficult to find size, rather than easier.

Fragmentation is caused by the various trading technologies, including algorithms, used to implement investment objectives. Nothing short of a consolidated limit order book and banning algorithms, floor brokers, reserve orders, and virtually all order management technology would eliminate it. By seeking the anonymity we crave, we create a lack of transparency and, in effect, fragment the market we so much want to consolidate.

The increased use of electronic trading technologies and the subsequent fragmentation has and will continue to shape the role of buy-side traders. It has and will change the way they view, analyse, trade, and report. And it will change the way that buy-side traders, brokers, and technology vendors approach the market.

While these tools help the buy-side trader reduce costs, gain efficiency, and manage a larger number of orders, they also make the role of the buy-side trader more difficult, as they speed up the market, reduce trade size, and force traders to hide more liquidity.

Avoid nasty little surprises!

Emerging Markets Report provides a comprehensive overview of the principal deals, trends, opportunities and challenges in fast-developing markets. For more information on how to order your individual copy of Emerging Markets Report please contact:

Paul Spendiff Tel:44 [0] 20 7074 0021 Fax:44 [0] 20 7074 0022 Email:paul.spendiff@berlinguer.com

84

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Company Name

Page

AIG

70

Allstate Insurance

65

American Safety Insurance Holdings Ltd Arab National Bank

10 31

Aspen Insurance Holdings Ltd. 10 Asset Managers Forum

14

AutoZone Inc.

62

Bahrain Financial Harbour

36

Bahrain Monetary Authority

36

Bank Muscat

42

Bank of America

66

Berkshire Hathaway

63

Bermuda Stock Exchange

10

BFH

36

BNP Paribas

44

Bond Market Association

14

Brewin Dolphin

79

Caisse des dépôts

20

Capco

76

Chrysler

48

Clearnet

77

Coldwell Banker

65

Colton Bernard

64

Commercial Bank of Qatar

31

Consumer Federation of America

28

CPI

22

Craftsman

63

Credit Suisse First Boston

63

Daimler

48

Daimler Chrysler

48

DaimlerChrysler AG

48

Davidowitz & Associates

64

Dean Witter

65

Deutsche Bank

44

Dime Savings Bank

Company Name

Dubai International Financial Centre

Page

36

Dubai International Financial Exchange

32

Emirates Bank

42

Enron

21

Equilend

71

eSecLending

71

ESL Investments Inc

62

Etisalat

32

European Investment Bank

59

Eurotunnel

57

F&C Asset Management

14

Federal Reserve Bank of New York

16

Financial Services Authority

10

Fitch Ratings

60

Ford

49

Franklin Mutual

59

FTSE

11

FTSE Group

34

GCA Validation Service

80

General Motors

46

Gibson, Dunn & Crutcher LLP

28

GMAC

47

Goldman Sachs

71

Great Western Financial

67

Gulf International Bank

42

Harvard Law School

27

Home Depot

63

Home Savings of America

67

Homeland Security

28

House Committee on Homeland Security 27 HSBC Bank Middle East Ltd

38

HSBC Holdings plc

10

68

International Swaps and Derivatives Association

76

Doha Bank

34

JP Morgan

44

Doha Securities Market

31

Kenmore

63

Kmart Corp.

62

Kuwait Stock Exchange

30

Donaldson, Lufkin & Jenrette LLP

27

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2005

Company Name

Page

Kuwait’s Gulf Bank

34

LCH

77

Lerach, Coughlin, Stoia, Geller, Rudman & Robbins LLP 28

Company Name

Retail Management Consultants

Page

64

Risk Management Association 71 Riyad Bank

30

46

SAMA

32

London Stock Exchange

79

SAMBA Financial Group

31

Mandalay Resorts

48

Martha Stewart

64

Saudi Arabian Monetary Authority

44

MBIA

59

Sears Holdings Inc.

62

Sears, Roebuck & Co.

62

SEC

28

Securities & Exchange Commission

64

Lincy Foundation

Merrill Lynch

54

Metro Goldwyn Meyer

48

MGM Grand

48

Microsoft

6

Securities Industry Association 28

Mirage

48

Morningstar Inc.

63

Nakilat

31

NASDAQ

11

Society for Worldwide Interbank Financial Telecommunication 78

National Bank of Bahrain

42

SS Kresge Co.

65

National Bank of Dubai

42

Standard & Poors

60

National Bank of Kuwait

30

State Street

70

National Commercial Bank

42

SunGard Data Systems

Neiman Marcus Group

6

Shell

47

Smartstream Technologies

78

Swiss American Securities

8 6

Northern Trust

70

TABB Group

81

Oaktree

59

Telekurs Financial

79

Omgeo

75

Thomson Financial

8

Organisation for Economic Co-operation and Development 22 Parmalat

21

Plunkett Research Ltd.

53

Providian Financial

67

PS Group Inc.

62

Public Company Accounting Oversight Board

16

Punk, Ziegel & Company

67

Qatar Financial Centre

36

Qatar Financial Centre Regulatory Authority 34 Qatar Gas Transport Company

31

Qatar National Bank

31

QNB

34

Q-tel

32

COMPANIES IN THIS ISSUE

FTSE Global Markets Company Directory

Trans International Airlines

48

UBS Investment Bank

80

United Nations Environment Programme

20

United States’ Securities and Exchange Commission

27

US Chamber of Congress

29

US Depository Trust and Clearing Corporation 79 Vanguard

70

Washington Mutual Bank

66

World Economic Forum

21

WorldCom

21

85

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MARKET REPORTS BY FTSE RESEARCH

FT SE

MARKET REPORTS 9.qxd

Page 86

FTSE Global Equity Index Series – Global, Year to Date

31st December 2004 - 30th June 2005

FTSE Regional Indices Performance (USD) 120

FTSE Global AC

115

FTSE Developed Europe AC

110

FTSE Japan AC

105

FTSE Asia Pacific AC ex Japan

100

FTSE Middle East & Africa AC

95

FTSE Emerging Europe AC

90

FTSE Latin America AC

5

0

FTSE North America AC

FTSE Regional Indices Capital Returns (USD)

