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The current turbulence in the credit market and other parts of the financial system should pass within the next few days. 

It has hardly been an unforeseen "bolt from the blue".  Many of the problems with subprime mortgages, over-leveraging by corporations and private equity firms, deteriorating credit standards, and failure to price risk properly have been widely discussed for more than a year.  This was most definitely an accident waiting to happen. HSBC Chairman Stephen Green warned more than a month ago that credit standards were falling fast and banks would soon come to regret some recent lending decisions. Even Citigroup Chairman Charles "Chuck" Prince acknowledged there would be casualities when the music stopped, though he went on to say the bank would continue on its current course for the time being because the music was still playing.  While the timing of the debacle seems to have caught some investors by surprise, the likelihood of a major correction cannot have done. 

The major central banks are now flooding the markets with short term liquidity in an attempt to defuse the panic and ensure the markets continue functioning without having to cut benchmark interest rates. It should have the desired effect.  By late Friday, most markets were steadying as the ECB, the Federal Reserve and other central banks injected record quantities of liquidity into the short-term money market. 

The advantage of liquidity injections is they can be reversed much more easily than interest rate cuts and the effect is more narrowly tailored to the financial system with fewer spillovers into the real economy.  The central banks are still worried about the degree of inflationary pressure in the real economy, and worry that interest rate cuts to bail out investors would simply encourage even more imprudent risk taking in future. 

There is every reason to think that the current round of liquidity injections will succeed in stabilising markets.  By Friday afternoon, markets appeared notably calmer, with credit spreads and short-term money rates easing and equity and commodity markets paring losses towards the end of the day.  Central bank officials and senior banking executives have now had all weekend to assess the damage and regain their nerve.  The markets should seem much calmer today.  They might even see a "relief" rally. 

There will be no return to the "status quo ante", however. 

The events of the last few days will have lasting and profound effects on the financial system that cannot be undone by the return of greater calm to the markets. 

There are plenty of people who will welcome the return of greater stability as a return to "business as usual".  They will claim that it demonstrates the increased resilience of the financial system to shocks -- just as the return to normal trading conditions after earlier bouts of market turbulence in May 2006, Feb 2007 and Jun 2007 was taken as proof that the system was fundamentally sound. 

What makes this bout of market turbulence different, however, is this time the central banks had to step in with an almost unprecedented infusion of liquidity to rescue the investment and commercial banks.  In the absence of massive liquidity support, it is certain one or more of the major banks and hedge funds would have failed last week as the toxic combination of falling asset prices, rising margin calls and lack of liquidity dragged them under. 

The central bank bailout means the current bout of market turbulence cannot be so easily dismissed as a brief hiatus in an otherwise well-functioning market.  It has revealed profound short-comings in the operation of financial institutions and will force a period of soul-searching and profound changes even after the immediate crisis has passed: 

(1)  The rescue operation has reaffirmed the key role of the central banks in the financial system.  It seems an obvious point.  But in recent years, many investors have begun to question the continued relevance of the central banking community. Central banks still control the near end of the yield curve, but appeared to have lost control over the back end. Former Fed Chairman Alan Greenspan noted recently that attempts to push up market interest rates in 2004 and 2005 failed because rate increases at the short-end of the curve had no impact on the longer-term rates which govern most household and corporate borro wing. Greenspan puzzled at the time about the "conundrum" of low long-term interest rates.  There is now a consensus long-term rates have been held down by the flood of liquidity from Asia and the Middle East as trade surpluses and petrodollars are recycled into western capital markets.  Even so, it has left many wondering whether central banks are an impotent relic of an earlier age, unable in the modern global capital market to have any real influence on interest rates and the availability of credit.  Last week's interventions have decisively refuted that point. 

(2)  Value-at-risk (VaR) methodology has been tested in the fire and found wanting.  VaR is an elegant, useful but limited way to understand the risks within a trading book or a portfolio of assets.  It assumes that movements in asset prices follow a Normal distribution and proceeds to estimate the maximum expected profit or loss at a 95% (2-sigma) or 99% (3-sigma) confidence level.  The theoretical shortcomings of VaR have been frequently written about and are widely known: 

(a)  VaR estimates provide only a maximum estimated loss at the 95% or 99% level.  They say nothing about possible losses in the extreme tails of the distribution.  Profits/losses will exceed VaR levels one day in 20 (for 95% VaR) and one day in 100 (for 99% VaR). The difficulty is that on those exceptional days, profits/losses could be many multiples of the profit/loss estimates for the 95-99% level.  In other words, VaR methodology does not really capture extreme values. It represents how a portfolio or trading book will perform in NORMAL circumstances - but says precisely nothing about how it will perform during a crisis major shock to the market (positive or negative). 

(b)  As it turns out, movements in asset prices DO NOT follow the Normal distribution.  Past experience suggests there are far more large upward movements and downward movements in asset prices than in the Normal distribution.  The distribution of asset-price movements displays "fat tails" (kurtosis) and extreme price movements occur far more frequently than Normal distribution and VaR theory suggests.  So not only does VaR methodology have little or nothing to say about profits/losses in the tails of the distribution, but those tails turn out to be more important than the theory suggests. 

(c) VaR methodology assumes that there is a continuous liquid market for the assets in the portfolio.  Profits can be realised and losses capped by buying/selling assets into a well-functioning market with at close to the current price and with minimal "slippage". But as recent events have shown, in a crisis, market functions can be severely impaired and liquidity evaporates. In these circumstances, potential losses are many times the level indicated by VaR levels. 

The limitations of VaR methodology are well known, but until now they have remained mostly an intellectual curiousity.  Financial regulators have been taking VaR limitations seriously for some time.  In the United Kingdom, the Financial Services Authority has required banks to perform "stress tests" on their portfolios to consider how they would behave during extreme market movements of the sort which lie in the fat tails of the VaR distribution.  Similar "stress testing" has been required in the United States and other jurisdictions.  But most investors and financial institutions still rely heavily on VaR to measure and manage the risk in their portfolios with little thought given to how they would behave in a crisis.  In many cases, the unstated assumption appears to be that the central banks would act to prevent any serious dislocation of asset values (the "Greenspan put") and there is therefore no need to worry about how asset prices behave in the fat tail because it is very unlikely to happen. 

(3)  The Basle II process is dead.  The 1988 Basle Capital Accord (Basle I) was a concordat among the major bank regulators which required banks to hold a minimum 8% prudential reserve ratio in a mix of equity and liquid debt against their risk-weighted portfolio of assets. Basle I used a fairly crude methodology to weight the risks in bank assets, dividing them into a handful of broad asset classes.  It was a very imprecise approach, but has been credited with enforcing a minimum capital requirement across the international banking system, and ensuring bank regulators do not engage in a "race for the bottom" in an effort to improve the competitive position of their own banks by easing capital standards.  Basle II is intended to update Basle I by creating a much more sophisticated risk-measurement and weighting system that would match the banks' capital requirements much more closely with the actual risks in their books.  Basle II would allow at least the biggest and most sophisticated banks to replace the crude "risk buckets" used to weight risk in the Basle I system with risk estimates generated by the own internal risk measurement systems (including VaR measurements). 

Basle II has been the subject of a bitter and protracted argument between the regulators and major banking institutions.  In theory, the more precise risk-weighting system would require different banks to maintain different capital ratios depending on different risk profiles of their lending and investment businesses.  Banks with riskier customers or more aggressive investment businesses would be required to hold more capital than those with safer clients and fewer asset market exposures.  Crucially, larger and more sophisticated banks would be allowed to use their own internal risk models (subject to validation by the regulators) while smaller and less sophisticated institutions would continue to use an (updated) set of risk buckets. 

In theory, if the larger banks can measure more risk more accurately and hold capital only against the actual risk in their book, they should be able to reduce capital requirements below 8%.  But the leading bank regulators have already indicated that they are uncomfortable with this.  They have indicated that the "aggregate" capital ratio in the banking system should not drop below 8%.  For every institution that is allowed to hold less than 8%, other institutions would be required to hold more. 

And what the bank regulators have given with one hand, they are busy trying to take away with the other.  There are signs that they are uneasy about even the largest financial institutions holding less than an 8% capital ratio.  So the major banks have been told that they may be allowed to cut their risk capital requirement below 8%, but the regulators reserve the right to top up the requirement by forcing them to hold capital against "operational" and other risks -- that could easily take the amount of capital held back to 8%.  So as the banks busily try to measure their risk more precisely to cut capital requirements below 8%, the regulators are busy creating new forms of risk to take the amount of capital back up to that level. 

Even before last week's events, there was little appetite among financial regulators to cut capital requirements -- either in aggregate or for the major financial institutions.  Capital requirements are seen as a "buffer", "cushion" or "shock absorber" that provides a first line of defence, an ability to withstand significant losses, that has allowed the financial system to weather a series of shocks successfully in the last two decades.  Recent commentary has emphasised how important this capital cushion is to the stability of the system. Published estimates have put losses from subprime lending at "no more than $100-200 billion" in aggregage and insisted that the banking system can absorb losses on this scale because total capital reserves are more than four times this figure. 

