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This Week Next Week - Justin Urquhart Stewart Commentary

May 17, 2010

Power and Responsibility

It’s all very well being able to wield power, but it is the responsibility that goes with it that is more important. As we have seen with the banking crisis, the irresponsibility of key officers and directors who seemed to be almost omnipotent was astonishing. No one seemed minded to criticise the sartorial elegance of these faux financial emperors. Was there any thought of responsibility or was it purely focused on the need for the return for the bottom line of the Profit & Loss account – well, as we all now know – the answer was yes.

There are of course many highly regarded courses, and probably qualifications, on ethics and behaviour, but all of these count for nought unless the culture of the company concerned and its employees actually live and breathe such standards. This is not “woolly and cuddly” thinking, but rather a very practical business discipline which will positively differentiate those who are willing to compromise their standards from those who are determined to “do the right thing”.

However there are other areas, and not just banks, where such responsibility lies. Take the Ratings Agencies. These beasts vary in size from big brand international concerns like Standard & Poor’s, Moody’s and Fitch, through to quite local and focussed evaluators of funds, services and capabilities. The concept of such evaluators is not only extremely useful, but also in many cases vital in order to
provide an independent and objective view and opinion on the state of any particular market or participant. However the fulcrum issue here is the quality and independence of such ratings.

As we now know, the credit agencies were more than happy to bestow AAA ratings on billions of dollars of less than perfect assets, many of which in fact turned out to be thoroughly toxic waste. The evidence? Of the AAA rated sub-prime mortgage backed securities in 2006, 93% has now been downgraded to junk status. Just what kind of reliability is that?

Many of these agencies really started life quite respectably as market researchers providing assessments of products for people looking to invest or use those facilities: somehow some of these have now morphed into something very different. It seems that some were in fact being hired by those people actually selling the debt packages and to provide a third party seal of approval. Here then is an obvious conflict of interest and open to abuse. What was becoming apparent was that various firms were selecting their preferred rating agency according to the likelihood of which one was going to give them the most favourable verdict. This system is thus inherently open to corruption and abuse, and this has been corroborated by a US Senate subcommittee which has been turning over some stones to reveal some very unpleasant truths.

These agencies of course have a broader influence and one which the UK is facing right now. There has been much talk of the UK’s Gilt debt potentially losing its AAA status. This though is not just a matter of national prestige and pride – it can have a very real impact. Most of the time, I find that the output of such agencies normally provide us something as helpful as yesterday’s weather forecast – really useful. In fact of course you can just bypass the agency and see how say UK debt is being judged by the price in the market. If the cost is rising then the risks are rising in which case the rating has already been lost. Who needs an agency for that?

No - what though is more vital for the UK is that if the AAA rating is lost, then there are many bond funds around the globe that are only allowed under their mandates to hold AAA debt. Thus any downgrade makes UK debt a forced sale, which in a bad market can make things considerably worse.

The impact of this will be higher interest rates, which will have a direct impact on companies by reducing investment, a direct impact on the household sector by pushing up mortgage rate and a direct impact on the government by pushing up the interest bill. By the way, the annual interest bill is climbing as the government’s debt rises. The interest bill is forecast to be £42 billion for 2010/11, up by £11 billion (assuming Gilt rates stay flat). £11 billion is more than we spend on probation services, courts and prisons put together or is equivalent to an extra 2% on VAT.

So what should be done? Control of who pays the agencies – i.e. not the product seller? Centralising all ratings through a regulatory body? Either way this must be addressed. The system was corrupt and they were part of that corruption.
In the meantime our new Chancellor of the Exchequer has a clear target – don’t lose the AAA credit rating.

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So much for a smooth Summer; volatility is back and across many asset areas around the globe. The “sand devils” I have previously referred to are still twisting and are sapping away the confidence of the recovery from last year’s nadir. A bit more cash might well become a more comforting asset over the next few months.

Even the enthusiastic commodities markets have been seeing a fall back, with iron ore prices down some 8% from a two year high in April. This is thought to be on concerns about falling demand from China as that nation continues to try to cool the pace of growth of their economy. Whether this is the start of a trend or just a blip remains to be seen, but either way it is certainly a sign of lost confidence that has rippled around the globe.

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This week watch out for the inflation data for the UK and the Euro zone on Tuesday to see if we are seeing any further upward pressure. The following day the new government will be interested to see the CBI Industrial Trends Survey to see if the recovery is gaining any traction. However it will be Friday that some key data will be out on the Public Sector Net Borrowing figures - the term eyewatering may well come to mind.

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And finally..............I love persistence, and this year’s award must go to a South Korean woman who earned a driver's license after 960 attempts. Yonhap News Agency reported on Thursday that 69-year-old Cha Sa-soon finally passed the driving part of the test last month. South Korea requires a written test first, and Cha took it nearly every day since April 2005 before passing last year. If she had left it much longer she would have failed the eyesight test.

And one more... Why we need cigarette butts! Hong Kong (Reuters) – Chemical extracts from cigarette butts can be used to protect steel pipes from rusting, a study in China has found. In a paper published by Industrial & Engineering Chemistry Research, scientists in China said they identified nine chemicals after immersing cigarette butts in water.

They applied the extracts to N80, a type of steel used in oil pipes, and found that they protected the steel from rusting. The chemicals, including nicotine, appear to be responsible for this anti-corrosion effect, they added.

Corrosion of steel pipes used by the oil industry costs oil producers millions of dollars annually to repair or replace. According to the paper, 4.5 trillion cigarette butts find their way into the environment each year. Apart from being an eyesore, they contain toxins that can kill fish.

China, which has 300 million smokers, is the world's largest smoking nation and it consumes a third of the world's cigarettes. Nearly 60 percent of men in China smoke, puffing an average of 15 cigarettes per day.

So they may clog your arteries but at least they won’t rust. I feel healthier already.

Have a good week.

Justin A. Urquhart Stewart
Director
Seven Investment Management Limited