10

8

6

4

2

0

-2

-4

-6

FTSE Developed Country Indices Capital Returns

25

20

15

10

Dollar Value

-5

Local Currency Value

-10

-15

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

SEPTEMBER/OCTOBER 2005 • FTSE GLOBAL MARKETS

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Page 87

FTSE All-Emerging Country Indices Capital Returns 100 90 80 70 60

%

50

Dollar Value

40 30

Local Currency Value

20 10 0

FT SE

Ar ge FT ntin SE a B AC FT raz SE i l A F T Ch C ile S FT FTS E C A hi C SE E na Cz Col A u ec C h mbi Re a A p FT ub C li S FT E E c A SE gy C Hu pt A n F T ga C FT SE ry SE In AC In dia do A FT nes C SE ia A C FT Isr S a FT E K el A SE or C M ea FT alay AC SE si FT M a A C SE ex ico FT Mor A SE oc C Pa co AC ki s FT FT tan SE SE AC Ph Per u ili F T p p i n AC SE es AC Po F FT TS lan SE E R d A So us C sia ut AC FT h A SE fric FT Ta a A S E iw C Th an F T a i l AC SE an Tu d A rk C ey AC

-10

FTSE Global All Cap Sector Indices Capital Returns (USD) 20 15 10 5

Capital

0

%

-5

Total Return

-10 -15

Co

ns

tru

ct

io

n

&

M O inin il Bu & g ild Ch G in em as St For g M ica ee es at ls El Ae l & try eria ec tro D ros Oth & P ls ni iv pac er ap e c e & rsi e & Me r En Ele fied D tals gi ctr I efe ne ic nd n er al us ce Ho i E t us Au ng qu rial eh to & ipm s ol mo Ma e d n b Fo Go ile chin t od od s & er Pe y Pr s rs od & Pa on T rt uc a er B ext s Ph l Ca s ev ile ar re & e s m & Pr rag ac H oc e eu ou es s tic se so al h o s H rs l & d ea Bi Pr lth ot od ec uc hn ts Ge o ne To log b y M r ed Lei al R acc ia su et o & re ai En & ler Su ter Ho s pp tai tel or nm s Te F tS e le oo co d er nt m & v m D Tra ice un ru ns s ica g R po tio et rt n aile S e rs r Ut El vice ilit ec s ie tric s - O ity th In B er ve L In an st ife su ks In m r fo S en As anc rm pe t C su e at cia om ran So ion lity c ftw Te & Re pan e ar ch Ot al ies e no he Es & lo r ta Co gy Fin te m H an pu ar c te dw e rS a er re vi ce s

-20

Stock Performance Best Performing FTSE All-World Index Stocks (USD) Orascom Telecom Holdings 145.7% Orascom Construction 137.7% Mitac International 102.2% Dacom Corporation 99.3% Korea Investment Holdings 90.1%

Overall Index Return FTSE Global AC FTSE Global LC FTSE Global MC FTSE Global SC FTSE All-World FTSE Asia Pacific AC ex Japan FTSE Latin America AC FTSE All Emerging Europe AC FTSE Developed Europe AC FTSE Middle East & Africa AC FTSE North Americas AC FTSE Japan AC

Worst Performing FTSE All-World Index Stocks (USD) Elan Corporation -74.3% Doral Financial -66.4% LG Card -60.5% TD Banknorth -60.1% Creative Technology -56.0%

No. of Consts

Value

1M

3M

YTD

Actual Div Yld

7,845 1,120 1,894 4,831 3,014 1,868 200 103 1,504 202 2,643 1,325

303.21 295.38 401.83 362.53 181.15 357.02 509.10 457.82 319.64 402.83 285.97 300.76

1.2% 0.5% 2.3% 2.8% 1.0% 3.4% 4.6% 6.5% 1.3% 2.5% 0.9% 0.0%

0.4% -0.1% 1.7% 1.6% 0.3% 3.0% 7.4% 3.4% -2.0% 0.4% 1.9% -3.5%

-0.8% -2.0% 2.1% 0.8% -1.1% 3.8% 8.3% 7.2% -1.9% -4.8% -0.4% -4.9%

2.10% 2.26% 1.76% 1.69% 2.16% 3.06% 3.59% 2.05% 2.83% 2.82% 1.70% 1.13%

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2005

87

88

io n

M

% FT SE De

FT SE

FT SE

FT SE

ed

op

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ed

op

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US

US

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30 -Ju

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31 -D e

10:34 pm

FT SE

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FT SE

FT SE

%

O inin & il Bu & g ild Ch G in em as g St For M ica ee es at ls El Ae l & try eria ec ro O & ls tr on Di sp the Pa ic ve ace r M per & rsi & e En Ele fied D tals gi ctr I efe ne ic nd n er al us ce Ho i E t us Au ng qu rial eh to & ipm s ol mo Ma e d n Fo Go bile chin t od od s & er Pe y Pr s rs od & Pa on T rt uc a er B ext s Ph l Ca i s e v le ar re & e s m & Pr rag ac H oc e eu o es s tic use so al ho s H rs & ld ea Bi Pr lth ot od ec uc hn ts Ge o n To log M L era ba y ed ei l R cc ia su e o & re tai En & ler Su ter Ho s pp ta tel or inm s Te F tS e le oo co d er nt m & v m D Tra ice un ru ns s ic g R po at e r io ta t n ile Se r r s Ut E l v i c ili e c e s tie t r s icit -O y th In B er ve L In an st ife su ks In m r fo S en As anc rm pe t C su e at cia om ran So ion lity c ftw Te & Re pan e ar ch Ot al ies e no he Es & lo r ta Co gy Fi te m H nan pu ar c te dw e rS a er re vi ce s