Recent turbulence has highlighted the crucial role that capital reserves play in maintaining the stability of the system - especially when banks are hit by unexpected market turbulence and lack of liquidity that is not envisaged by their standard VaR and other risk models.  In the circumstances, there will be even less appetite than before to allow the financial system to trim capital requirements. 

Basle II will continue, but the emphasis has been changing for some time, and recent events will accelerate this shift. Regulators will still allow larger and more sophisticated banks to use internal risk measurement systems.  But the emphasis will be on using internal risk systems to improve management UNDERSTANDING of the risks in the portfolio.  There will be markedly less willingness to allow these risk measurements to be used to cut the total amount of capital held in any meaningful way.  Regulators will be more determined now than before to protect the overall "cushion" in the financial system. 

There will be more emphasis on a "prudential" approach to capital reserves -- supplementing precise risk measurements from internal models with the need to hold additional capital against stress-testing "worst case scenarios". 

(4)  Last week's central bank bailout has highlighted the issue of "moral hazard".  The term was originally coined in the insurance industry to describe how a person's behaviour may change once they have taken out an insurance policy in ways that increase their risk-taking and therefore the risk in the insurer's portfolio.  For example, a person who has insured their vehicle against theft may be more likely to leave the car unlocked when leaving it unattended for a short while than a person who would bear the whole cost if it was stolen. Providing insurance causes people to act in riskier ways. The same basic problems exists in the financial system.  By standing ready to bail out banks and investors in a crisis, the Fed and other central banks may have encouraged them to assume greater risks at lower rates of return. The common criticism of financial bailouts and interest rate cuts led by former Fed Chairman Alan Greenspan in 1987, 1998, 2000 and 2003 is that they created a moral hazard problem and contributed to the mispricing of risk exhibited in the last three years. 

Current Fed Chairman Ben Bernanke and his colleagues are clearly determined not to repeat this mistake.  The Fed is trying to supply short-term liquidity (to keep the markets functioning) while resisting pressure to cut interest rates (hoping that the markets will force recognition of the losses on subprime and other lending in the medium term and adjust risk-pricing accordingly). 

But as the dust settles, there will be questions about how far the Fed's implicit guarantee (either through interest rate cuts or the supply of emergency liquidity) is providing a subsidy to the investment banks and hedge funds, causing them to take excessive risk and contributing to a general mispricing. 

In practice, there is no way to ELIMINATE moral hazard without risking a return to the boom-bust lending cycles of the nineteenth century accompanied by frequent and sometimes widespread bank failures.  But there might be ways to mitigate it. 

Crucially, the Fed and other central banks will be determined to ensure that banks continue to hold sufficient capital and that they absorb at least some of any losses from the re-pricing of risk assets that is now underway.  In the same way insurers try to prevent moral hazard by imposing an "excess" on policies, requiring the insured person to bear the first portion of any claim, the current crisis has highlighted the importance of ensuring the banks hold capital reserves to absorb the first portion of any losses from periods of extreme market volatility.  It will make the regulators even more determined to ensure that the capital ratio and shock absorbers are not diluted under the Basle II process.  The bank regulators probably cannot require hedge funds to hold similar "prudential" reserves against periods of market turbulence (it is too complicated), but they will intensify the pressure on the banking institutions who LEND to the hedge funds and provide much of their credit, and banks may come under pressure to make sure they hold enhanced prudential reserves against the likelihood that hedge fund borrowers will run into trouble. 

(5)  Donald Rumsfeld.  The current crisis was entirely predictable -- and predicted.  There is nothing surprising about it.  The mispricing of risk and deteriorating credit standards were noted by many people at the time (Green and Prince among them) and were an outgrowth of the natural credit cycle that has been present for hundreds of years.  Crucially, the correction was triggered from WITHIN the market.  There was no EXTERNAL trigger.  No war.  No energy crisis.  No major corporate credit default.  No emerging market crisis.  The problem originated in the US housing market with the rapidly rising default rates on subprime loans.  But the problems in that area have been known for at least a year, and the severity of them has been known for at least six months.  The recent bout of market turbulence is simply the latest in a series (May 2006, Feb 2007, Jun 2007) albeit the most severe to date. 

If the current bout was entirely predictable and arose for reasons INTERNAL to the major financial markets, it will nonetheless focus more attention on risks in the fat tails of the asset-price distribution. 

It recalls former US Defense Secretary Donald Rumsfeld's phrase about "known knowns, known unknowns, and unknown unknowns".  It is the unknown unknowns which constitute the major risk in the system and which are the major issue for risk managers.  The price of risk needs to be set to reflect those "unknown unknowns" as well as the normal asset price volatility.  Again it argues for a more prudential approach to investment management to supplement VaR and other "algorithmic" or "quant" based strategies. 

(6)  There will be an increased preference for liquid and transparent instruments in the medium term.  Credit and other asset markets are characterised by a natural cycle.  Low interest rates in the core economies (North America, Western Europe, Japan and the Anglosphere) and the core asset markets (government bonds, high-grade corporate bonds and equities) tend to prompt an increased flow of capial into the periphery (emerging markets, lower-grade corporate paper, alternative assets and commodities) in search of better yields.  Credit standards tend to deteriorate.  And investment money tends to be redirected from more liquid markets to less liquid assets (which promise better returns).  But when interest rates increase in the core economies, the outflow of capital slows or even goes into reverse.  Economies and asset classes on the periphery of the system see the sharpest slowdown in new funds, and price falls are often exacerbated by the lack of liquidity and depth in these markets and the "rush for the exits". 

Low western world interest rates in 1990-91, 1998-2000, and 2002-2005 all prompted a huge outflow of investment funds from the core of the financial system (North America, Western Europe, Japan, government bonds and high-grade corporate paper and equities) to the periphery (emerging markets, lower-grade corporate paper, alternative assets and commodities).  Increases in interest rates in 1980-82, 1994, 2000 and 2004-2006 have all staunched or reversed the flow (albeit sometimes with a delay). 

The same cycle that saw banks rushing to loosen lending standards in 2003-2006 in the competition for customers is now exhibiting a rush to tighten them to stem loan losses to households and corporate creditors.  Lending standards for credit cards were tightened substantially last year, and standards for subprime mortgages, conventional mortgages and previously "covenant light" corporate loans have all been tightened markedly in the last few months and weeks. 

By the same token, however, investors will prefer more liquid and transparent investments in the medium term.  The last three years has seen a huge surge in enthusiasm for very illiquid and non-transparent assets such as CDOs, privately traded equities and infrastructure.  The major banks have been busy forming "dark pools of liquidity", private exchanges restricted to sophisticated institutional investors (is Goldman Sachs GSTrUE) to allow venture capital companies to exit from their investments (at least in part) by selling equity stakes to pension funds and other institutional investors without having to undergo a full IPO in the public markets.  At the same time, a busy "market" for CDOs and other instruments has grown up which are thinly traded if at all, and valued through a "mark-to-model" process rather than "marked-to-market" against a liquid traded visible price each day. 

But it is these illiquid, non-transparent, marked-to-model asset classes which have seen the biggest loss of value during the recent bout of market turmoil.  Dow Industrials have lost -5.5% of their value since peaking in Jul but are still up +6.5% since the start of the year.  Prices for crude oil and base metals futures have slipped from recent peaks but are still far higher than they were at the start of the year.  In contrast CDOs based on subprime mortgages have seen catastrophic losses and in some cases have become impossible to value because there is no longer a functioning market for them. 

The difference is that publicly traded equities, commodity futures, bonds etc, have public, visible and liquid markets where there is daily price discovery and an effective regime for marking everyone's positions to market quickly at the end of each day, forcing early recognition of profits and losses.  CDOs, dark pools, and infrastructure investments have proved much harder to value.  The "markets" for many of these items (never very actively traded) have disappeared entirely during the recent bout of turmoil. 

At the margin, investors are likely to respond to the recent bout of turmoil by shunning illiquid non-transparent assets in favour of market-traded liquid transparent ones.  At the very least, institutional investors will display much more scepticism about "mark-to-model" assets.  These asset classes will not disapppear entirely.  But investors will show a marked preference for liquid market-traded securities, and demand much better returns for holding illiquid thinly traded ones.  The appearance of a greater liquidity premium for exchange traded assets and liquidity discount for non-exchange traded ones is part of the overall re-pricing of risk that has been underway for six months now and is likely to extend well into 2008.  The migration of business away from the public exchanges (NYSE, CBOT, LME, NYMEX, ICE) to less-transparent and less-regulated OTC forums (dark pools, private exchanges etc) is likely to slow (at least for a time) as major institutional investors such as pension funds demand for transparent investment strategies from their money managers.   