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MARKET REPORTS BY FTSE RESEARCH

Co

MARKET REPORTS 9.qxd

Page 88

FTSE Global Equity Index Series – Developed ex US, Year to Date

31st December 2004 - 30th June 2005

FTSE Developed Regional Indices Performance (USD)

110

FTSE Developed (LC/MC)

105

FTSE Developed Europe (LC/MC)

FTSE Developed Asia Pacific (LC/MC)

100

FTSE All-Emerging (LC/MC)

95

FTSE Developed ex US (LC/MC)

FTSE US (LC/MC)

90

0

-10

FTSE Developed Asia Pacific ex Japan (LC/MC)

FTSE Developed Regional Indices Capital Returns (USD) 4

3

2

1

0

-1

-2

-3

-4

FTSE Developed ex US Indices Sector Capital Returns (USD)

20

15

10

5

-5

Capital

Total Return

-15

-20

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

SEPTEMBER/OCTOBER 2005 • FTSE GLOBAL MARKETS

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Page 89

Stock Performance Best Performing FTSE Developed ex US Index Stocks (USD) Sembcorp Marine 87.1% Chiyoda Corp 69.8% Canadian Natural Resources 69.5% StarHub 60.9% Sembcorp Industries Limited 59.4%

Overall Index Return FTSE Developed ex US (LC/MC) FTSE USA (LC/MC) FTSE Developed (LC/MC) FTSE All-Emerging (LC/MC) FTSE Developed Europe (LC/MC) FTSE Developed Asia Pacific (LC/MC) FTSE Developed Asia Pacific ex Japan (LC/MC) FTSE Developed ex US (AC) FTSE Developed ex US LC FTSE Developed ex US MC FTSE Developed ex US SC

Worst Performing FTSE Developed ex US Index Stocks (USD) Pacifica Group -44.2% Privee Zurich Turnaround Group -49.6% Henderson Group -52.9% Creative Technology -56.0% Elan Corporation -74.3%

No. of Consts

Value

1M

3M

YTD

Actual Div Yld

1,360 739 2,099 915 513 774 296 3,696 524 1,894 4,831

192.47 491.66 177.72 273.41 192.66 177.64 302.12 323.40 303.39 371.26 403.58

1.5% 0.3% 0.8% 3.2% 1.2% 1.2% 4.2% 1.6% 1.4% 1.8% 2.3%

-1.6% 1.6% 0.1% 3.4% -2.1% -1.3% 3.9% -1.6% -1.6% -1.5% -1.5%

-2.1% -0.8% -1.4% 3.9% -2.3% -3.1% 3.4% -1.6% -2.7% 0.5% 2.3%

2.53% 1.75% 2.11% 2.89% 2.89% 1.86% 3.43% 2.48% 2.64% 1.76% 1.69%

FTSE Global Equity Index Series – Asia Pacific, Year to Date 31st December 2004 - 30th June 2005

FTSE Asia Pacific Regional Indices Performance (USD) 110

FTSE Global AC FTSE Developed Asia Pacific (LC/MC)

105

FTSE Developed Asia Pacific ex Japan (LC/MC) 100

FTSE Asia Pacific (LC/MC) FTSE All-Emerging Asia Pacific AC

95

FTSE Japan (LC/MC)

5 n0 30 -Ju

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30 -A pr -0 5

31

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90

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2005

89

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6 4 2

%

0 -2

-4

ob al AC F ia TS E Pa D ci e fic ve De (L lop ve C/ e lo M d ex p e d C) Ja A pa s i a n P (L ac FT C/ i f i M c SE C) A As llia Em Pa er ci gin fic g FT AC SE As D FT i a ev SE e P Ja ac lop pa ifi e c d n AC In de x FT (L SE C/ M As C) ia Pa ci fic (L C/ FT M SE C) As ia Pa ci fic FT M SE C As ia Pa ci fic FT SC SE As ia Pa ci fic LC

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As

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FTSE Asia Pacific All Cap Sector Indices Capital Returns (USD) 20 15 10 5

%

Capital

0

Total Return

-5 -10

io

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M O inin il & g ild Ch G in em as St For g M ica ee es at ls El Ae l & try eria ec tro D ros Oth & P ls ni iv pac er ap e c e & rsi e & Me r En Ele fied D tals gi ctr I efe ne ic nd n er al us ce Ho i E t us Au ng qu rial eh to & ipm s ol mo Ma e d n b Fo Go ile chin t od od s & er Pe y Pr s rs od & Pa on T rt uc a er B ext s Ph l Ca s ev ile ar re & e s m & Pr rag ac H oc e eu ou es s tic se so al ho s H rs l & d ea Bi Pr lth ot od ec uc hn ts Ge o ne To log M r b y ed Lei al R acc ia su et o & re ai En & ler Su ter Ho s pp tai tel or nm s Te F tS e le oo co d er nt m & v m D Tra ice un ru ns s ica g R po tio et rt n aile Se rs r U t E l vice ilit e c s ie t r i c s - O ity th In B er ve L In an st ife su ks In m r fo S en As anc rm pe t C su e at cia om ran So ion lity c ftw Te & Re pan e ar ch Ot al ies e no he Es & lo r ta Co gy Fin te m H an pu ar c te dw e rS a er re vi ce s

-15

Co

ns

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MARKET REPORTS BY FTSE RESEARCH

FTSE Asia Pacific Regional Indices Capital Returns (USD)

Stock Performance Best Performing FTSE Asia Pacific Index Stocks (USD) Mitac International 102.2% Dacom Corporation 99.3% Korea Investment Holdings 90.1% Sembcorp Marine 87.1% Hyundai Engineering & Construction 80.4%

Worst Performing FTSE Asia Pacific Index Stocks (USD) Guangdong Kelon Electrical Holdings (H) -45.4% Nakornthai Strip Mill -45.9% Privee Zurich Turnaround Group -49.6% Creative Technology -56.0% LG Card -60.5%

Overall Index Return FTSE Global AC FTSE Asia Pacific AC FTSE Asia Pacific (LC/MC) FTSE Asia Pacific LC FTSE Asia Pacific MC FTSE Asia Pacific SC FTSE Developed Asia Pacific ex Japan (LC/MC) FTSE Developed Asia Pacific Index (LC/MC) FTSE All-Emerging Asia-Pacific (LC/MC) FTSE Japan Index (LC/MC)

No. of Consts

Value

1M

3M

YTD

Actual Div Yld

7845 3193 1335 497 838 1858 296 774 561 478

303.21 324.41 183.50 310.05 358.83 379.82 302.12 177.64 208.81 111.28

1.2% 1.6% 1.4% 1.3% 1.8% 2.7% 4.2% 1.2% 2.3% -0.2%

0.4% -0.5% -0.5% -0.4% -0.9% -1.0% 3.9% -1.3% 2.5% -3.6%

-0.8% -1.0% -1.6% -2.0% 0.4% 4.4% 3.4% -3.1% 4.3% -6.0%

2.10% 2.05% 2.07% 2.13% 1.80% 1.88% 3.43% 1.86% 2.76% 1.12%

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

90

SEPTEMBER/OCTOBER 2005 • FTSE GLOBAL MARKETS

&

Bu

M

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M C

LC

AC

AC

Eu Al ro l-E pe m er AC gi ng Eu ro pe FT AC SE Eu ro FT zo SE ne De AC ve lo pe d ex Eu FT r SE UK ope Eu AC ro fir st 30 0 FT SE ur of irs t8 FT 0 SE ur of irs t1 00

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FT SE

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Eu ro pe

Eu ro pe

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FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2005

30

31

05

n-

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5

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5

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10:34 pm

30

5

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31

05

05

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28

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31

4

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31

4/8/05

FT SE

FT SE

FT SE

FT SE

FT SE

FT SE

%

O inin il & g ild Ch G in em as St For g M ica ee es at ls El Ae l & try eria ec tro D ros Oth & P ls ni iv pac er ap c er e M er & si & e En Ele fied D tals gi ctr I efe ne ic nd n er al us ce Ho i E t us Au ng qu rial eh to & ipm s ol mo Ma e d n b Fo Go ile chin t od od s & er Pe y Pr s rs od & Pa on T rt uc a er B ext s Ph l Ca s e v ile ar re & e s m & Pr rag ac H oc e eu ou es s tic se so al ho s H rs l & d ea P B i r lth ot od ec uc hn ts Ge o ne To log M r b y ed Lei al R acc ia su et o & re ai En & ler Su ter Ho s pp tai tel or nm s Te F tS e le oo co d er nt m & v m D Tra ice un ru ns s ica g R po tio et rt n a ile S e rs r Ut El vice ilit ec s ie tric s - O ity th In B er ve L In an st ife su ks In m r fo S en As anc rm pe t C su e at cia om ran So ion lity c p ftw Te & Re an e ar ch Ot al ies e no he Es & lo r ta Co gy Fin te m H an pu ar c te dw e rS a er re vi ce s

n

io

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MARKET REPORTS 9.qxd

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FTSE Global Equity Index Series – Europe, Year to Date

31st December 2004 - 30th June 2005

FTSE European Regional Indices Performance (EUR) 115

FTSE Global AC (EUR)

110

FTSE Developed Europe ex UK LC/MC (EUR)

FTSEurofirst 300 (EUR)

105

FTSE Developed Europe AC (EUR)

100

FTSEurofirst 100 (EUR)

FTSE Eurozone LC/MC (EUR)

95

FTSEurofirst 80 (EUR)

FTSE European Regional Indices Capital Return (EUR)

25

20

15

10

5

0

FTSE Developed Europe Sector Indices Capital Returns (EUR)

30

25

20

15

10

5

Capital

0

Total Return

-10

-5

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

91

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MARKET REPORTS BY FTSE RESEARCH

Stock Performance Best Performing FTSE Developed Europe Index Stocks (EUR) Sacyr-Vallehermoso 65.4% OMV 62.4% Metso Corporation 54.5% Vestas Wind Systems 50.1% Deutsche Boerse 46.2%

Overall Index Return (EUR)

Worst Performing FTSE Developed Europe Index Stocks (EUR) Elan Corporation -71.2% Henderson Group -47.1% Invensys -29.0% Benetton -21.6% Alcatel -20.8%

No. of Consts

Value

1M

3M

YTD

Actual Div Yld

7845 1607 215 362 1030 1504 103 741 1027 300 80 100

303.21 305.54 340.21 370.15 388.05 304.02 435.45 314.68 315.51 1141.39 3970.81 3806.24

1.2% 3.4% 3.1% 3.4% 4.2% 3.3% 8.6% 3.6% 3.2% 3.2% 3.3% 3.4%

0.4% 5.3% 5.0% 5.3% 6.2% 5.2% 11.0% 4.5% 4.7% 5.2% 3.3% 5.1%

-0.8% 10.3% 9.0% 12.3% 15.1% 10.2% 20.4% 9.3% 9.6% 9.6% 7.3% 9.3%

2.10% 2.82% 2.97% 2.48% 2.32% 2.83% 2.05% 2.82% 2.68% 2.93% 3.10% 3.15%

FTSE Global AC FTSE Europe AC FTSE Europe LC FTSE Europe MC FTSE Europe SC FTSE Developed Europe AC FTSE All-Emerging Europe AC FTSE Eurobloc AC FTSE Developed Europe ex UK AC FTSEurofirst 300 FTSEurofirst 80 FTSEurofirst 100