我收到了大量有关我上周专栏文章的读者来信。在那篇专栏文章中，我指出美国占据全球主导地位的时代行将结束。其中一些来信完全是言辞粗鄙的辱骂——从“阳物嫉妒”(penis envy)到讨厌美国，说我什么的都有。

但其中也有更为讲理的论点。这就是，我过于轻信高盛(Goldman Sachs)的预测，即到2027年，中国的经济规模将超越美国。我收到的很多电子邮件都谈出了这一点。以下是其中一封（作者希望隐去姓名）：

“你应该回过头去读读上世纪80年代那些关于日本将超越美国的文章，在那之前还有巴西奇迹，以及50年代，一些人认为苏联将主宰世界，因为他们找到了办事的方法。”线性盈利预测造就了上世纪90年代的互联网股票估值奇迹（你只须将同样的增长率推至未来10年），似乎政治科学家也犯下了同样的错误。一时间，中国社会中的结构性问题变得并不重要（当然，15年前的正统观点是，如果没有民主，就不可能实现可持续的长期经济增长，而这就是当时为什么中国未进行广泛的政治改革而经济不能增长的原因）。

中国经济增长的动力来自新增劳动力和资本投入。这是个一次性事件，尽管其持续时间非常长（前苏联持续了20多年），经济增长动力最终也会枯竭。美国经济增长奇迹能够持续如此之久的原因在于，美国是一个自由和富于创造力的社会。从长期角度看，美国能够不断提高生产率。

中国将在未来2年至3年吸收剩下的多余劳动力。目前尚无证据表明，西方资本真的在中国获得了大幅超额回报，而中国正在大规模补贴其国内资金成本。可以说，中国内地银行比日本银行在上世纪80年代的情况还要糟糕。未来20年至30年，与中国的独生子女政策相比，欧洲的人口结构问题根本算不了什么。中国正面临严重的环境问题，已经不能食品自给。试想，按全球标准支付食品价格将给中国政治稳定造成何种影响……诸如此类的问题还有很多很多。

未来30年，中国会变得更加强大吗？这一点是肯定的。中国将成为世界上最大的经济体吗？没人真正知道。

我猜想，数年后，当中国经济出现急刹车时，金融报刊就会撰写发人深省的文章，解释所有人如何误读了中国的增长奇迹，以及限制中国未来20年发展的重大结构性增长障碍（当然，这也是错的）。

那么，我自己如何看待这一点呢？

首先——这些观点中多数都非常有力。显然，在中国的政治稳定、银行系统脆弱性和环境等方面，都存在严重问题。我今年早些时候去北京时发现，中国政府官员似乎真的担心，如果不能维持两位数的经济增长，将出现社会动荡。他们似乎也远不能确信，未来几十年中国一定能够保证经济增长和政治稳定。

那么，为什么我仍然倾向于认为，中国经济规模确实会在20年内超越美国呢？

首先、或许也是最无力的理由是，过去15年来，我一直听到关于中国即将崩溃的预测，而迄今为止，什么事情也没有发生。1992年至1997年间，我曾担任驻亚洲的外国记者和编辑，当时人们对天安门事件的记忆依然清晰。目前人们对中国表示出的担忧——民主、银行系统、国有企业、农村社会动荡和西方保护主义——在当时都存在，担忧程度甚至更强。然而，中国经济却一直在增长。当然，所有这些阴暗的预测最终可

能将被证明是正确的，这就像我们所有人最终都难免一死。与此同时，中国的经济增长势头绝对令人敬畏。

第二个、也是最重要的一点，这是一个数字游戏。中国最终会成为世界最大经济体的原因在于，中国的人口规模大约是美国的四倍。上世纪80年代末，关于日本将超越美国的预测一直令人难以信服。两国人口规模的差距意味着，要想超越美国，日本人的平均富裕程度必须达到美国人的两倍以上——这种情况永远不可能发生。

相比之下，如果你认为中国永远不可能超越美国，那么你就必须相信，中国的人均国内生产总值(GDP)无法达到美国的25%。迄今已有多个亚洲“经济小虎”达到并远远超过了这一水平——日本、台湾、韩国和新加坡（一个超小型经济体）——它们中的一些完成了从威权到民主的艰难转型，而并未中断经济增长。

我的同事马丁•沃尔夫(Martin Wolf)指出，如果中国的人均GDP达到葡萄牙——西欧最贫穷的国家——的水平，其整体GDP将超过美国和欧盟的总和。

因此，你不必否认有关中国政治、环境和社会动荡等问题的观点，就能相信中国经济规模最终将超越美国。你只须记住，工业化和快速经济增长的进程一旦启动，就会保持非常强有力的势头。它们能够经受社会严重动荡的考验——即使偶尔爆发战争——并继续推进。

作者：英国《金融时报》专栏作家吉迪恩•拉赫曼(Gideon Rachman)

In the new liquidity factories, buyers must still beware

By Mohamed El-Erian

FINANCIAL TIMES  

Published: March 22 2007 02:00 | Last updated: March 22 2007 02:00 

Market drivers of liquidity currently exceed influences coming from traditional monetary policy instruments. But this is not to say that these instruments are no longer effective. They still are, but at wider levels of economic fluctuations and with less precision - thus raising interesting issues for policymakers and investors.

Over the past two years, markets have developed powerful liquidity factories as more investors have embraced debt in an attempt to increase the impact of their investments. The process has been facilitated by stable global economic conditions, widespread use of derivatives and low borrowing costs. As overall market leverage has increased, the impact on markets has more than offset the US Federal Reserve's 2004-2006 campaign of 17 successive interest rate increases.

A way of illustrating the forces at work is to follow the journey of a dollar as it is reallocated by investors away from a traditional public equity investment and towards private equity. To make the illustration particularly vivid, let us focus on a "public-to-private" deal led by a leveraged buy-out fund in the context of an unchanged monetary policy stance.

The journey starts with the liquidation into cash of a dollar's worth of public equity holdings, which is then allocated to the LBO fund. By -accessing the debt markets, the fund enhances the purchasing power of the dollar (typically 3-4 times) as it ventures into the public markets looking for a company to "take private". On the closure of the deal, the augmented amount ends up as cash in the hands of the seller(s) of the targeted company.

This journey results in higher leverage driven by a multiplier that is internal to the markets. This "endogenous" process expands the economy's balance sheet and boosts asset prices. The boost to asset prices is enhanced by the adaptive nature of investor expectations. Having observed the beneficial impact of an LBO bid on a targeted company's share price, investors adjust. Rather than just being reactive, they actively seek and reprice companies and sectors that may end up on the target list of LBO funds - thus generalising the positive catalyst on share prices.

Higher policy interest rates disrupt this process only if they undermine economic growth, curtail the flow of investor funds to "alternatives" and widen risk spreads in debt markets. Otherwise, successive rate increases coincide with (rather than arrest) the increase in endogenous liquidity, as was the case in 2004-2006.

Monetary policy's recent failure to mop up liquidity does not mean it has become ineffective. Rather, this episode illustrates the unusual potency of the current private equity phenomenon. But, to be sustained over time, the phenomenon needs to develop sources of permanent capital. While recent initiatives by Blackstone and Fortress suggest that private equity firms are pursuing such sources, they are the exception rather than the rule.

The time will come when endogenous liquidity shifts from being accommodating to being restrictive. This occurs naturally over a number of years as a critical mass of companies held in private hands seeks to "exit" back into the public markets.

Timing could be accelerated by a disruption in underlying economic conditions and a sustained spike in risk aversion. As the debacle in the sub-prime mortgage sector illustrates, the resulting credit withdrawal could be quite dramatic.

Given these considerations, it is not surprising that successive increases in US policy rates have not had the impact predicted by traditional models. It is also understandable that, notwithstanding inflation indicators, policymakers have been cautious about raising rates too far lest they trigger a sharp reversal in endogenous liquidity. Looking forward, it would seem reasonable to expect them to require unambiguous evidence of a significant slowdown in economic activity before embarking on a sustained loosening of monetary policy.

What about investors? So far, the increase in endogenous liquidity has rewarded risk-taking beyond what would be warranted by fundamentals. It is prudent to remember that leverage can work against investors on the way down as much as it has worked for them on the way up. When this occurs, the best-positioned investors will be those that have mitigated risk through appropriate asset diversification and the purchase of insurance.

The writer is president and chief executive of the Harvard Management Company, faculty member at the Harvard Business School and deputy Treasurer of the university

China's Concerns in 2007: Fears of a Perfect Storm

By Rodger Baker, Stratfor 

The year 2007 is an important one for China's leadership. At the National People's Congress (NPC) session in March, the government is likely to enact legislation equalizing the status of private property with state property and addressing the imbalance in tax rates between foreign and domestic businesses -- both moves designed to encourage domestic Chinese entrepreneurship. In the fall, the Communist Party of China (CPC) will meet for its Congress -- bringing changes to the Politburo, stacking the political deck with supporters of President Hu Jintao and providing an early glimpse of the next-generation leadership slated to take power in 2012. Lastly, this is the final year of preparations for the symbolically important summer Olympics, which Beijing will host in 2008. 