FTSE UK Index Series – Year to Date 31st December 2004 - 30th June 2005

FTSE UK Index Series Performance (GBP) 120

FTSE 100

115

FTSE 250

110

FTSE 350

105

FTSE SmallCap

100

FTSE All-Share 95

FTSE AIM n-Ju

FTSE techMARK

30

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05

05

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5

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28

31

31

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90

FTSE All-Share Sector Indices Capital Returns (GBP) 30 25 20 15 10

%

5

Capital

0 -5

Total Return

-10 -15

Co

ns

tr

uc

tio

n

M

O inin & il Bu & g i l d Ch G a in em s Fo g ic El S M r ec te es a als t e tr on Ae l & try eria ic ro O & ls & sp th Pa p En Ele ace er M er gi ctr & e ne ic D ta er al ef ls Ho in E e us Au g & qui nce pm eh to ol mo Ma en d c Fo Go bile hin t od od s & ery Pe Pr s rs & Par od on Te ts uc al e Ph Ca rs Be xtile ar re & ve s m & Pr rag ac H oc e eu ou es s tic se so al ho H rs s & ld ea Bi Pro lth ot d ec uc hn ts Ge o ne To log M L ral ba y ed ei R cc ia su et o & re ail En & ers Su ter Ho pp tai tel or nm s Te F tS e le oo co d er nt & v m m D Tra ice un ru ns s ic g R po at e rt io ta n ile S e rs r Ut El vice i l i ec s t i e tr s icit -O y th e B r In ve L In ank st ife sur s In m A a n e fo Sp nt ssu ce rm e Co ra at cia m nce So ion lity p ftw Te & Re an O c ar h t al E ies e no he s & lo r ta Co gy Fin te m H an pu ar ce te dw rS a er re vi ce s

-20

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

92

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8

6

4

2

0

FT SE

M

g

FT SE

AI

gl in ed

FT SE

FT SE

Fl

Al

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Stock Performance Best Performing FTSE All-Share Index Stocks (GBP) Oxford Biomedica BTG Elementis Xaar Edinburgh Oil & Gas

Overall Index Return FTSE 100 FTSE 250 FTSE 350 FTSE SmallCap FTSE All-Share FTSE Fledgling FTSE AIM FTSE techMARK 100

105.7% 100.6% 86.3% 75.8% 58.8%

Worst Performing FTSE All-Share Index Stocks (GBP) Phytopharm -62.2% Gresham Computing -60.9% Superscape Group -58.5% Sanctuary Group -56.3% Games Workshop Group -56.3%

No. of Consts

Value

1M

3M

YTD

Actual Div Yld

Net Cover

P/E Ratio

100 250 350 344 694 313 711 100

5113.20 7368.70 2606.40 2920.20 2560.17 3327.20 998.27 1198.68

3.0% 3.6% 3.1% 3.3% 3.1% 3.1% 4.3% 3.4%

4.5% 3.3% 4.3% 0.4% 4.2% -1.6% -8.3% 5.7%

6.2% 6.2% 6.2% 5.9% 6.2% 5.6% -0.7% 0.2%

3.23% 2.59% 3.14% 2.07% 3.10% 2.17% 0.51% 1.58%

2.11 2.11 2.11 1.40 2.10 -2.00 0.55 -

14.66 18.32 15.08 34.51 15.37 0 356.48 -

FTSE Xinhua Index Series 31st December 2004 - 30th June 2005

MARKET REPORTS BY FTSE RESEARCH

FTSE UK Index Series - Capital Return YTD (GBP)

FTSE Xinhua Index Series Performance (RMB/HKD) – H1 2005 140

FTSE/Xinhua China 25 (HK$)

130

FTSE Xinhua All-Share (RMB)

120

FTSE Xinhua Small Cap (RMB)

110

FTSE/Xinhua China A50 (RMB)

100

FTSE Xinhua 600 (RMB) FTSE Xinhua China Bond Total Return Index (RMB)

90

n-Ju 30

31 -M

05

5 ay -0

5 pr -0 -A 30

5 -M ar -0 31

05 28

-Fe

b-

n-Ja 31

31

-D

ec

-0

05

4

80

FTSE Xinhua Index Series Index Name

FTSE/Xinhua 25 (HK$) FTSE/Xinhua China 50 (RMB) FTSE Xinhua All-Share (RMB) FTSE Xinhua 600 (RMB) FTSE Xinhua Small Cap (RMB) FTSE Xinhua China Bond Total Return Index (RMB)

Consts

Value

1M

3M

YTD

Actual Div Yld

25 50 992 600 392 30

8496.46 3813.10 2033.55 2200.66 1428.42 95.87

4.8% 3.3% 0.5% 0.7% -0.9% 2.0%

2.9% -6.7% -10.0% -9.6% -12.1% 4.9%

2.4% -8.8% -16.9% -15.7% -23.0% 9.7%

3.05% 2.70% 2.05% 2.22% 1.06% 3.26%

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2005

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FTSE Hedge Management Styles (USD) – 5-Year Performance 160

FTSE Hedge

140

FTSE All-World

120

Directional

100

Event Driven Non-Directional

80 60

nJu

De

05

4 c-0

04 nJu

3 De

c-0

03 Ju

n-

2 c-0

nJu

De

02

1 c-0 De

01 nJu

De

n-

c-0

00

0

40

Ju

MARKET REPORTS BY FTSE RESEARCH

FTSE Hedge Index Series

FTSE Hedge – Management Styles & Strategies (NAV Terms) Directional Equity Hedge Commodity Trading Association (CTA) / Managed Futures Global Macro Event Driven Merger Arbitrage Distressed & Opportunities Non-directional Convertible Arbitrage Equity Arbitrage Fixed Income Relative Value * Based upon indicative index values as at 30 June 2005

Index Level*

1 mth

3 mth

YTD

Ann Return (5-Year)

Volatility (3-Year)

2986.53 2063.02 1993.98 1817.63 3078.20 2026.45 2074.19 2958.66 1926.47 1966.03 1994.57