As the regime takes on these social and economic challenges and lays the groundwork for a smooth continuation of power for the next half-decade, there is a core concern among China's top leaders, more acute for 2007 than in many other years: Taiwan. Parliamentary elections will take place there this year -- the final year of President Chen Shui-bian's second term. The Chinese are also very much aware of the political shift in Washington and the window of time until the U.S. presidential elections in 2008. These factors, along with Beijing's apparent obsession with maintaining stability and a positive public image ahead of the Olympics, are combining to create a perfect storm of conditions that, from Beijing's perspective, signal Taiwan will take the final political step of declaring independence in 2007.  

To fully grasp the implications of this perspective -- and how China's fears are likely to drive its actions -- it is useful to consider the state of affairs that long has been agreed upon by mainland China, Taiwan and the United States.  

Under the present arrangement, China has the seat at the United Nations and Taiwan is viewed officially as merely an "economic"area. In every realistic sense, Taiwan conducts its economic, political and social affairs as a sovereign state -- though of course, China exerts its own influence and money in order to limit the number of nations that recognize the island diplomatically as an independent state. Everyone else just plays along -- paying lip service to mainland China's position while carrying out diplomatic and economic relations with Taiwan in "semi-official" ways. So long as China doesn't invade or physically reclaim Taiwan and Taipei doesn't formally declare independence, an uneasy half-truth is perpetuated, and both sides go about their business.  

By its own calculus, China cannot afford to lose Taiwan to a formal independence move. The social and political structure of mainland China -- not to mention the legitimacy of the CPC -- are still, to a great degree, predicated on actively maintaining the myth that Taiwan is a part of China. And while Beijing and the international media have moved away from using the overt and loaded appellation of "breakaway province" to describe Taiwan, a formal declaration of independence -- unless met with a swift military response -- would significantly weaken the regime.  

At the same time, Beijing does not want to undertake military action against Taiwan. For one thing, while China might have the military power to hurt Taiwan badly, it is not capable of the kind of  sustained operation  that would be required to invade and forcibly reunify Taiwan. Second, any such invasion of Taiwan would draw in the United States and possibly Japan -- neither of which, for strategic and geographic reasons, can allow China to reclaim Taiwan and thus project power into the midst of the South China Sea and its vital sea-lanes. In general, the United States has sought to keep separatist sentiments in Taiwan contained: It offers assistance and military sales to Taiwan on the condition that Taipei will not force the independence issue and draw the United States into a war with China.  

This trilateral relationship has been frequently strained and tested, most noticeably (in recent times) with the lead-up to Taiwan's 1996 elections. At that time, Beijing carried out missile tests in the Taiwan Strait, and the United States sent two carrier battle groups into the area to keep the two sides from tangling. 

During the past decade, though, the balance has been maintained primarily through political means: Washington carefully controls Chen's "instigations" through comments by government officials, diplomats and others; through selective permission (or denial) of flight stopovers in the United States; and through economic and political dialogue with Beijing.  

Since Sept. 11, 2001, the United States has been particularly keen on keeping Chen under control, taxed as it has been with U.S.military forces caught up in conflicts in Afghanistan and Iraq and the emerging nuclear crises in North Korea and Iran. During this time, Washington has adopted a more cooperative track with China, pushing the "responsible stakeholder" dialogue as a way to engage Beijing and keep tensions down. Though the Defence Department frequently has sought to stir up  fears  of the "China threat" and Congress has pursued economic action related to the Chinese trade imbalance and currency rates, the general tenor of relations between Beijing and Washington has been smooth for the past five years.  

Correctly or otherwise, however, Beijing now sees this era as potentially coming to an end -- and Taiwan as being at the centre of the shift. On Jan. 17, in comments that were given substantial play in the Chinese press, Yang Yi -- a spokesman for the State Council's Taiwan Affairs Office -- said 2007 is a crucial year for opposing Taiwanese secessionist activities, and warned that Taipei might seek "de jure independence." Yang's comments were not all that unusual: Chinese officials, particularly those in the Taiwan Affairs Office, frequently caution against Taiwanese independence moves, and Beijing was particularly provoked this month over an overnight stopover Chen made in San Francisco on Jan. 8. Beijing viewed this as an intentional snub on Washington's part and as a major shift in the U.S. attitude from less than a year ago, when the United States denied Chen permission for a similar stopover. 

From Beijing's standpoint, there are three situations that could come together this year to herald a crisis on the Taiwan front. 

The Shift in Washington   

First, the leadership in Beijing is extremely concerned that the shift from Republican to Democratic control in the U.S. Congress could spell the beginning of the end of the current round of rapprochement in Sino-U.S. relations. Though Beijing views the Republicans as being hawkish on the military front (and as the key voices in the "China threat" line of argument in the United States), it also sees this movement as having been subsumed by the Republican White House, which has advocated a more balanced and consultative approach to Chinese relations. 

There are no such expectations of the Democratic Congress.China now anticipates a move to push economic and financial actions against China through Congress. It is the Democratic Party that is seen as the most motivated to attack the established economic and business relationships between the two powers. With the Democrats in charge of the legislature and the popularity of the Bush administration fading, Beijing sees little that would stop Congress from becoming more aggressive in its moves to punish or contain China.  

A related concern, tied to the extended U.S. war in Iraq, then begins to emerge. Again, peering through the Chinese lens, the war is unpopular among Americans, and the Democrats -- positioning themselves for presidential elections next year -- will seek to reduce the U.S. presence in Iraq. However, they cannot afford to look dovish. To demonstrate that the party is strong on U.S.national security, and to gain support from the Pentagon, the Democrats could shift attention to issues like North Korea and China. China's military restructuring and its recent  space experiments  are perfect fodder for Democratic presidential hopefuls seeking to point out the failures of a presidency that, it will be argued, has gotten the United States tied down in an interminable war in Iraq and missed the "real" threats on the horizon, such as China.  

That concern by itself would be manageable for Beijing. After all, the regime has balanced competing pressures from the United States before. The political shift and cycles in Washington could complicate matters at the CPC Congress and the NPC session next year (where a new vice president is likely to be named), but this does not constitute a crisis. However, if Taiwan generates significant pressure this year as well, the U.S. Congress could compound that pressure by giving tacit or overt support to the island's moves toward independence.  

Taiwan: Chen Presses Ahead  

This is Chen's final full year in office. Presidential elections are scheduled for March 2008, and Chen, having already served two terms, will not be eligible to run again. China sees Chen -- a member of the Democratic Progressive Party (DPP) (the "pro-independence" party in Taiwan) -- as an ideologue; someone who will do everything in his power (and maybe a little beyond his power, as constitutional amendments in 2005 demonstrated) to bring about Taiwanese independence. And his time is running out.  

Chen already has spearheaded one round of constitutional revisions in Taiwan, having added the right of referendum to the document in 2005. That is something Beijing fears will pave the way for a popular vote on independence in Taiwan. Chen also has pushed for use of the name "Taiwan" to be used on Taiwanese passports, instead of the "Republic of China" nomenclature preferred by Beijing. (The existing terminology pays at least historical homage to the Taiwanese government's original claim to legitimacy as the government of all of China -- and this keeps the "one China" illusion alive).  

At this point, Chen is continuing with moves to create a "Taiwan identity," which ultimately would smooth the path toward independence.First, he is pressing with renewed vigour for Taiwan to gain a seat of its own at the United Nations -- or, at minimum, to have all of the island's positions there officially placed under the name "Taiwan." Both changes would qualify as steps away from the status quo and toward a more formal recognition of Taiwan's sovereignty from mainland China. This, by the way, is both the perception of the leadership in Beijing and the way Chen himself publicly characterizes the measures.  

Chen is also pushing for additional constitutional reform in 2007. Under the changes passed in 2005, any new constitutional reform would need approval both from parliament and, by referendum, from Taiwanese citizens. 

Though there is little concrete thus far in Chen's proposals for additional changes, he has played up one key issue -- redefining the territory of Taiwan. According to Article 4 of the Taiwanese Constitution, "The territory of the Republic of China within its existing national boundaries shall not be altered except by a resolution of the National Assembly." The definition of this territory, however, is interpreted, as per the preamble to the constitution, as the territory of the Republic of China founded by Sun Yat Sen -- a territory that, in the 1936 draft constitution, included mainland China and Mongolia but not Taiwan, which was still a possession of Japan. This legal dilemma has been reviewed by the Taiwanese Supreme Court, which deemed the definition of territory a political concern and refrained from determining exactly what the "existing national boundaries"actually were. 