0.6% 1.0% 0.4% -0.5% 0.4% 0.8% 0.0% 0.3% 1.6% -0.3% 0.1%

-0.9% 0.0% -2.2% -2.3% -0.3% 1.0% -1.4% -0.6% -1.2% -0.9% 0.1%

-1.3% 1.3% -5.5% -4.8% 0.0% 1.2% -0.9% -0.1% -3.7% 1.0% 1.1%

8.0% 7.6% 11.4% 6.0% 3.2% 1.7% 4.5% 3.8% 7.2% 4.3% 1.9%

5.0% 4.1% 15.0% 6.3% 4.2% 1.5% 7.1% 1.7% 5.3% 2.7% 1.4%

FTSE EPRA/NAREIT Global Real Estate Index Series FTSE EPRA/NAREIT Global Real Estate Index Series Performance (Total Return) – Year to Date

125

FTSE EPRA/NAREIT Global Total Return Index ($)

120

FTSE EPRA/NAREIT North America Total Return Index ($)

115 110

FTSE EPRA/NAREIT Europe Total Return Index (€)

105

FTSE EPRA/NAREIT Eurozone Total Return Index (€)

100

FTSE EPRA/NAREIT Asia Total Return Index ($)

95

05

5

30

-Ju

n-

-0 ay 31 -M

pr -0 5 -A 30

ar -0 5 31

-M

b05 -Fe 28

n-Ja 31

31

-D

ec

-0

05

4

90

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

94

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FTSE EPRA/NAREIT Global Real Estate Indices (Total Return) Index Name

Consts

Value

1M

3M

YTD

Actual Div Yld

286 139 82 32 65

2270.88 2860.83 2358.41 2553.49 1570.63

3.9% 5.2% 2.9% 4.5% 3.5%

9.3% 13.7% 13.7% 16.8% 3.6%

3.9% 6.4% 15.2% 22.5% 0.2%

3.89% 4.49% 3.10% 3.97% 3.27%

FTSE EPRA/NAREIT Global ($) FTSE EPRA/NAREIT North America Index ($) FTSE EPRA/NAREIT Europe (€) FTSE EPRA/NAREIT Euro Zone (€) FTSE EPRA/NAREIT Asia ($)

FTSE Bond Indices FTSE Bond Indices Performance (Total Return) – Year to Date FTSE Eurozone Government Bond Index (€) FTSE Euro Corporate Bond Index (€) FTSE US Goverment Bond Index ($) FTSE Pfandbriefe Index (€) FTSE Gilts Index Linked All Stocks (£) FTSE Japan Government Bond Index (¥)

106

104

102

100

98

05 n-

-0 ay M

FTSE Euro Emerging Markets Bond Index (€) FTSE Gilts Fixed All-Stocks (£)

Ju

5

5 r-0 Ap

5 ar -0 M

5 -0 Fe b

5 -0 Ja n

De

c-0

4

96

FTSE Bond Indices (Total Return) Index Name

Consts

FTSE Eurozone Government Bond Index (€) FTSE Pfandbrief (€) FTSE Euro Emerging Markets Bond Index (€) FTSE Euro Corporate Bond Index (€) FTSE Gilts Index Linked All Stocks (£) FTSE Gilts Fixed All-Stocks (£) FTSE US Government Bond Index ($) FTSE Japan Government Bond Index (¥) FTSE China Government Bond Index (RMB)

253 327 43 324 9 29 113 225 30

Value

154.53 177.61 203.23 143.83 1919.08 1875.25 147.42 111.53 95.87

1M

1.1% 1.0% 1.4% 1.1% 1.9% 1.4% 0.6% 0.5% 2.0%

3M

3.6% 3.1% 4.3% 3.1% 4.1% 4.7% 3.6% 1.0% 4.9%

YTD

4.9% 4.1% 4.2% 3.8% 3.9% 4.6% 3.2% 1.7% 9.7%

Actual Div Yld

3.16% 2.84% 4.30% 3.35% 1.63%* 4.18% 4.07% 0.89% 3.26%

* Based on 0% inflation

FTSE Research Team contact details Carl Beckley Director, Research & Development carl.beckley@ftse.com +44 20 7448 1820

Bin Wu Senior Index Design Executive bin.wu@ftse.com +44 20 7448 8986

Jamie Perrett Senior Index Design Executive jamie.perrett@ftse.com +44 20 7448 1817

Andreas Elia Research Analyst andreas.elia@ftse.com +44 20 7448 8013

Gareth Parker Head of Index Design gareth.parker@ftse.com +44 20 7448 1805

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2005

95

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Page 96

CALENDAR

Index Reviews September – Early December 2005 Date

Index Series

Review Type

Effective Data Cut-off (Close of business)

Early Sep Early Sep 1-Sep 02-05-Sep 5-Sep 7-Sep 7-Sep 7-Sep 7-Sep 8-Sep

ATX S&P US Indices SMI Index Family S&P MIB DAX FTSE Goldmines Index Series FTSE/JSE Index Series FTSE/ Hang Seng Asiatop FTSE UK Index Series FTSE Global Equity Index Series (incl. FTSE All-World) NASDAQ 100 FTSE techMARK 100 FTSEurofirst 80 & 100 FTSEurofirst 300 FTSE Euromid FTSE eTX FTSE Multinational FTSE4Good Index Series FTSE Global Islamic FTSE TMT FTSE Global 100 S&P MIB STOXX STOXX Blue Chips DJ Global Titans 50 S&P US Indices S&P Europe 350/ S&P Euro S&P 500 S&P Midcap 400 S&P/ ASX 200 S&P TSX Russell US Indices CAC 40 Nikkei 225 TOPIX New Index Series FTSE Xinhua Index Series TSEC Taiwan 50 FTSE/ ASE 20 OMX H25 Hang Seng MSCI Russell US Indices NZSX 10 ATX IBEX 35 OBX KFX DAX FTSE JSE Africa Index Series FTSE All-Share FTSE UK Index Series FTSE techMARK 100 FTSE Euromid FTSE Eurofirst 300 FTSE eTX FTSE Global Equity Index Series (incl. FTSE All-World) NASDAQ 100