Now, it is obvious that the current Republic of China/Taiwan territories are limited to Taiwan and a few additional islands; Taipei no longer makes much claim to mainland China or Mongolia. Thus, Chen's attempts to "clarify" the boundary definitions in the constitution signal another step toward a more formal independence, laying the groundwork for recognition of Taiwan as it truly exists. From Beijing's perspective, this would eradicate the last vestiges of a link between the sovereignty of Taiwan and the sovereignty of the People's Republic. 

If Chen is to succeed in his quest for constitutional change, he must move quickly. Parliamentary elections are due in Taiwan in December, and the Kuomintang Party (KMT) and People First Party have recovered from their differences to field a joint set of candidates, who will have the upper hand over Chen's DPP. The opposition parties already have a slight lead in parliament, making any constitutional change difficult at best -- but then, Chen managed to pass reforms against the wishes of the KMT in 2005, and he could pull it off again.  

Self-Generated Pressure: The Olympics 

There is one more element that causes Beijing to view Chen as such a dangerous player in 2007: the Olympics. The Chinese leadership has spent years preparing for the big show, and is doing everything in its power to portray China as a major modern nation. The 2008 Olympics will be a venue for showcasing China's modern and global role, and for sweeping away any lingering stigma from the 1989 Tiananmen Square incident (which still haunts China -- for instance, by restricting its access to the European arms market).

Beijing wants to use the Olympics to bring China more fully into the world political and security sphere. But this near-obsession with the Olympics -- and with fostering a sense of stability to go with it -- is an Achilles' heel for Beijing. During this period, Chen might perceive China as being less decisive or less likely to respond militarily to incremental moves toward Taiwanese independence. As Beijing sees it, Chen will capitalize on China's overwhelming desire to maintain its image and make his move while Beijing's hands are tied. According to the same logic, the new U.S. Congress might signal that it, too, supports -- or at least doesn't oppose -- Chen if he should take action now.  

Beijing's concern about an attempt by Taipei and Washington to exploit the opportunities of 2007 already has begun to play out in Chinese actions -- specifically with the test earlier this month of an anti-satellite system. Chinese leaders could have carried out such a test at a different time in order to avoid stirring trouble.They didn't. They conducted the test and then, initially, simply winked when Washington called them out -- before finally admitting to it outright and asking no forgiveness. A China deeply concerned about maintaining a non-threatening image and smooth relations with Washington in the run-up to the Olympics would not behave in that manner.  

The Implications 

Beijing's choice of actions sends a few very clear messages to Washington and Taipei. First, the regime is signalling that it would be a miscalculation to think the Olympics outweigh China's strategic interests. Beijing wants the Olympics to be a success that substantially alters global opinion of China, but this is not a goal to be achieved at the expense of the state and the party.

Second, it has signalled that Taiwan should not be so quick to rely on U.S. naval intervention if the cross-Strait situation deteriorates rapidly. Knocking out the satellite, combined with moving new J-10 fighters to the Taiwan Strait area and tailing a U.S. carrier strike group with a Chinese submarine last year, constitutes a message to the United States that intervention over Taiwan might not be as easy or painless as it was in 1995-1996. This, then, is supposed to convince Washington that it needs to put a little tighter leash on Chen and control his "separatist tendencies." 

The political and military stakes are high. While the Chinese military demonstrations are certainly impressive, there are those within the U.S. defence and political establishment who argue that countering China is something better done earlier than later, after Beijing has a chance to build up a more substantial and technologically advanced military force. Further, with China facing its own political sensitivities this year -- as the next-generation leadership is selected and economic and social stresses climb -- Beijing is perhaps at a point of maximum vulnerability, particularly with the added economic burden and international image issues related to the Olympics. 

By default or design, 2007 is shaping up to be a very tense year for the China-Taiwan-U.S. relationship.

Subprime subsidence

Dec 13th 2006 | NEW YORK

From The Economist print edition

Parts of America's mortgage market are in turmoil. Some on Wall Street see this as an opportunity. Others are biting their nails

MORTGAGE lending is hardly the raciest business, but it has its moments. “It's a bit like the definition of combat: 59 minutes of boredom followed by a minute of sheer terror,” says Michael Youngblood, an analyst at Friedman, Billings, Ramsey, an investment bank. “And we seem to be going through another one of those minutes now.”

What has set pulses racing is subprime lending—mortgages extended at higher than normal rates to those with weak credit histories. In America, where it is most advanced, this market is under a lot of strain, and so, by extension, is the giant asset-backed securities market that is linked to it. The market for prime mortgages (those extended to higher-quality borrowers) is faring better, though it, too, is showing signs of weakness, exacerbated by cooling house prices. Might these troubles, some wonder, be the canary in the mine, warning of a looming credit crunch as investors, for years free with their money, recoil from risk?

Once a backwater, subprime is now very much in the mainstream. Annual loan originations grew fivefold between 2001 and 2005, to $625 billion, according to Inside Mortgage Finance, a newsletter.

But with rapid growth has come fragility. According to UBS, the rate of subprime-loan delinquencies of 60 days or more stood at around 8% in October, nearly double the rate of a year before. Foreclosures are also around twice as high as they were. Worse, loans are decaying remarkably quickly: the number of borrowers falling behind on payments in the first few months has leapt, to around 4% of the total. This has taken some analysts by surprise. But Anthony Sanders, finance professor at Ohio State University's Fisher College of Business, thinks they should have seen it coming: “With the traditional mortgage market flat, the growth has been in the one area nobody wanted to go into.”

This is already producing casualties. A number of mid-sized mortgage firms have failed in recent weeks. The latest, on December 7th, was Ownit Mortgage Solutions, the 17th-largest subprime lender. Others—such as H&R Block's Option One Mortgage—are for sale, their owners keen to leave the business. Earlier this month, in another bad sign, KeyCorp sold its subprime arm, Champion, for an undisclosed sum thought to be well below the $200m-250m tag analysts had put on it.

These troubles did not come out of the blue. Their origins lie in 2004, when some of the big subprime lenders began to compete hard for market share. By late 2005, this battle had pushed rates for ropy borrowers down to a little over 7%. This led to a boom in new business as thousands scrambled onto the housing ladder.

But the Federal Reserve had already started raising short-term interest rates, flattening the yield curve, the difference between short and long rates. (Since banks borrow short and lend long, their margins are higher when the curve is steep.) When this began eating into lenders' profits, they reacted by pushing subprime rates back up. This time, though, they could not attract the same quality of borrower as before: with the housing market looking vulnerable, only the desperate were willing to borrow at interest rates of over 8%.

The lenders compounded their problems greatly by loosening their underwriting standards in a further attempt to keep business chugging along. Sometimes these were waived altogether. Adding insult to imprudence, they lured borrowers with “alternative” mortgage products, such as “negative amortisation” deals (where payments are so low that the overall debt gets bigger, not smaller) and adjustable-rate products (where teaser rates jump after a couple of years). Mark DiRienz of Moody's, a rating agency, says the “payment shock” was made worse by rules that allowed lenders to go from a low introductory rate straight to one much higher than the prevailing rate.

New subprime lending has tailed off this year as mortgage firms have, belatedly, become fussier about whom they will serve. They say they will plough more resources into vetting applications but, as Mr Youngblood points out, this would raise their costs. There is no easy way out.

Moody's and other debt-raters have cast a worried eye over the market, placing subprime deals on watch for a possible downgrade. Regulators are also twitchy. They have stepped up warnings about slack lending standards.

Nerves are also jangling in the capital markets. These days large numbers of housing loans are moved off banks' books, bundled together as so-called mortgage-backed securities (MBSs) and sold to investors. In theory, this helps the banks to reduce risk, makes money for intermediaries who trade the securities, and allows the investors to pick tranches of debt that match their risk appetite. Thanks to financial alchemy, an MBS made up of low-quality loans can still enjoy a good credit rating.

If too many of the home loans backing the security are toxic, however, investors will feel pain. That is happening now. The ABX Home Equity 06-2 index, whose price reflects the market's view of bonds rated BBB-minus backed by subprime loans made earlier this year, has fallen sharply since mid-November (see chart). Hedge funds and others have been using derivatives to short bonds backed by subprime mortgages.

Dubious mortgages are now a growing share of the mortgage-backed market, so there is scope for more trouble. Of the $1.02 trillion of MBSs issued in the first half of this year, over 40% was linked to subprime loans, up from 6-8% in 2000-03, says CreditSights, a research boutique.

In a sign of how important the MBS market has become to Wall Street's big securities firms, they are playing a lead role in consolidating the subprime business. Since the summer, Morgan Stanley, Merrill Lynch and Bear Stearns have all bought mortgage lenders; Lehman Brothers has acquired several in the past three years.

The point of this “vertical integration” is to feed the banks' securitisation desks, which are hungry for assets that can be profitably turned into fancy instruments: not only MBSs but also so-called collateralised debt obligations, pools of derivatives much loved by hedge funds. Owning your own mortgage originator also means not having to bid against other broker-dealers when housing loans come to market, thus saving money, says Art Frank, a mortgage strategist at Barclays Capital.