Quarterly review Phase 2 float adjustment Semi-annual review Semi-annual constiuent review Quarterly review/ Ordinary adjustment Quarterly review Quarterly review Semi-annual review Quarterly review Annual review/ Developed Europe

30-Sep 16-Sep 30-Sep 19-Sep 16-Sep 19-Sep 2-Sep 16-Sep 16-Sep 16-Sep

9-Sep 9-Sep 9-Sep 9-Sep 9-Sep 9-Sep 9-Sep 9-Sep 9-Sep 9-Sep 9-Sep 13-Sep 14-Sep 14-Sep 14-Sep 14-Sep 14-Sep 14-Sep 14-Sep 14-Sep 14-Sep 15-Sep Sep/Oct Oct Oct 13-Oct 13-Oct Oct/Nov 24-Oct 11-Nov 16-Nov 30-Nov Nov/Dec Early Dec Early Dec 1-Dec 1-Dec 5-Dec 7-Dec 7-Dec 7-Dec 9-Dec 9-Dec 9-Dec 9-Dec 9-Dec 9-Dec

Quarterly review / Shares adjustment 16-Sep Quarterly review 16-Sep Annual Review 16-Sep Quarterly review 16-Sep Quarterly review 16-Sep Quarterly review 16-Sep Annual review 16-Sep Semi-annual review 31-Aug Semi-annual review 26-Aug Annual review 16-Sep Quarterly review 31-Aug Quarterly review - shares & IWF 19-Sep Quarterly review 16-Sep Annual review 16-Sep Quarterly review 16-Sep Quarterly review 16-Sep Quarterly review 16-Sep Quarterly review 16-Sep Quarterly review 16-Sep Quarterly review 16-Sep Quarterly review 16-Sep Quarterly review 30-Sep Quarterly review Oct/Nov Annual review Oct Introduction of free float factors (Phase 1) 28-Oct Quarterly review 24-Oct Quarterly review 21-Oct Semi-annual review 30-Nov Quarterly review 31-Oct Quarterly review 11-Dec Quarterly review 30-Nov Quarterly review / Additions 16-Dec Quarterly review Dec Quarterly review 31-Dec Semi-annual review 1-Jan Semi-annual review 16-Dec Semi-annual review 16-Dec Quarterly review 16-Dec Quarterly review 2-Sep Annual review 16-Dec Quarterly review 16-Dec Quarterly review 16-Dec Quarterly review 2-Sep Quarterly review 16-Dec Quarterly review 16-Dec Annual review / North America Annual review

16-Dec 16-Dec

31-Aug 31-Jul 31-Aug 19-Aug 16-Sep 31-Aug 6-Sep 30-Jun

31-Aug 2-Sep 2-Sep 2-Sep 2-Sep 30-Jun 16-Sep 16-Sep 6-Sep 16-Sep 1-Sep 1-Sep 14-Sep

31-Aug 31-Aug

16-Sep 30-Sep 30-Sep 24-Oct 30-Sep 12-Dec

30-Nov 30-Nov 30-Nov 16-Sep 6-Dec 6-Dec 30-Nov 16-Sep 2-Dec 2-Dec 30-Sep 1-Dec

Sources: Berlinguer, FTSE, JP Morgan, Standard & Poors, STOXX

96

SEPTEMBER/OCTOBER 2005 • FTSE GLOBAL MARKETS

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Page 97

ETFR exchange-traded funds report

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The shadow of the tax man

By Marsha Zapson

It’s tax time. Or rather, it’s time to start implementing strategies that will make April 2005 a little less painful.

For investors bemoaning losses in their portfolios, take heart. Those losses can be the basis for year-end tax harvesting strategies. And this year, such strategies are particularly applicable since most equity markets are significantly below their five-year highs.

Portfolios with stocks, mutual funds, closed-end funds, or ETFs that have unrealized losses might just benefit from tax management strategies before year end. Tax swaps and fund substitutions can improve a portfolio’s tax efficiency by offsetting losses for 2004 as well as realized or future capital gains.

With 160 passively managed equity index-linked ETFs and 111 actively managed equity closed-end funds suitable for swaps, investors have a wide palette to choose from, says Paul Mazzilli of Morgan Stanley. Both types of funds offer diversified portfolios that trade as

Issue No. 49 December 2004

IN THIS ISSUE DVY doubles Cover QQQ home coming Page 4

individual stocks on almost every major US exchange.

In many cases, he says, investors might favor strategies using combinations of ETFs and closed-end funds because certain market segments or countries have only one of each fund type. For those using ETFs, Mazzilli’s list of potential tax swap candidates is reproduced on page 8 and includes the percent each ETF is below its five-year high and above its two-year low.

Golden ETFs Page 7 ETF swap list Page 8 Minding '03 tax changes Page 9 ETFR databank Page 11

Swapping strategies Until ETFs became available in just about every conceivable flavor, Sean Clark had a major headache come tax time every year. These days, Clark, who is CFO of family run advisory Clark Capital Management in Philadelphia, swaps stocks for ETFs and the reverse.

Only a very small segment of his business uses mutual funds, and ETFs are generally used as mutual fund substitutes. However, at year end, Clark relies heavily on ETFs because of “the 8

Dow Jones Indexes plans to double the number of constituents in its Select Dividend Index to 100 stocks from its current 50 on December 20, 2004. The Select Dividend index is the basis for the iShares DJ US Select Dividend fund (DVY) that trades on the New York Stock Exchange.

I n t roduced a year ago, the index m e a s u res the perf o rmance of dividend-

exchange-traded funds report

The power of dividends

By Marsha Zapson

When Divy doubled its girth recently, it was an event that went largely unnoticed in the investment community. Yet this reconstitution—or more accurately, redesign—is the single most comprehensive overhaul of an ETF the industry has so far seen.