Although Wall Street has been taking some subprime lenders under its wing, it has been helping to push others towards bankruptcy. As the market has turned in the past year, the big banks have started scrutinising loans offered up for securitisation far more closely—and are throwing far more than they used to back at the subprime lenders. Moreover, they can force the lenders to repurchase securitised loans if they turn sour in their first few months of life. Merrill Lynch has been on both sides of this tussle: it had a 15% stake in Ownit, the firm that went bust last week.

Subprime's woes do not—yet—amount to a financial crisis. However, there could be more pain ahead, for instance when some $475 billion-worth of adjustable-rate mortgages switch to higher rates next year. And the better-quality bits of the market are also running out of steam. HSBC, the world's third-largest bank, has seen a deterioration across its American mortgage operations. Combined third-quarter profits for the country's nine largest mortgage lenders were $991m, less than half the level for the same period last year.

After years of loose money in financial markets, some observers think the mortgage morass could cause investors to rethink their attitude to other forms of credit risk, such as high-yield bonds. Housing loans are not the only area that has seen a weakening of underwriting standards. Where subprime goes, other businesses may follow.

Are Deal Makers
On Wall Street
Leaking Secrets?

Trading Jumps Before Acquisitions
As Low Surveillance, High Payoff
May Be 'Recipe for Bad Behavior'
By SERENA NG and DENNIS K. BERMAN in New York and KARA SCANNELL in Washington
July 28, 2006; Page C1
WALL STREET JOURNAL

As the boom in corporate takeovers continues, unusual trading in obscure investments or via offshore accounts is raising concerns about insider trading.

Suspicious trading patterns -- including increased activity and well-timed bets -- have cropped up in several companies' securities in advance of news of their involvement in big transactions, suggesting Wall Street's deal-making machine may be leaking confidential information.

The list includes deals both mammoth and modest: the just-announced $21 billion leveraged buyout of hospital operator HCA Inc.; the $1.7 billion buyout of Petco Animal Supplies Inc.; the $2.6 billion sale of Maverick Tube Corp. to Tenaris SA; and Anadarko Petroleum Corp.'s $21 billion offer for both Kerr-McGee Corp. and Western Gas Resources Inc.

Some of the trading is in a corner of the financial markets that hardly existed during past takeover waves, which featured questionable trades mainly in plain-vanilla stocks, bonds and options. In advance of the HCA deal, there was a notable uptick in trading in financial contracts tied to HCA's bonds -- derivatives known as credit-default swaps.

Credit-default swaps are private contracts intended to be insurance policies against a company going bankrupt, but they also allow investors to bet on the likelihood of a bond default and are especially popular with fast-trading hedge funds that cater to wealthy clients and institutional investors. The more likely a company is to default, the more expensive its credit-default swaps become. When a company is bought in a leveraged buyout, as is happening with HCA, it assumes dramatically more debt, increasing the likelihood of a default.

In the five days before news of a potential HCA deal was disclosed in The Wall Street Journal on July 19, the price of HCA's credit-default swaps rose 11%, according to data from Markit Group. The market was effectively betting that the likelihood of an HCA default was rising at a time when prices more broadly in that market were rising just 4%, as measured by a Dow Jones index for these instruments. Triad Hospitals Inc., whose contracts usually move in tandem with HCA, declined 2% during the same period, Markit data show. The difference was starker in the six weeks leading up to the news. HCA swaps rose 31% in price, while a broad market index rose 10%, and Triad rose 11%.

After HCA reached a deal with its private-equity sponsors, prices of its credit-default swaps rose more than 60% and its bonds dived in value.

A surge of trading in stock options tied to HCA stock in advance of news of the deal has attracted the attention of the Securities and Exchange Commission. On July 14, options traders bought and sold 10,322 options contracts, which gave buyers the right to purchase HCA stock at a fixed price in the future. By comparison, the average daily volume in call options during June was 1,142 contracts, according to data from Options Clearing Corp.

SEC officials say insider-trading enforcement actions have stayed relatively consistent in recent years. Since Oct. 1, 2005, the agency has brought 40 such cases; it had 42 such cases in fiscal 2004 and 52 in fiscal 2002.

But that could change as the takeover boom grows. A March study by England's equivalent of the SEC, the Financial Services Authority, found suspicious stock-price movements prior to 29% of the merger announcements it studied between 2000 and 2004. The study recommended more "visible enforcement action."

"Definitely something is going on. In the last few years, with all these hedge funds, there's probably a lot more leakage," says Narayanan Jayaraman, a Georgia Tech University professor.

To be sure, rumors are the markets' oxygen, and it can be difficult for regulators to prove the distinction between an ill-gotten piece of information and long-churning speculation that just happens to be true.

 
The merger market is changing in ways that have increased the possibility of leaks and the opportunities for players involved to profit from them before they are public. Deals are taking longer to play out and involve more deal makers. During the 1980s and 1990s, merger deals typically took a few weeks to consummate. In 1996, WorldCom Inc. spent two weeks from its first takeover discussion to seal its $12 billion deal for MFS Communications Inc. But boards have since grown wary of quick deals, demanding more methodical study. Discussions of a takeover of HCA began back in April.

"Clearly, the length and size of the deals seems to require more time, which of course increases potential leakage," says Cam Funkhouser, senior vice president of market regulation at the National Association of Securities Dealers.

The increasing use of lots of borrowed money to acquire companies in leveraged buyouts creates more leak potential. As the deals grow larger, more money, and thus more bankers and lawyers, are coming in "under the tent," in Wall Street parlance. In HCA's $21 billion transaction, announced Monday, six financial firms -- Bank of America Corp., Citigroup Inc., Credit Suisse Group, J.P. Morgan Chase & Co., Merrill Lynch & Co. and Morgan Stanley -- and at least seven law firms were involved.

Banks and law firms typically are required to submit to market regulators the names of people who worked on a given transaction. The HCA list is 40 pages long, a person familiar with the matter says.

Though using offshore accounts for illegal trading is nothing new, technology is making such trading easier. "There appears to have been an increase in illegal insider-trading activity taking place outside the United States in U.S.-traded securities," said Randall Lee, director of the SEC's Pacific Regional Office. "With advances in technology and the increasing globalization we're seeing people engage in insider trading anywhere."

In the case of Tenaris's acquisition of Maverick Tube, the SEC said in a complaint filed in federal court in Chicago that several individuals used accounts in Buenos Aires to make more than $1.1 million in profits from purchases of U.S. shares and call options of the latter company. Tenaris is an oil-and-gas pipeline supplier owned by an Argentinean conglomerate; Maverick Tube is based in Chesterfield, Mo.

In the Petco case, the SEC this month asked a federal judge to freeze $862,000 of profits in offshore funds used to trade Petco options in advance of its sale to a private-equity group -- even though regulators didn't identify the traders.

The SEC used a similar tack last November when it obtained an emergency asset freeze against "unknown purchasers" of call options in Placer Dome Inc. stock, a few days before Barrick Gold Corp. made an offer to buy Placer. At least 5,000 of the options were under water and set to expire at the time of the purchase, the SEC alleged. The SEC estimated the buyers used overseas accounts to make improper gains totaling more than $1.9 million. Petco didn't return a call for comment.

The rise of derivatives markets -- less closely regulated than stock and bond trading -- also creates new opportunities for insider trading. Regulators in the U.S. and the United Kingdom recently have been studying credit-default swap prices, but it isn't clear whether that is a prelude to a formal investigation.

Trading in credit-default swaps takes place away from formal exchanges. Banks, hedge funds, money managers and other institutions enter into contracts directly with each other and trade them in the so-called over-the-counter market.

"You're talking about a very large and unregulated market which makes it hard to identify malfeasance or to ensure that people are abiding by the rules," said Chris Dialynas, a portfolio manager at bond behemoth Pacific Investment Management Co., or Pimco, a unit of Allianz AG. "The surveillance is low and the payoff is high -- that's a recipe for bad behavior."

Mr. Dialynas added that there aren't policing mechanisms or specific penalty systems in place for parties that trade credit derivatives using inside information. However, lawyers say that the SEC can probably find a way to bring cases against people or firms who buy and sell credit protection using inside information if it can be shown that fraud was involved in the transactions.

A few years back, four trade associations associated with debt markets jointly released a set of guidelines for banks with access to inside information about corporate borrowing plans.

"There's still lingering concern out there, but it's obvious to us that the large financial institutions have put in place internal barriers to prevent information from being shared across their divisions," says Kimberly Summe, general counsel for the International Swaps and Derivatives Association, one of the groups behind the guidelines.

In late 2002, the manager of Marshall Wace LLP, a large London hedge-fund firm, received two important phone calls from an investment bank that was about to unveil a client's offering of securities.

Such an offering would be of keen interest to investors. It could be expected to hurt the stock of the issuing company, French telecom giant Alcatel SA. That's because the securities could dilute existing shareholders' stakes.

 
A call from an underwriter before an offering isn't a heads-up the average investor can expect, but hedge funds can. The private investment pools control so much cash -- some $1.2 trillion -- and trade so heavily that they can account for up to half of the daily volume on the New York and London stock exchanges. That makes them big sources of commissions for securities firms. The firms, in turn, court the funds by feeding them steady streams of trading ideas and information about stocks, bonds and what other financial-market participants are up to.

For regulators, this constant flow of information stirs concerns about unfair advantages -- or worse, possible illegal insider trading. And in the Alcatel case, investigators for a French securities regulator have asserted that Marshall Wace ordered a big sale of Alcatel shares about two minutes before the unveiling of the new securities offering. After the unveiling, the share price fell steeply.

Marshall Wace and three other hedge-fund firms "used privileged information to make substantial capital gains with certainty," said France's Autorité des Marchés Financiers, known as the AMF, in a preliminary, unpublished report 19 months ago reviewed by The Wall Street Journal.

Marshall Wace strongly denies that it traded on nonpublic information. It didn't sell until after the announcement of an Alcatel securities offering, Marshall Wace said, and a lawyer for the firm said this was supported by counterparties to the trades. The other hedge-fund firms the AMF cited, all London based, are Ferox Capital Management, GLG Partners LP and Meditor Capital Management. All declined to comment.

There have been other recent probes, as well, of whether hedge funds have misused inside information. Britain's Financial Services Authority, or FSA, has notified GLG and a star trader there of plans to fine them a total of $2.61 million for alleged improper February 2003 trading in Sumitomo Mitsui Financial Group. GLG declined to comment. The trader is appealing the decision.

"We have become increasingly concerned by the risks generated by institutions exploiting the information they legitimately receive for illegitimate purposes," Hector Sants, a managing director of the FSA, said in a speech last month, speaking generally. "We are now considering what enforcement action might be necessary in cases where there does appear to have been misuse of information."

In an earlier speech last year, Mr. Sants said that some hedge funds were "testing the boundaries of acceptable practice concerning insider trading and market manipulation." He added, according to a transcript: "It may not be simply a question of considering whether hedge-fund managers act inappropriately, but also whether their models (including the high commissions they generate and their trading methodology) may create incentives for others to commit market abuse."

Securities firms profit from hedge funds in more than one way. First, the commissions the funds pay are disproportionately large because the funds magnify their bets with borrowed money and rapidly turn over their holdings. Securities firms also provide various exotic investment products to the funds and lend them shares to sell short when they want to bet against a stock. "It's possible that hedge funds generate more than 50% of total revenues for some of the major brokerage houses," says a report soon to be released by Greenwich Associates, a consulting firm in Greenwich, Conn.

Regardless of the outcome of the investigation into trading in Alcatel shares, Marshall Wace's investment strategy illustrates the sort of symbiotic relationships between hedge funds and securities firms that concerns regulators. Marshall Wace has honed to a science the harvesting of trading ideas from securities firms -- recommendations such as to buy stock X or sell stock Y. It carefully assesses their marketplace value and links its commission business to this.

 
Marshall Wace manages $7 billion, in three hedge funds. The firm was set up nine years ago by Paul Marshall, a money manager, and Ian Wace, a brokerage-firm trader. Mr. Wace, an intense 43-year-old who never graduated from college, largely holds the investing reins. He often operates in cramped quarters among traders with just an ashtray marking his space.

At first, Marshall Wace proceeded much as many other hedge funds do: making bullish stock bets sometimes offset by bearish ones. But by 2001 the firm was finding it hard to unearth enough good investments, and returned some of investors' money to them.

Like other big funds, Marshall Wace received a steady flow of trading ideas from brokers that wanted its business. Mr. Wace hit on the notion of precisely tracking how well the ideas panned out. At his behest, a summer employee, Anthony Clake, now an executive at the firm, developed a computer model to do this.

Marshall Wace calls this strategy TOPS, for Trade Optimized Portfolio System. (It was TIPS at first, but the firm feared this might sound suspicious, said one person at the firm.) The program draws 800 to 900 ideas a day in London, according to a Marshall Wace executive. He said that globally, TOPS elicited about 500,000 trading ideas last year from 246 securities firms, including 2,200 individuals at those firms.

Stock salesmen at securities firms are asked to submit ideas and rate their degree of conviction about each one. They're asked to suggest how to allocate capital among the ideas. "All TOPS is a Hoover," said Mr. Wace. "It sucks in great quantities of ideas and tries to sieve out what is interesting."

Marshall Wace gives securities firms regular reviews showing how much profit their ideas generated and where they stand in its rankings, brokers said. It then directs most of its copious commissions to those whose ideas helped it most.

This setup gives the firms and their employees strong incentives to provide ideas that will pay off -- particularly since Marshall Wace trades so heavily. Brokers estimate Marshall Wace paid more than $250 million in commissions in both 2004 and 2005. It accounts for 2% to 3% of volume on European exchanges, a spokesman for Marshall Wace says. In 2002, Marshall Wace traded $15 billion face value of securities through Goldman Sachs Group Inc. alone, said a person familiar with the matter. Marshall Wace and Goldman wouldn't comment.

 
Some securities firms have internally debated whether they should participate in TOPS. At Morgan Stanley, senior stock executives and lawyers last year discussed whether the program could put the firm at risk of violating certain regulatory rules, according to a participant in the meeting and another person briefed on it. They said Morgan Stanley also was concerned about making sure that orders placed by its other clients stayed confidential and didn't get whispered to Marshall Wace in exchange for its fat commissions. Traders at the firm say it has continued to participate in Marshall Wace's system.

Marshall Wace is aware of the regulatory minefield. In an internal document for a broker presentation two years ago, it spelled out its policies in a section called "Trade Ideas that Raise Cautionary Flags." The document said Marshall Wace wouldn't trade on brokerage firms' investment research and ratings changes before these become publicly available. It also wouldn't use trading ideas that were based on confidential orders from securities firms' other clients.

What about information that is based on private conversations or meetings with companies? "Maybe, if already in public domain," said the document.

How about information about significant corporate events that are imminent but not yet disclosed? "Maybe, if based on independent research," it said.

Marshall Wace says its system, far from raising the danger of trading on nonpublic information, actually reduces that risk. After all, the program generates "a full audit trail of all idea flow received," Mr. Wace said through a spokesman. As a result, he said, the system amounts to "a substantial improvement in the compliance procedures."

Marshall Wace "has access to the same information as every other fund-management firm," Mr. Wace said. "It is just that we have designed a process to collect more of it, more efficiently, and collate, measure and implement any part of it more effectively."

Nonetheless, French regulator AMF in late 2004 pointed to what it considered possible use of nonpublic information by Marshall Wace at the time of the Alcatel issuance of new securities. The AMF's preliminary report was a notice to recipients that action might be taken against them.

It described a December 2002 phone call to Mr. Wace from Philippe Guez, then an official responsible for trading in French and Spanish shares at Deutsche Bank AG. The two had once been Deutsche Bank colleagues.

The report said Mr. Guez called to gauge Mr. Wace's appetite for investing in a possible issuance of new securities by Alcatel. The report said Mr. Guez then told Mr. Wace that their conversation meant Mr. Wace now had inside information and thus was barred from trading in Alcatel before any announcement of an offering of Alcatel securities. Such calls by an underwriter -- Deutsche Bank's role vis-à-vis Alcatel -- are a legitimate technique known as "testing the market." It helps underwriters determine the proper size and shape of a securities offering and how to price it.

Mr. Wace doesn't dispute this part of the AMF's account of events, said a Marshall Wace executive. Mr. Guez declined to comment.

The AMF report said the call to Mr. Wace was on the evening of Dec. 11, 2002, or the next morning, Dec. 12. Late in the afternoon of Dec. 12 came an announcement that Alcatel would offer between $640 million and $835 million of bonds convertible into new Alcatel stock. Sometime close to this announcement -- the exact timing is at issue -- Mr. Wace ordered a sale of 2.2 million Alcatel shares.

The AMF report said Mr. Wace told the agency that he placed sell orders at "the instant of the announcement." The AMF report, however, contended that he did so about two minutes earlier, after receiving a second call from Deutsche Bank. The AMF report said that a bank official named David Maslen made this second call, from a cellphone, and that Mr. Maslen confirmed he'd spoken to Mr. Wace.

According to the AMF report, Mr. Wace placed sell orders for 400,000 Alcatel shares each with J.P. Morgan Chase & Co., Credit Suisse Group and the Banc of America Securities unit of Bank of America Corp., and ordered a million-share sale through Goldman Sachs.

The announcement of an Alcatel convertible-bond offering came at 5:14 p.m. Paris time that day. J.P. Morgan placed the sell order from Marshall Wace at 5:12 p.m., said the AMF report. This was the same time as the report said Mr. Maslen called Mr. Wace -- and a crucial two minutes before the bond announcement.