The iShares Dow Jones Select Dividend Fund, known colloquially as Divy because of its DVY ticker, added 51 stocks to its coffers in December 2004.

Originally, Dow Jones’ Select Dividend Index (and the iShares fund tracking the index) held 50 of the highest dividend paying stocks in the DJ US Total Market Index, which covers 95% of US market capitalization.

That change, along with the introduction of a new liquidity screen, has meant radical surgery rather than a mere rebalancing for the DVY portfolio. An obvious example: Banc of America, formerly the largest holding at 4.9% of the original index, was demoted to fourteenth, weighing in at a mere 1.4%. (See

paying stocks selected for their high yields, their track re c o rdsof maintaining or increasing dividends over the past five years, and their ability to sustain c u rrent payouts in the coming year.

Ye a r-to-date through November, the index gained 15.1% compared to 5% to 6% for most US broad-market indexes.

“Given that about 55% of the 1,617 companies in our DJ US Total Market Index pay a cash dividend, and that more companies are joining the trend or are increasing their existing payouts, we decided that doubling the 3

IN THIS ISSUE

Coveting gold Page 6 Modeling with ETFs Page 6 Ryan Beck offers ETF portfolios Page 7 Pick your poison Page 8 ETFR databank Page 11

Index Development Partners, Inc. (IXDP) is planning to get into ETFs in a big way, according to Business Wi re. In midNovember, IDP raised $9 million by issuing 56.25 million shares of common stock at $0.16 per share to a group of

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Investors look overseas for returns

By Marsha Zapson

The top five

As the US dollar lost more ground among world currencies last year, it spurred US investors to—once again—seek investments outside the US. In fact, 2004 saw the largest single-year purchase of foreign stocks by Americans from January through October, totaling $62.1 billion, according to the US Treasury Department. By year’s end, that number is expected to exceed the previous $71 billion record set in 2003.

Not surprisingly, ETFs tracking non-US capital markets outperformed their domestic brethren. The soft dollar not only enhanced modest gains in Europe, it magnified returns for US investors who swapped those foreign currencies back into greenbacks.

US-based marquee indexes, like the Dow (up 3.2%), S&P 500 (up 9%) and Nasdaq 100 (up 8.7%), lost ground last year to Europe’s DJ/Stoxx 600 index, for example. It rose 9.5% in euros, but 18% in US dollars. The currency lift propelled the DJ/Stoxx beyond the S&P 500 for the third consecutive year.

Of the five ETFs that topped 2004’s performance chart, four were iShares MSCI c o u n t ry funds. The stellar performer here was the iShares Austria (EWO), up a whopping 73.1%.* After that came standouts iShares Mexico (EWW), up 49.0%; the iShares Belgium (EWK), up 44%; and the iShares South Africa (EZA), up 44%.

Austria, which was also up about 67% in 2003, owes much of the run up to its role in the development of eastern Europe, and has become viewed as a gateway to that region. The economies of Poland, Hungary and Czechoslovakia, which entered the European Union last year, are today robust, and Austria, in particular, was a beneficiary of that success.

Both the iShares Austria and Belgium funds are dominated by diversified financials, with Austria devoting about 27% of the index to that sector and Belgium some 30%. “But, if you look across the entire list of companies, the outperformance is really across the board 10 and not isolated to one or two

Issue No. 51 February 2005

IN THIS ISSUE Turkey Titans ETF launches Cover China’s first ETF Page 3 Russell index adds 40 IPOs Page 5 New options for SPDRS Page 7 Pick your poison Page 8 ETFR databank Page 11

U P D AT E S

Steinhardt completes $9m financing, and plans ETFs

Name:

investors led by hedge fund aficionado Michael Steinhardt.

IDP intends to use the financing proceeds to sponsor ETFs and other financial products based on proprietary stock indexes created and owned by the firm.

The investing group includes the private equity firm RRE Ventures, cofounded by former American Express chairman and CEO James Robinson III, and Quantitative Financial Strategies, Inc. The company's new board of directors includes: Michael Steinhardt as 3 non-executive chairman, RRE

Turkey Titans ETF launches Even as Merrill Lynch upgraded Turkish equities to overweight from neutral in its global emerging markets portfolio, a new ETF tracking the 20 most liquid blue-chip stocks in Turkey’s market was launched early in 2005.

On its first day of trading (January 14), the Dow Jones Istanbul 20 ETF (TR20I) traded 3.2 million shares, or around US

ORDER

$15 million. For the three days prior to launch, the ETF had an initial public off e ring, attracting seed money from institutional investors in Spain, the Netherlands, the UK and US, among others.

The new ETF—which is UCITS III compliant—tracks the DJ Turkey Titans 20 index and is comprised of the 20 most liquid stocks in Turkey’s market. It is highly correlated with the MSCI World Turkey Index, FTSE All World Turkey Index, and the Istanbul Stock Exchange’s National30 Index.

Finans Portföy, a Turkish3

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Steinhardt completes $9m financing Cover

graph below comparing the top ten holdings of the original and reconstituted indexes.)

“Dow Jones tweaked it for the better, and by adding more names, the index better represents dividend-paying stocks in the US market,” says Patrick O’Connor, senior portfolio manager with iShares.

The DJ Select Dividend Index is among the youngest indexes on which an ETF has been based. It owes its existence to the Bush administration’s tax cuts, one of which resulted in dividend income being treated at the lower capital gains tax rates, rather than as ordinary income. All of a sudden, dividends became hot. And over the last three years, the percent of dividend-payers among the 1,600 or so names in the DJ Total Market Index has risen from around 50% to 55%, and many of the original 50% have lifted their payouts, in some cases dramatically.

That benefit coincided with many stock investors who were bat- 8

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Issue No. 50 January 2005

U P D AT E S

U P D AT E S

Popular DVY doubles its girth

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