The AMF report said Marshall Wace had "provided time dating of orders that was not in accordance with the reality of making the orders." It added that, "having been in a position of privileged information, Mr. Wace made a decision to make four orders simultaneously expecting that the issue would be publicly announced." The AMF drew up its report in November 2004.

 
Ian Wace in a video of a London charity event.
According to a Marshall Wace filing to the U.S. Securities and Exchange Commission, J.P. Morgan "subsequently discovered [the 5:12 order time] to be incorrect and have written to the AMF to correct this. They have confirmed that the order in question was passed after the announcement of the bond transaction and apologised for the incorrect submission, which they believe is due to unsynchronised time clocks on different front office systems."

Time-stamping of trades often is inexact, traders say. Trade times aren't always clocked instantly, especially those put in manually, as many were in 2002, said Mark Edwards, a trading specialist at Investment Technology Group, a brokerage firm in Los Angeles. Moreover, many hedge-fund traders say they first phone in orders and agree on price, and only later do parties to a deal get around to time-stamping the orders.

Marshall Wace maintains it didn't jump the gun on any of the trades. They "were only placed by [Marshall Wace] after the announcement by Alcatel S.A. of the convertible bond issue," and Marshall Wace "has received confirmation of this fact from all the counterparties concerned," said a statement from Schillings, a London law firm representing Marshall Wace. The firm added that it's Marshall Wace's understanding that the counterparties have provided this information to the AMF.

Goldman Sachs has told Marshall Wace it didn't receive the sell order until the bond announcement, according to a person familiar with the situation. Banc of America Securities and Credit Suisse declined to comment.

Alcatel shares, already declining for a few minutes before the bond announcement, slid still more afterward. They fell 15.6% in the final 16 minutes of trading in Paris after the announcement, the AMF report said. It added that Marshall Wace made a profit of about $672,000 on its trades. In all, the report said, the four hedge-fund firms made $2.6 million to $3.5 million on trades the report alleged were done using privileged information.

Marshall Wace invested heavily in the Alcatel convertible bonds, buying about $127 million of the offering, said an executive of the hedge-fund firm.

Following French procedure, the AMF has referred its allegations to a prosecutor and named one of its own officials to oversee the matter. This official will eventually present the AMF's findings in another report, to be followed by a hearing before a sanctions commission. If the commission calls for penalties against the hedge-fund firms, they can seek a review by the Paris Appeals Court.

As for Deutsche Bank, the bond underwriter whose employees called Mr. Wace before the offering, the AMF said: "This ongoing sanction case involves Deutsche Bank as well as various hedge funds." Although sounding out potential buyers before an offering is legitimate, the AMF report said Deutsche Bank had failed to "observe the requirements relating to testing the market," and said "this investigation was made difficult by the uncooperative attitude of Deutsche Bank."

Some securities lawyers said that while Deutsche Bank's first call to Marshall Wace would have been a justifiable testing of the appetite for Alcatel bonds, the second one -- just minutes before the announcement -- would lack this purpose and thus could be problematic. Deutsche Bank declined to comment.

      米皮用当地出产的一种籼米制成。制作工序包括泡米、磨浆和蒸制，然后师傅当着顾客的面，用一把几十斤重的大刀切成细条，拌上特制的辣椒油（叫“油泼子”）、醋和盐，加上黄瓜丝和豆芽，一碗碗看来红通通、吃来“筋、薄、细、软”、凉爽可口的米皮就可以上桌了。米皮通常凉食，所以也叫凉皮。关中一带还有一种用小麦制成的面皮，与米皮合起来统称凉皮。

      讲起来，米皮颇有来历。相传秦始皇在位时，有一年大旱，秦镇稻田多出稗秕，农人无法完成粮食进贡任务。当地一位叫李十二的农民，将打下的稻米用水拌湿，碾成米粉，和成糊状蒸熟，切成条状，制成了最早的米皮上贡，始皇帝大喜，钦定秦镇米皮为朝廷贡品。后来，每年正月二十三，秦镇家家户户蒸米皮，纪念李十二。制作米皮的习俗与技艺由此世代相传，成了陕西地方一道历史知名小吃。

      我自己家乡是没有凉皮的。后来下山下乡在白山黑水之间，也不知凉皮为何物。第一次吃凉皮是80年代一次到西安开会，发现现在的同事宋国青教授，宁可放弃会议伙食也要到街上吃凉皮。跟着他蹲在街边吃了一碗，从此知道何为凉皮,到任何地方逢有凉皮再不选其他。三周前在西安，满街市面皮米皮应有尽有，可是久仰秦镇大名，临走看时间还够，打车直奔秦镇去也。说来不好意思，几十分钟车程奔波（因为修路），刚一碗米皮下肚就饱了。不甘心，又动员开车师傅与我分食一碗。

      饭后在镇上走走，看那些小吃店的招牌。写“百年老字号”的很多，是不应该奇怪的——从秦始皇时代就开始的手艺，就是经营了百年还是非常年轻。可是至少不下10家都打出“薛家老店”的旗号，就不明白究竟哪家才是真的。“闻香下马、知味停车”很传神，前句讲历史，后句说现在。最欣赏的是：“宁愿一人吃千次，不愿千人吃一次”，摆明古朴的关中人现在追求的是长期商业利益。“特制米皮”很平实，“米皮世家”有味道，“皮霸子”略为张扬，“秦镇米皮研究中心”就不免过于隆重其事。行来看去，意外发现了一个大名堂。

      原来这里的小吃店，家家的招牌上都有“传授技术”四个字。想起店主送给我的名片，拿出来看，背面印有“想学米皮操作技术人员的理想之家”字样。走回去请教，到底怎样“传授技术”？店主说，谁来都行，每个学员交费500元，我们管吃管住，一星期包教包会米皮制作的全套技术。“要是一周学不会呢”？“继续学，不加费用”。我问学员多不多？“多，每批5－6个，几乎不断。全国各地都有来的”。为了加深我的印象，店主拿出好几张学员结业照，点着说明他们分别是内蒙的，新疆的，贵州的。“你看这个，他回大庆开了一个米皮店，比我们店大多了”！我又问搞技术传授多少年了？店主答，十多年了。谁发明的？说不好，反正家家都这样搞。

      就是说，秦镇的米皮生意，既卖米皮，也卖米皮制作技术。骤眼看去，是一个奇怪现象。常见的餐饮买卖，为自家招工收徒是有的，招来的徒工学得技术后跑掉，甚至另起炉灶，也是有的。但像秦镇米皮这样，家家大张旗鼓出售制作技术，完全不在乎“商业秘密”流失，不免过于夸张了吧？从道理上问，卖家掌握的技术秘诀，有极大的商业价值，为什么秘笈而不自珍？仅收一笔小钱，不但公开传授，且“包教包会”？难道不怕影响产品销售？不怕制造出竞争对手？古老相传的“保护知识产权”的意识，比如“教会徒弟、饿死师傅”，又比如“传儿不传女”之类，怎么突然就不管用了？

      想、想、想，我在秦镇街上想到了三点，觉得可以拿出来向读者报告。第一点容易，秦镇米皮的制作秘诀，为当地居民共同掌握，你不授人别人也可能“泄密”，不比美国可口可乐的配方，知识资产的专属性高，保守容易。第二点困难，但因为身在秦镇，有直接的观察，被我想到了——米皮制作技术虽然可以包教，但“秦镇米皮”的特殊味道并不容易掌握。否则，怎样解释西安城里那么多凉皮，可是人们还非要跑到秦镇来食米皮？这就是说，技术可以教授，但“know-how”（诀窍）绝不易学。由此学得技术、未掌握诀窍者，还是无法与秦镇人竞争。最后一点最重要，市场绝对够大，五湖四海跑来学制米皮的，有的是机会开辟出一个自己的新市场。只要“买家”足够多，“技术贸易”可也。

       合并上述三点，米皮的“产品交易”与“技术交易”，就可以合乎逻辑地相安无事了。是的，包教外人技术并不妨碍店家出售米皮。络绎不绝的求学人口来到镇上，还增加了秦镇米皮的需求量——“包吃”者，米皮管够是也。反过来，外传技术可得一笔追加的收入。以我光顾的那家为例，每天平均卖200碗，进帐300元；5个学员在店，每天摊得的“学费”差不多就是500元。打个折扣算，传技术比单纯卖米皮，收入倍增。你当然可以拒绝外传技术，但只要你的邻居传授，你争他不赢。

      难怪现在凡人口积聚到一定密集程度的地方，可享受的传统地方小吃就有如此之多！“兰州拉面”、“过桥米线”、“沙县小吃”、“土家火烧”，应有尽有，甚至还有“印度飞饼”。从来没有看到谁下达全国推广计划，但是不知不觉之间，老百姓用很低的价钱，就可以享受各地历史知名小吃。反省起来，这早就是一个应该追问的经济现象。举一反三，“保护知识产权”原来有多条路线可走。自发市场选择里面的学问，世人千万不可轻看。